In This Episode
- The role of interpersonal awareness
- How to see what traders are doing
- Probabilities and why you need to know them
- Open position ratios
How to Think About Game Theory
There can be misconceptions when it comes to how game theory should be used in trading. In this episode, we talk about the different facets of game theory and how they relate to successful trading.
One of the key elements in game theory is knowing the other players and what they are doing. Walter talks about indicators that you can look at to understand what traders are doing.
Another thing that traders should understand is the statistics behind their strategy and their current trading results. Many traders don't truly understand statistics, and could gain a significant advantage by tracking key metrics.
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Read the Transcript
Hugh: Hi, Walter. What do you know about game theory and how it applies to trading?
Walter: Okay. So this is really interesting. Actually, I will put a link in the show notes to some people who want to see this because there is a good example of this. I think you can play along with it. I won't go down that rabbit hole. I will let you guys click on the show notes and go down that one.
The way I think of it is because I have read some books on it that are really complex. I kind of think of game theory, maybe differently than most in two ways. I think of it as a probability. So in terms of probabilistic thinking which is really good for traders, obviously. And then the other side of it is like perception and awareness of what other people are thinking.
So kind of like if you are in a situation where you are at a party and you are talking to some people. You'll notice some people aren't very perceptive of what other people are thinking. Maybe they just go on and on. Keep talking about themselves and everyone else is just sitting there going, “Oh, my god!”
The person does not realize that they are turning everyone off by sitting there and just rabbiting on about themselves. That is a person that has low interpersonal intelligence, we would say.
With game theory, I think part of it is being aware of what the other participants in the game are doing. So poker is a great example of this. If you bluff or you think someone else might be bluffing, you are trying to figure out what is going on.
That is one element of game theory. Which is sort of almost like psychology and interpersonal relations, and understanding that. In trading, it could be looking at where all the orders are. So you can look on websites and brokers will show you where all the buy orders are. Where all the sell orders are.
Same thing with open position ratio. You can see what the crowd is doing. Are most traders buying or selling? Or, what is going on? So that is one element as I have seen it of game theory. I really love the open position ratios. If you guys are interested in that. I have got plenty of videos on YouTube all about that stuff.
I can put those in the link down there if you guys want to go down that rabbit hole. I do not want to get into that right now but that is part of it. Understanding what the other participants are doing. Where the order placements are and where the open position ratios are at, is really important in that sense. The other side of it is probabilities.
It is really fascinating to me that a lot of traders do not understand it. So probabilities come into a lot of places. Probabilities come in when you are trying to decide: Is my trading system in a draw down? That is normal or not normal. Another one is: Is my reward to risk ratio sufficient to make profit given my win rate? That is another thing.
So all of these elements of probabilities are very important. For example, let's say you like to trade trendy kangaroo tails. Which is just a pullback after the market's been going up and it pulls. Let's say, it is going up or down. Either way it goes up after the market and it is a signal that says the pullback is over.
Now let's say, you like trading those. You've back tested them and you get a certain win percentage. It is fifty-eight or whatever but you find that if you add another element to that, which is understanding where the orders are placed on the charts to your kangaroo tails, trendy kangaroo tails, you’ve actually really improved that strategy. That probably would be the case.
If you saw a whole lot of people who had their orders basically on the other side of your kangaroo tail then that means that you would know that there's a lot of people thinking that it is going to break out. It is going to go the other way or if there are a lot of orders down where your order is going to be. Or, if there are a lot of orders where you take profit is going to be, that will be like a magnet. If it gets closer, you really want to get there.
So all of those things, I think, are really important in terms of game theory. To me, game theory is thinking about what are the probabilities that this is going to go this way or that way. And so, what should I do for you know, my overall. I am trying to make a profit here.
The other thing is what are the other people doing. Trading is so different because it is not like a closed system like a poker game. Where you only have five people you know, and there are a limited number of possibilities. Although there are many you know, with all the different hands and everything, it still is limited.
Whereas, with trading it is kind of like an open system. These things can come in and impact the markets in really drastic ways that sometimes we are not even aware of. But, I think just understanding what your other market participants are doing and what they are thinking, and understanding where the probabilities lie is probably the most important thing in terms of thinking of trading like a game. What are your thoughts about this?
Hugh: I actually do not have too much input on this one. I haven't really looked into game theory that much. So I just wanted to get your ideas on this one.
Walter: The thing is, if you get into some of these books, they are super mathematical. A lot of game theory is just thinking about what is my opponent or what are the other participants doing. If I do this, what are they going to do, you know. It is really just that. So I think you can really simplify.
I am a big fan of the eighty-twenty thing, you know. You just cut it down and just do this much to get the maximum. I like that approach and some people won't. They’ll want to get deep into it and that is fine but I think just thinking in terms of what the other people are doing, that is a big part of game theory.
Hugh: Hey there! I hope you find this episode useful. I just want to let you know that Walter and I give away something valuable every month that helps traders improve their skills. You can enter to win by simply leaving an iTunes review and leaving a comment on our YouTube videos.
At the end of each month, we'll look at the comments and reviews from the month and we'll pick a winner at random. Each comment and each review counts for one entry during the month that it's pitted.
So, if you're interested in that, be sure to enter after this podcast is over. Alright, back to the episode.
Walter: You can map it out and make charts, and everything. Choice charts and all that stuff but it really comes down to thinking about, you know, where are the best probabilities. What is likely to happen versus unlikely which is not always the way we think.
A lot of times we think what is likely to happen is what happened last time and that is not true. That is not necessarily true at all. So we are not really set up to think mathematically. We are more emotional creatures in general and reactionary.
I think if people just start like a real simple task would be, if you have a trade and you go, “Okay, I am going to buy here”. What are the people thinking that are going to sell in the exact same situation. What do they see? You know, just trying to break out of your filter and the way you see the market, that is a really big part of it I think.
Hugh: Kind of like a crowd psychology you think?
Walter: Yeah. Sometimes what will happen is the kangaroo tail will print and I do not take it. I explain in my videos the reason I am not taking it. Let's say, there's a resistance level here and the kangaroo tail goes through it, like this.
So you have a big kangaroo tail. There is a big difference between having a kangaroo tail that starts here and goes across that level, that resistance level. Versus one that's kind of on top of it. Sitting on top of it because the ones on top of it are a breakthrough and a bounce.
It is going to go higher but the one that's sitting below it, just penetrates it and it's going to go lower. Sometimes it is hard to see the difference but like understanding that the people that see that kangaroo tail on top of the support and resistance, they think it's a reversal. And then I am the guy that thinks it is going to be a trend continuation pattern.
Thinking in terms of that and knowing the difference between the two I think is really important because it just helps you out in life. Just thinking about other’s perspectives, you will be a better conversationalist. If you can get in the head of somebody else. People like it when you ask questions about themselves you know like as you've noticed you know. They do. They really do.
It is a great way for people to go, “I really like Hugh. You know he is a good guy.” “Oh, really. What do you like about him?” “Well, he just seems like a real friendly guy, you know.” “Well, what does Hugh do?” “Oh, I don't know. We didn't really talk about that.” Because the whole time he was letting you talk about yourself you know and that sort of thing. Do you know what I mean?
Hugh: I used to get nervous like when I was younger talking to people. At a certain point, I just discovered to ask about them and then they will do all the talking. It is all good.
Walter: I was the same. I would always deflect off into, you know like they would say something. I am like, “Oh, yeah. What about you?” I would always do that and now I am so old. I am just like, whatever.
Hugh: Whatever.
Walter: When people start doing that to me, I can see it all the way and I am like, “Yeah. Okay man.” I am just like, “Whatever.” I did not even care but when I was younger I was really aware of it. Like you say and I would always just kind of like shift it back because I didn't want the spotlight on me, you know.
Hugh: Alright, cool. Thanks, Walter.
Walter: Thanks, see you.
Hugh: All the information in this podcast is for educational and informational purposes only and is not trading or investment advice.
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