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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 BEAT THE MARKET A scientific Stock Market System Random House New York BEAT THE MARKET 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 9 8 7 © Copyright, 1967, by E. O. Thorp and S. T. Kassouf All rights reserved under International and 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 Contents INTRODUCTION 3 Chapter 1 A SYSTEM IS BORN 7 First venture into the market. The market calls: boardrooms and chartists. 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 two basic rules relating warrant prices to stock prices. Adjusted warrants and adjusted exercise price. Reading the financial pages. Checking the two rules. The warrant-stock law: predictability in the stock market. 3 SHORT SELLING: PROFITS IN BAD TIMES 33 Short selling. Selling warrants short. Molybdenum warrants and the avalanche effect. 4 THE BASIC SYSTEM 43 Hedging: high profit with low risk. Changing the mix. Deeper insight into the basic system. The basic system: preview. An in- credible meeting. vi Contents 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. How much 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 basic system. Performance through the 1929 crash. 8 MORE ON WARRANTS AND HEDGING 103 Over-the-counter, regional, and Canadian warrants. What determines warrant prices? What is a warrant worth? Reverse hedging. Spotting candidates for reverse hedging. 9 CAN ANYTHING GO WRONG? 127 Short squeezes. 1929 again? Volatile price movements. Extension of warrant privileges. Banning of short sales. Extensive use of the basic system. 10 THE GENERAL SYSTEM: THE EVALUATION OF CONVERTIBLE SECURITIES 141 Scope of convertibles. Convertible bonds. Anatomy of a convertible bond. Reverse hedging with Collins Radio “warrants.” Picking con- vertible bond situations. Best candidates for reverse hedging. Basic system with latent warrants. The basic system with Dresser In- dustries “warrants.” Finding the best basic-system hedges with convertible bonds. Convertible preferred stocks. Call options. Puts, calls, and the basic system. 11 DECIPHERING YOUR MONTHLY STATEMENT 169 Your brokerage account. The cash account. The margin account. The short account. Calculations in a mixed account. Applicability to the basic system. 12 PORTFOLIO MANAGEMENT 181 Exploiting a rise in the price of the common. Exploiting a decline in the price of the common. Diversification? Having several ac- counts. Long-term gains. Contents vii 13 WHY WE ARE SHARING THE SECRET 189 They wouldn’t believe us. I want to do it myself. The threat of rediscovery. 14 WHAT THE FUTURE HOLDS 195 How much can be invested in the basic system? How much can be invested by the entire system? A general solution for the stock market. 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 BEAT THE MARKET A scientific Stock Market System Introduction We present here a method by which investors can consistently make large profits. We have used this method in the market for the past five years to earn 25% a year. We have made prof- its during two of the sharpest stock market drops of this century; we have made profits when the stock market soared; and we have also made profits in stationary and churning markets. We have used mathematics, * economics, and electronic computers to prove and per- fect our theory. After reading dozens of books, investigating advisory services and mutual funds, and trying and rejecting scores of systems, we believe that ours is the first scientifi- cally proven method for consistent stock market profits. This book analyzes convertible securities and their associated common stock. These securities are now held in the portfolios of several million investors. More than 300 of the 3,500 securities traded on the New York and American stock exchanges are convertibles. Our methods apply to these convertibles jointly with their more than 200 associated common stocks. (We emphasize * Some of the research which made this book possible is based in part upon mathematical research supported in part by Air Force grant AF-AFOSR 1113-66. that our profits generally come from both the common stock and the convertibles.) The total of over 500 securities is about 15% of all the securities listed and has a market value of per- haps $50 billion. We predict and analyze the price relationships which exist between convertible securi- ties (warrants, convertible bonds, convertible preferreds, puts, and calls) and their common stock. This allows us to forecast future price relationships and profits. We do not need to pre- dict prices of individual securities in order to win. The minimum amount required to operate the system is determined by the amount required to open a margin account. This amount is subject to change. As we write, it is $2,000. Our method does not require you to invest all your funds in it, though we expect most readers will wish to do so. It is natural, for instance, to begin with a trial investment, increas- ing it as you gain skill, confidence, and success. If the total equity in your brokerage account is at least $2,000, then you are free to invest any portion of it by our system, ranging from a few dollars to the total amount. We begin the book by telling how we discovered the system. Then, as needed back- ground, we discuss warrants, short selling, and hedging. In the fifth chapter we illustrate the system with investments made by one of the authors over a five-year period. The sixth chap- ter shows the reader how to select his own investments with that part of our method we call the basic system. Next we present the historical performance of the basic system, which aver- aged more than 25% a year over a seventeen-year period. When the reader finishes the first nine chapters, he can successfully operate his own stock market investments. Chapter 10 shows how to extend our analysis to the entire area of convertible securities. 4 We conclude by discussing accounting and monthly statements, portfolio management, and the future for our method. The scientific proof of the basic system, indicated in the exposition, consists of four parts: (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 interested reader, appendixes indicate the technical foundations for our method. this supplementary material 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 from trees. This book needs to be studied. However, we intend Beat the Market to be useful and profitable to the entire investment public, from professionals to beginners. 5 Chapter 1 A SYSTEM IS BORN On October 5, 1961, Sheen Kassouf began a series of investments which averaged 25% a year over the next five years. Kassouf tells of his trial and rejection of the usual stock mar- ket approaches and how he then discovered the basis of our system. First Venture into the Market In 1957 I sought investment opportunities. The advertisements of brokerage houses and advi- sory services implied that stock market profits were just a matter of following their proce- dures. I subscribed to a respected advisory service and received hundreds of pages of finan- cial data, charts, and advice. Emerson Radio was rated “promising” so I purchased 100 shares. The stock market had been declining and now this general decline quickened. Analysts and financial writers could not agree on an explanation. They blamed Sputnik, the economy, credit and banking conditions, foreign interests selling stock, deteriorating “technical” posi- tion, and “wedge formations” in the stock averages. I continued to buy Emerson. My broker * asked, “What shall I * Most investors place orders with a registered representative, also known as a customer’s man or an account executive.