Tuesday, December 05, 2006
Game thoery
What makes a good trader? Is it luck, innate talent, or is plain hard work? The question is an illusive one and perhaps one of the most difficult to answer. There are those who believe that traders are not born and can be made (the turtles for example) and those who believe that a good trader can only be shaped. There is one quality however that all great traders’ posses and that is the ability to clearly articulate their thought process. Almost all traders have a great intuitive sense but only a few can actually translate those thoughts into words. Over the last few years we have learnt and grown as traders. However the time has come now to communicate our thoughts. I will “try” to document experiences and learning’s that I have been through. I hope this process of communicating our thoughts makes us all better traders.
I read somewhere - In the markets there are no mistakes only lessons learnt.
When he conceptualized Nash’s equilibrium, John Forbes Nash didn’t know his principals would be applied across all walks of life. Somewhat similar to decision theory, game theory (based on Nash’s equilibrium) studies decisions that are made in an environment where various players interact. As a trader I have always been fascinated with game theory and have tried very often to apply it to the markets. To explain game theory a little more I will talk about one of the most commonly used examples, prisoner’s dilemma. Prisoners dilemma is a non zero sum game wherein the only concern of each prisoner is to maximize his own payoff.
Let’s take an example. Two prisoners A and B are arrested; the police however do not have sufficient to convict them. The prisoners each are placed in different rooms. The police tell convict A that if he confesses prisoner B will get a 5 year sentence and he (prisoner A) will be let free. Prisoner B is conveyed the same only in his case prisoner A will be convicted. If neither of the two convicts confesses then they both walk away free however if both of them confess then both get 2 years. The only way a prisoner can maximize his payoff is to betray his fellow prisoner, in an ideal world each prisoner would betray his fellow prisoner. However unknowingly each prisoner would get 2 years jail time. If however prisoner A keeps quite he is not sure his fellow prisoner will do the same. Herein lays the prisoners dilemma.
So why and how does “the game theory” apply to the markets?
I read somewhere - In the markets there are no mistakes only lessons learnt.
When he conceptualized Nash’s equilibrium, John Forbes Nash didn’t know his principals would be applied across all walks of life. Somewhat similar to decision theory, game theory (based on Nash’s equilibrium) studies decisions that are made in an environment where various players interact. As a trader I have always been fascinated with game theory and have tried very often to apply it to the markets. To explain game theory a little more I will talk about one of the most commonly used examples, prisoner’s dilemma. Prisoners dilemma is a non zero sum game wherein the only concern of each prisoner is to maximize his own payoff.
Let’s take an example. Two prisoners A and B are arrested; the police however do not have sufficient to convict them. The prisoners each are placed in different rooms. The police tell convict A that if he confesses prisoner B will get a 5 year sentence and he (prisoner A) will be let free. Prisoner B is conveyed the same only in his case prisoner A will be convicted. If neither of the two convicts confesses then they both walk away free however if both of them confess then both get 2 years. The only way a prisoner can maximize his payoff is to betray his fellow prisoner, in an ideal world each prisoner would betray his fellow prisoner. However unknowingly each prisoner would get 2 years jail time. If however prisoner A keeps quite he is not sure his fellow prisoner will do the same. Herein lays the prisoners dilemma.
So why and how does “the game theory” apply to the markets?
# posted by Gyp Trader : 10:34 AM
