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Exploiting Game Theory for Profit in the Stock Market

Game theory is a way of addressing situations in which the outcome of a person’s decisions depends not only on his own choices, but also on the actions of other people he interacts with. In this article, Professor Aaron Brown expounds upon how a savvy trader can use game theory to make a profit in the stock market. He references “risk arbitrage,” as an example of how this economic theory can help people make money in real life. Risk arbitrage is a relatively low risk strategy of turning a profit by carefully analyzing the market situation through the lens of a constantly changing environment in which one must predict the actions of other players in order to figure out the best strategy for himself. One way to do so is to analyze historical data of past trades.

Professor Brown emphasizes the importance of identifying the major players in any trade. One should first identify company A and B’s management, board of trustees, shareholders etc and try to analyze each of their goals for the trade and what actions they would most prefer to partake in. A savvy trader should next establish the payoff function for each action by each party. He must also take into account what information is available to which parties in the trade. Keeping track of what other alliances and side payoffs may be in play can also help one pick up on what each player’s preferred action may be. The author suggests that one should never rely on pure game theory strategies when investing in the stock market, but rather should temper game theory strategy predictions with statistical analysis.

This article directly applies the concept of game theory to a prudent real life application. The stock market has a fluid environment in which actions taken by each participant has the potential to make waves and affect even distantly related actions. Something like the stock market crash in 1930 had such an intense effect on society that it pulled our whole economy into depression. Likewise, the actions of investment bankers on Wall Street have helped lead to the current recession we are now experiencing. As such, actions taken in the stock market can have far reaching consequences. In order to successfully play in the stock market, one must also understand what sort of effects the actions of each entity might have on the rest of the market, as well as the economy as a whole. Only by understanding and being able to predict the motivations and actions of others can one exploit this knowledge to turn a profit himself.

The concepts we learned in class about figuring out the dominant or mixed strategies can be directly applied to trading in the stock market. A trader can use game theory calculations to determine the favored actions of a target company as well as the probabilities with which they may play that strategy and adjust one’s own actions in accordance to maximize one’s profit. The stock market is a constantly adapting assortment of strategies, actions and counter actions that all adhere to the policies of game theory. The tangled webs between companies and shareholders intertwine to create a great many shining examples of game theory, risk and strategy in action.




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September 2012