Lesson 4: Trade According to Game Theory Game theory is the study of human conflict and cooperation within a competitive situation. In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting. Game theory creates a language and formal structure of analysis for making logical decisions in competitive environments. The formal application of game theory requires knowledge of the following details: the identity of independent actors, their preferences, what they know, which strategic acts they are allowed to make, and how each decision influences the outcome of the game. Depending on the model, various other requirements or assumptions may be necessary. Finally, each independent actor is assumed to be rational. Game theory has a wide range of applications, including psychology, evolutionary biology, war, politics, economics and business. Despite its many advances, game theory is still a young and developing science. Game theory brought about a revolution in economics by addressing crucial problems in prior mathematical economic models. In game theory, every decision-maker must anticipate the reaction of those affected by the decision. In business, this means economic agents must anticipate the reactions of rivals, employees, customers and investors. Suppose executives in charge of Apple iOS and Google Android are deciding whether or not to collude and exert duopolistic power over the market for smartphone operating software. Each firm knows that if they work together and do not cheat each other, they will be able to restrict output and raise prices, thereby enjoying above-normal profits. A simple application of the prisoner’s dilemma shows Apple and Google cannot maintain a stable equilibrium while colluding together, even under the unrealistic assumption that no other market competitors exist or could exist. #Whe have four possible scenarios: 1. Both Apple and Google sell the agreed-upon amount, do not cheat, and enjoy above-normal profits. 2. Apple only sells the agreed-upon amount of operating software, but Google sells the quantity at which it receives maximal net return. Google realizes even greater profits by discretely offering goods at sub-duopoly prices, and Apple loses market share. 3. Google doesn’t cheat, but Apple does. Apple realizes even greater profits by cheating, and Google loses market share.
4. Both Apple and Google compete normally and realize normal profits. Whether or not Google cheats, Apple is better off cheating, and vice versa. The same logic holds true whether discussing individual brokers, advisors, salesmen or entire firms. You've taken a trade and it's moved favorably in your direction, producing a "paper" profit. At some point that paper profit needs to be locked in, otherwise the profits could evaporate, or worse yet, turn into a loss. Day traders close all positions before the closing bell, so while exiting at the close is one option, here are three other scenarios to take profits while day trading. Take profits at an established area or level where the price tends to reverse. Let’s assume Apple’s stock made multiple attempts to drop below the 118.80 region, but it couldn't. This indicates a support area. If in a short position, exit slightly above the support area. While there is a possibility the price could continue falling, taking profits in this area isn't a bad idea. If the price does continue to fall, support will be broken and another short trade can be sought out. This method should be combined with trend analysis. During a strong uptrend, resistance is more likely to be broken (than during a range), so wait to see if the price does in fact break through it. If the price declines off the resistance area, exit long positions immediately. During a strong downtrend, support is more likely to be broken than during a range. In this case, wait to see if support is broken in the hopes of extracting a bit more profit. If the price moves higher off the support area, exit the short trade. Another scenario is the Price "Stalls" and Reverses. Taking profit slightly above support, for short trades, or slightly below resistance, for long trades, involves studying the tendencies a stock, forex pair, or futures contract has exhibited so far during the day. There are times it may be more profitable to not exit at support or resistance. An exit is still required though. If the price runs strongly in your favor, watch for the price to stall. A stall, or consolidation, is a collection of three or more price bars that don't progress the trend--they move more laterally. Assume you are long. When the price moves mostly sideways for at least three bars, the price momentum has stalled. Place an exit just below the high point of the stalled bars. Alternatively, get out of the trade if the price falls below the low of the three bar (or more) consolidation. If short and the price stalls for three bars or more, place an exit near the low of the consolidation, and/or exit if the price moves above the high point of the consolidation. A stall or consolidation doesn't mean the price will reverse; it is just one profit taking opportunity. If you believe the uptrend is likely to continue after the stall (and you are
long) exit only if the price drops below the low of the consolidation. That way, you protect profits. But if the price moves higher, you can profit further and look for another exit at a higher level. Now let’s examine the concept of profit taking before major economic news events. A top day trading scenario to take profits is right before a major economic or company-specific news release. This is done to protect profits, as opposed to try to get the best exit price. Day traders typically focus on capturing normal market movements throughout the day. A major economic news release--such as the Non-Farm Payrolls or an FOMC announcement--can cause massive price moves. These moves may result in significant losses. Day traders are better off taking profits right before the news announcement to avoid the risk of losing all their profit, and/or sustaining a large loss. Once out of the trade, the trader can then look to re-enter based on the trend that develops following the announcement. The bottom line is: taking profits at support or resistance requires attention to the tendencies of the market being traded, as does exiting when momentum slows or reverses. While there are always opportunities to get in to other trades, there may not be another opportunity to take a profit at advantageous levels such as these. Monitor economic and company specific news and exit before it is released. These events can cause massive price moves, which day traders are best to avoid. Book your profits, and look to re-enter after the news release. These profit taking methods won't work in all day trading scenarios--sometimes there isn't a consolidation or relevant support/resistance. These are simply top profit taking scenarios you may consider adding to your trading plan.