Beat the Market - Ed Thorp

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    Other books by EDWARD O. THORP

    Elementary Probability

    Beat the Dealer

    Other books by SHEEN T. KASSOUF

    Evaluation of Convertible Securities

    A Theory and an Econometric Model

    for Common Stock Purchase Warrants

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    BEAT THE MARKET

    A scientific Stock Market System

    Random House New York

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    A Scientific Stock Market System

    Edward O. Thorp, Ph.D.Professor of Mathematics University of California at Irvine

    Sheen T. Kassouf, Ph.D.Assistant Professor of Economics University of California at Irvine

    BEATTHE MARKET

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    9 8 7

    Copyright, 1967, by E. O. Thorp and S. T. Kassouf

    All rights reserved under Internationaland Pan-American Copyright Conventions.

    Published in New York by Random House, Inc.,

    and simultaneously in Toronto, Canada,

    by Random House of Canada Limited.

    Library of Congress Catalog Card Number: 67:22624

    Manufactured in the United States of America

    Designed by Betty Anderson

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    Contents

    INTRODUCTION 3

    Chapter

    1 A SYSTEM IS BORN 7

    First venture into the market. The market calls: boardrooms andchartists. The circus. Fundamentals: the better they are, the

    faster they fall. Textron and Molybdenum. The moment of discov-ery. Steady profits in bust and boom.

    2 WARRANTS: OPTIONS ON THE FUTURE 15

    Rediscovery of the system: Ed Thorp under a tree. What is a

    warrant? Get rich quick? The warrant-stock diagram. The twobasic rules relating warrant prices to stock prices. Adjusted warrantsand adjusted exercise price. Reading the financial pages. Checkingthe two rules. The warrant-stock law: predictability in the stockmarket.

    3 SHORT SELLING: PROFITS IN BAD TIMES 33

    Short selling. Selling warrants short. Molybdenum warrants andthe avalanche effect.

    4 THE BASIC SYSTEM 43Hedging: high profit with low risk. Changing the mix. Deeperinsight into the basic system. The basic system: preview. An in-credible meeting.

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    5 THE SYSTEM IN ACTION: $100,000 DOUBLES 51

    The Molybdenum story. Moly coda. Bunker-Ramo (Teleregister).Catskill conference: Sperry Rand.

    6 HOW TO USE THE BASIC SYSTEM 71

    Identifying the listed warrants. Picking short-sale candidates. Using

    the warrant-stock diagram. Which are best? Choosing the mix. Howmuch protection: Dividing your capital among the candidates. Final

    points. Summary of the basic system.

    7 FURTHER PROOF: THE HISTORICAL RECORD 91

    A simplified mechanical strategy. The potential future for the basicsystem. Performance through the 1929 crash.

    8 MORE ON WARRANTS AND HEDGING 103

    Over-the-counter, regional, and Canadian warrants. What determineswarrant prices? What is a warrant worth? Reverse hedging. Spottingcandidates for reverse hedging.

    9 CAN ANYTHING GO WRONG? 127

    Short squeezes. 1929 again? Volatile price movements. Extension ofwarrant privileges. Banning of short sales. Extensive use of the basicsystem.

    10 THE GENERAL SYSTEM: THE EVALUATION OF

    CONVERTIBLE SECURITIES 141Scope of convertibles. Convertible bonds. Anatomy of a convertiblebond. Reverse hedging with Collins Radio warrants. Picking con-vertible bond situations. Best candidates for reverse hedging. Basicsystem with latent warrants. The basic system with Dresser In-dustries warrants. Finding the best basic-system hedges withconvertible bonds. Convertible preferred stocks. Call options. Puts,calls, and the basic system.

    11 DECIPHERING YOUR MONTHLY STATEMENT 169Your brokerage account. The cash account. The margin account.The short account. Calculations in a mixed account. Applicabilityto the basic system.

    12 PORTFOLIO MANAGEMENT 181

    Exploiting a rise in the price of the common. Exploiting a declinein the price of the common. Diversification? Having several ac-counts. Long-term gains.

    vi Contents

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    13 WHY WE ARE SHARING THE SECRET 189They wouldnt believe us. I want to do it myself. The threat ofrediscovery.

    14 WHAT THE FUTURE HOLDS 195How much can be invested in the basic system? How much can beinvested by the entire system? A general solution for the stockmarket.

    APPENDIX

    A Mathematics of the avalanche effect. 199

    B Over-the-counter and Canadian warrants. 200

    C Scientific proof that hedging can offer high expected return. 200

    D The prediction of warrant prices. 201

    E Basic-system hedge performance, 1946-1966. 204

    REFERENCES 209

    INDEX 213

    Contents vii

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    BEAT THE MARKET

    A scientific Stock Market System

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    troduction

    We present here a method by which investors can consistently make large profits. We h

    sed this method in the market for the past five years to earn 25% a year. We have made p

    s during two of the sharpest stock market drops of this century; we have made profits w

    e stock market soared; and we have also made profits in stationary and churning mark

    We have used mathematics, * economics, and electronic computers to prove and

    ct our theory. After reading dozens of books, investigating advisory services and mu

    nds, and trying and rejecting scores of systems, we believe that ours is the first scien

    ally proven method for consistent stock market profits.

    This book analyzes convertible securities and their associated common stock. Th

    curities are now held in the portfolios of several million investors. More than 300 of

    500 securities traded on the New York and American stock exchanges are convertibles.

    ethods apply to these convertibles jointly with their more than 200 associated com

    ocks. (We emphasize

    * Some of the research which made this book possible is based in part upon mathematical rese

    pported in part by Air Force grant AF-AFOSR 1113-66.

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    at our profits generally come from both the common stock and the convertibles.) The

    f over 500 securities is about 15% of all the securities listed and has a market value of

    aps $50 billion.

    We predict and analyze the price relationships which exist between convertible sec

    es (warrants, convertible bonds, convertible preferreds, puts, and calls) and their com

    ock. This allows us to forecast future price relationships and profits. We do not need to

    ct prices of individual securities in order to win.

    The minimum amount required to operate the system is determined by the am

    quired to open a margin account. This amount is subject to change. As we write,

    2,000. Our method does not require you to invest all your funds in it, though we expect m

    aders will wish to do so. It is natural, for instance, to begin with a trial investment, incr

    g it as you gain skill, confidence, and success. If the total equity in your brokerage acc

    at least $2,000, then you are free to invest any portion of it by our system, ranging fro

    w dollars to the total amount.

    We begin the book by telling how we discovered the system. Then, as needed b

    round, we discuss warrants, short selling, and hedging. In the fifth chapter we illustrate

    ystem with investments made by one of the authors over a five-year period. The sixth c

    r shows the reader how to select his own investments with that part of our method we

    e basic system. Next we present the historical performance of the basic system, which a

    ged more than 25% a year over a seventeen-year period.When the reader finishes the first nine chapters, he can successfully operate his

    ock market investments. Chapter 10 shows how to extend our analysis to the entire are

    onvertible securities.

    4

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    We conclude by discussing accounting and monthly statements, portfolio managem

    nd the future for our method.

    The scientific proof of the basic system, indicated in the exposition, consists of

    arts:

    (1) We show (Chapter 7) that the basic system gained more that 25% per year

    for seventeen years (after commissions but before taxes). We also show that

    when stocks fell from September 1929 to 1930, the basic system could have

    doubled an investment.

    (2) A statistical analysis, with the aid l basic-system

    opportunities from 1946 to 1966 (Appendix E).

    (3) Our five-year cash record of no losses and an average return of 25% per

    year with the method. One of the authors more than doubled $100,000 in

    just four years (Chapter 5).

    (4) A theoretical argument that convinced colleagues in whom we confided

    (Appendix C).

    The tables and charts in the book make our strategy easier to use. For the intere

    ader, appendixes indicate the technical foundations for our method. this supplemen

    aterial need not be read to successfully employ our winning method.

    We do not claim that you can breeze through this book and then shake the money f

    ees. This book needs to be studied. However, we intendBeat the Marketto be usefulrofitable to the entire investment public, from professionals to beginners.

    5

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