The Physics of Wall Street: a brief History of Predicting the Unpredictable

Beating the Dealer 
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investing capital to spur growth. Worse, he had the nerve to take a 
financial interest in bad news. this struck many investors as déclassé. 
views on short selling changed in the 1970s and 1980s, in part because 
of thorp’s and others’ work, and in part because of the rise of the chi-
cago School of economics. As those economists argued at the time, 
short selling may seem crude, but it serves a crucial social good: it 
helps keep markets efficient. If the only people who can sell a stock are 
the ones who already own it, people who have information that could 
be bad for the company often don’t have any way of affecting market 
prices. this would mean that information could be available that isn’t 
reflected in the stock price, because the people who have access to the 
information aren’t able to participate in the market. Short selling pre-
vents this situation.
Whatever the social impact, short selling does have real risks at-
tached. When you buy a stock (sometimes called taking a “long” po-
sition, in contrast to the “short” position that short sellers take), you 
know how much money you stand to lose. Stockholders aren’t respon-
sible for a corporation’s debts, so if you put $1,000 into At&t, and 
At&t goes under, you lose at most $1,000. But stocks can go up arbi-
trarily high. So if you make a short sale, there’s no telling how much 
money you stand to lose. If you sell $1,000 worth of At&t short, when 
it comes time to buy the shares back to repay the person you borrowed 
them from, you might need to come up with a lot more money than 
you originally received in the sale in order to get the shares back.
Still, thorp was able to find a broker who was willing to execute 
the required trades. this solved one problem, of figuring out how to 
apply Kelly’s results in the first place. But even if thorp could ignore 
the social stigma of short selling — and he could — the real dangers of 
unlimited losses remained. Here, though, thorp had one of his most 
creative insights. His analysis of warrant pricing gave him a way of 
relating warrant prices to stock prices. Using this relationship, he re-
alized that if you sell warrants short, but at the same time you buy 
some shares of the underlying stock, you can protect yourself against 
the warrant increasing in value — because if the warrant increases in 
value, according to thorp’s calculations the stock price should also in-
crease, limiting your losses on the warrant. thorp discovered that if 

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you pick the right mix of warrants and stocks, you can guarantee a 
profit unless the stock price moves dramatically.
this strategy is now called delta hedging, and it has spawned other 
strategies involving other “convertible” securities (securities that, like 
options, can be exchanged for another security, such as certain bonds 
or preferred shares of stock that can be converted to shares of common 
stock). Using such strategies, thorp was able to consistently make 20% 
per year . . . for about forty-five years. He’s still doing it — indeed, 2008 
was one of his worst years ever, and he made 18%. In 1967, he wrote a 
book, called Beat the Market, with a colleague at Uc Irvine who had 
worked on similar ideas.
Beat the Market was too unusual, too different from then-current prac-
tices, to change Wall Street overnight. Many traders simply ignored it; 
most who read it didn’t understand it, or missed its importance. But 
one reader, a stockbroker named Jay regan, saw thorp’s genius. He 
wrote to thorp and proposed that they enter a partnership to create a 
“hedge fund.” (the term hedge fund, originally “hedged” fund, was al-
ready twenty years old when thorp and regan first met, but nowadays 
so many hedge funds are based on ideas related to thorp’s delta hedg-
ing strategy that the name might as well have originated with thorp 
and regan.) regan would take care of the tasks that thorp hated: he 
would promote the fund, find and manage clients, interface with bro-
kers, execute the trades. thorp would just be responsible for identify-
ing the trades and working out the mix of stocks and convertibles to 
buy and sell. thorp wouldn’t even have to leave the West coast: regan 
was happy to run the business end of things from new Jersey, while 
thorp stayed in newport Beach, california, building a team of math-
ematicians, physicists, and computer scientists to identify favorable 
trades. the deal seemed too good to be true. thorp quickly agreed.
the company that thorp and regan created was initially called 
convertible Hedge Associates, though in 1974 they changed the name 
to Princeton-newport Partners. Success came quickly. In its first full 
year, their investors made just over 13% each on their investments, after 
fees — while the market returned only 3.22%. they also had some im-
pressive early admirers. one of their earliest investors, ralph Gerard, 
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t h e p h y s i c s o f wa l l s t r e e t

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