Have you seen the new film 21?

Based on the 2002 mostly-non-fiction book Bringing Down the House by Ben Mezrich, it's about a group of MIT math students and their professor who learn to count cards and make a killing in Vegas. The movie takes some liberties with the book and mixes in other true stories of various groups who infiltrated The Strip repeatedly in the 80s and 90s, who were collectively known as the MIT Blackjack Team. But they still successfully pay homage to the man who started it all. In 21, Kevin Spacey stars as the MIT professor who finds a 20-year old book about gambling by Ed Thorp, the original card-counting math whiz from MIT.  In a minute, I'll tell you something else Thorp did related to options trading that I bet will surprise you.

First, let's talk Vegas!  Thorp's book Beat the Dealer was published in 1962, and it detailed his system for not only exploiting the simple mathematical advantages to be found in blackjack, but also how to systematically bet in any gambling game for maximum long-term profit.  His ideas were based primarily on the work of a Bell Labs scientist named John Kelly, who developed a theory of gambling, that became known as the Kelly criterion. 

Kelly's formula was also called Edge/Odds, because it simply took the theoretical advantage one expected from a given gamble, based on your information "edge," and divided that by the actual odds of winning.  This number told you how much of your bankroll to bet on the next go.  As you can see, counting cards is only half the battle--you have to know when and how much to bet to leverage that information successfully. And Thorp proved the system worked by banking sizable profits at the blackjack table for several years.

Remember the 1988 movie "Rain Man?"  With that as my only education in gambling, I concluded that you must need to have special brainpowers to succeed with card counting—either you're an idiot savant or an MIT math whiz.  So I ignored all card playing and gambling as a waste of my time, and my limited brainpower.  But then I worked next to some options traders in the 1990s who taught me how they were basically using a more formalized Edge/Odds strategy.  They weren’t making big predictions about market direction. They were simply using probability to make calculated, risk-controlled bets for small profits that they could repeat over and over again. I realized immediately that this was the problem with most discretionary traders losing all their capital—they didn't have a system for matching their bet size with any kind of “knowledge advantage” and the solid probability estimates they needed to weight that info with.

Smart traders, especially options traders, figured out systems for controlling information and risk to take mathematical advantages from—and profits out of—the market.  But you know who figured this stuff out first?  It wasn't the finance professors who won Nobel prizes for theoretical pricing models.  It was the gamblers!  300 years ago, dice-playing math junkies carved out the initial components of probability theory that still help casinos and options traders today gain their “statistical edge” and consistent advantage.

And Ed Thorp, back in the 1950s and 60s, over a decade before the Black-Scholes formula for options became widely available to traders, did something else to put him in the history books: while he was busy taking Vegas to the cleaners, he was also able to scratch out the first primitive option pricing model because the roots of it were all in basic probability and gambling theory.

Today, expert gamblers like poker champ Daniel Negraneau know Edge/Odds simply as “When you get the best of it, make the most of it.” Expert option traders, who don’t live and die every day with “all in” type bets, call it volatility trading.

Whatever happened to Ed Thorp? In the late 60s, he went on to start the famous hedge fund Princeton-Newport Partners which achieved a 15% annual rate of return for over 20 years.  Thorp’s story is detailed in the book by essayist William Poundstone, Fortune's Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street.

I think I'm gonna go see "21" tonight.  I heard there's a great scene in the beginning where one of professor Spacey's students knocks his socks off by correctly solving the Monty Hall problem.  This is a classic probability brain-buster I found in the Market Wizards books when I first started trading.  I'll tell you about that mind-blowing “trader brain food” in our next edition of Options Physics.