Top Trader_4. Trade According to Game Theory

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.