The Quants by Scott Patterson - Excerpt
The Quants by Scott Patterson - Excerpt
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How a New Breed
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of Math Whizzes
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Conquered Wall Street
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and Nearly
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Destroyed It
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QUA NT S
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• •
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PAT T E R S O N
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ISBN 978-0-307-45337-2
10 9 8 7 6 5 4 3 2 1
First Edition
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Contents
The Players ix
1 • ALL IN 1
5 • FOUR OF A KIND 64
12 • A FLAW 262
Notes 313
Glossary 323
Acknowledgments 327
Index 329
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The Players
ix
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x TH E Q UANTS
Aaron Brown, the quant who used his math smarts to thoroughly
humiliate Wall Street’s old guard at their trademark game of Liar’s
Poker, and whose career provided him with a front-row view of the
explosion of the mortgage-backed securities industry.
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A LL I N
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Peter Muller stepped into the posh Versailles Room of the century-
old St. Regis Hotel in midtown Manhattan and took in the glittering
scene in a glance.
It wasn’t the trio of cut-glass chandeliers hung from a gilt-laden
ceiling that caught his attention, nor the pair of antique floor-to-
ceiling mirrors to his left, nor the guests’ svelte Armani suits and gem-
studded dresses. Something else in the air made him smile: the smell
of money. And the sweet perfume of something he loved even more:
pure, unbridled testosterone-fueled competition. It was intoxicating,
and it was all around him, from the rich fizz of a fresh bottle of cham-
pagne popping open to the knowing nods and winks of his friends as
he moved into a room that was a virtual murderer’s row of topflight
bankers and hedge fund managers, the richest in the world. His people.
It was March 8, 2006, and the Wall Street Poker Night Tournament
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2 TH E Q UANTS
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All In 3
composed of only about fifty people, had racked up a track record that
could go toe-to-toe with the best investment outfits on Wall Street,
cranking out $6 billion in gains for Morgan.
Muller and Simons were giants among an unusual breed of in-
vestors known as “quants.” They used brain-twisting math and super-
powered computers to pluck billions in fleeting dollars out of the
market. By the early 2000s, such tech-savvy investors had come to
dominate Wall Street, helped by theoretical breakthroughs in the ap-
plication of mathematics to financial markets, advances that had
earned their discoverers several shelves of Nobel Prizes. The quants
applied those same breakthroughs to the highly practical, massively
profitable practice of calculating predictable patterns in how the mar-
ket moved and worked.
These computer-driven investors couldn’t care less about a com-
pany’s “fundamentals,” amorphous qualities such as the morale of its
employees or the cut of its chief executive’s jib. That was for the di-
nosaurs of Wall Street, the Warren Buffetts and Peter Lynches of the
world, investors who focused on factors such as what a company ac-
tually made and whether it made it well. Quants were agnostic on
such matters, devoting themselves instead to predicting whether a
company’s stock would move up or down based on a dizzying array of
numerical variables such as how cheap it was relative to the rest of the
market, how quickly the stock had risen or declined, or a combination
of the two—and much more.
That night at the St. Regis was a golden hour for the quants, a
predators’ ball for the pocket-protector set. They were celebrating
their dominance of Wall Street, just as junk bond kings such as
Michael Milken had ruled the financial world in the 1980s or swash-
buckling, trade-from-the-hip hedge fund managers such as George
Soros had conquered the Street in the 1990s.
Muller flicked a lock of sandy brown hair from his eyes and
snatched a glass of wine from a passing tray, looking for his friends. A
few nonquants, fundamental investors of the old guard, rubbed el-
bows with the quant crowd that night. David Einhorn, the boy-faced
manager of Greenlight Capital (so named when his wife gave him the
green light to launch a fund in the 1990s), could be seen chatting on a
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4 TH E Q UANTS
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All In 5
later that year. Lasry was known for being a cool investor whose icy de-
meanor belied his let-it-roll mentality. He was said to have once wa-
gered $100,000 on a hand without even looking at his cards. And won.
The real point of Asness’s needle was that he never knew when
the globetrotting Muller would be in town. One week he’d be trekking
in Bhutan or white-water rafting in Bolivia, the next heli-skiing in the
Grand Tetons or singing folk songs in a funky cabaret in Greenwich
Village. Muller had even been spotted belting out Bob Dylan tunes in
New York’s subway system, his keyboard case sprinkled with coins
from charitable commuters with no idea the seemingly down-on-his-
luck songster was worth hundreds of millions and flew around in a
private jet.
Asness, a stocky, balding man with a meaty face and impish blue
eyes, wore khaki pants and a white tee peeking out from his open col-
lar. He winked, stroking the orange-gray stubble of his trimmed beard.
Though he lacked Muller’s savoir faire, Asness was far wealthier,
manager of his own hedge fund, and a rising power in the investment
world. His firm, AQR, short for Applied Quantitative Research, was
managing $25 billion and growing fast.
The year before, Asness had been the subject of a lengthy and
glowing profile in the New York Times Magazine. He was a scourge of
bad practices in the money management industry, such as ridiculously
high fees at mutual funds. And he had the intellectual chops to back
up his attacks. Known as one of the smartest investors in the world,
Asness had worked hard for his success. He’d been a standout student
at the University of Chicago’s prestigious economics department in
the early 1990s, then a star at Goldman Sachs in the mid-1990s before
branching out on his own in 1998 to launch AQR with $1 billion and
change, a near record at the time. His ego had grown along with his
wallet, and so, too, had his temper. While outsiders knew Asness for
his razor-sharp mind tempered by a wry, self-effacing sense of humor,
inside AQR he was known for flying into computer-smashing ram-
pages and shooting off ego-crushing emails to his cowed employees at
all hours of the day or night. His poker buddies loved Asness’s cutting
wit and encyclopedic memory, but they’d also seen his darker side, his
volatile temper and sudden rages at a losing hand.
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All In 7
gram for New York City’s public schools—a fitting beneficiary, as the
players were Wall Street’s glorified mathletes. Muller, Asness, Griffin,
and Weinstein were all quants. Math was the very air they breathed.
Even the custom-made poker chips at the event were stamped with the
names of mathematical river gods such as Isaac Newton.
The potent combination of their mathematical brilliance, fever-
ishly competitive natures, and out-on-the-edge gambling instincts led
to an almost fanatical obsession with poker—the odds, the looping
mental games, the bluffing (if I bet this much, he’ll think that I think
that he thinks . . .). Asness didn’t take the game as seriously as Muller,
Weinstein, and Chris did. He’d picked it up in the past few years after
an internal tournament at AQR (which he happened to win). But the
guys he was playing against were insane about poker. Muller had been
frequenting poker halls since the 1980s during his days as a young
quant in Berkeley, California. In 2004, he’d become so serious about
the game—and so good at it—that he joined the World Poker Tour,
pocketing nearly $100,000 in winnings. He played online poker obses-
sively and even toyed with the bizarre notion of launching an online
poker hedge fund. Weinstein, more of a blackjack man, was no slouch
at the poker table, having won a Maserati in a 2005 NetJets poker
tournament. Griffin simply hated to lose to anyone at anything and
approached the poker table with the same brainiac killer instinct that
infused his day-to-day trading prowess.
No matter how hard they might play elsewhere, no poker game
mattered more than when the gamblers around the table were their fel-
low quants. It was more than a battle of wits over massive pots—it was
a battle of enormous egos. Every day they went head-to-head on Wall
Street, facing off in a computerized game of high-stakes poker in fi-
nancial markets around the globe, measuring one another’s wins and
losses from afar, but here was a chance to measure their mettle face-to-
face. Each had his own particular strategy for beating the market.
Griffin specialized in finding cheap bonds through mathematical for-
mulas, or, via the same logic, cheap, down-on-their-luck companies
ripe for the picking. Muller liked to buy and sell stocks at a superfast
pace using Morgan Stanley’s high-powered computers. Asness used
historical tests of market trends going back decades to detect hidden
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8 TH E Q UANTS
patterns no one else knew about. Weinstein was a wizard with credit
derivatives—securities whose value derives from some underlying
asset, such as a stock or a bond. Weinstein was especially adept with a
newfangled derivative known as a credit default swap, which is essen-
tially an insurance policy on a bond.
Regardless of which signature trade each man favored, they had
something far more powerful in common: an epic quest for an elusive,
ethereal quality the quants sometimes referred to in hushed, reverent
tones as the Truth.
The Truth was a universal secret about the way the market
worked that could only be discovered through mathematics. Revealed
through the study of obscure patterns in the market, the Truth was the
key to unlocking billions in profits. The quants built giant machines—
turbocharged computers linked to financial markets around the
globe—to search for the Truth, and to deploy it in their quest to make
untold fortunes. The bigger the machine, the more Truth they knew,
and the more Truth they knew, the more they could bet. And from that,
they reasoned, the richer they’d be. Think of white-coated scientists
building ever more powerful devices to replicate conditions at the mo-
ment of the Big Bang to understand the forces at the root of creation.
It was about money, of course, but it was also about proof. Each
added dollar was another tiny step toward proving they had fulfilled
their academic promise and uncovered the Truth.
The quants created a name for the Truth, a name that smacked of
cabalistic studies of magical formulas: alpha. Alpha is a code word for
an elusive skill certain individuals are endowed with that gives them
the ability to consistently beat the market. It is used in contrast with
another Greek term, beta, which is shorthand for plain-vanilla market
returns anyone with half a brain can achieve.
To the quants, beta is bad, alpha is good. Alpha is the Truth. If
you have it, you can be rich beyond your wildest dreams.
The notion of alpha, and its ephemeral promise of vast riches,
was everywhere in the hedge fund world. The trade magazine of
choice for hedge funds was called Alpha. A popular website fre-
quented by the hedge fund community was called Seeking Alpha. Sev-
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All In 9
eral of the quants in the room had already laid claim, in some form or
another, to the possession of alpha. Asness named his first hedge fund,
hatched inside Goldman in the mid-1990s, Global Alpha. Before mov-
ing on to Morgan in 1992, Muller had helped construct a computer-
ized investing system called Alphabuilder for a quant farm in Berkeley
called BARRA. An old poster from a 1960s film noir by Jean-Luc
Godard called Alphaville hung on the walls of PDT’s office in
Morgan’s midtown Manhattan headquarters.
But there was always a worry haunting the beauty of the quants’
algorithms. Perhaps their successes weren’t due to skill at all. Perhaps
it was all just dumb luck, fool’s gold, a good run that could come to an
end on any given day. What if the markets weren’t predictable? What
if their computer models didn’t always work? What if the truth wasn’t
knowable? Worse, what if there wasn’t any Truth?
In their day jobs, as they searched for the Truth, channeling their
hidden alpha nerds, the quants were isolated in their trading rooms
and hedge funds. At the poker table, they could look one another in
the eye, smiling over their cards as they tossed another ten grand
worth of chips on the table and called, looking for the telltale wince of
the bluffer. Sure, it was a charity event. But it was also a test. Skill at
poker meant skill at trading. And it potentially meant something even
more: the magical presence of alpha.
As the night rolled on, the quants fared well. Muller chalked up
victories against Gowen and Cloutier in the early rounds. Weinstein
was knocked out early, but Muller and Asness kept dominating their
opponents. Griffin made it into the final ten before running out of
luck and chips, as did Einhorn. The action got more intense as the
hour grew late. Around 1:30 a.m., only three players were left: Muller,
Asness, and Andrei Paraschivescu, a portfolio manager who worked
for Griffin at Citadel.
Asness didn’t like his first two cards on the next deal and quickly
folded, happy to wait for a better draw, leaving the pot to Muller and
Paraschivescu. The crowd fell quiet. The incessant honking city whir
of Fifth Avenue penetrated the suddenly hushed room.
Breaking the silence, Griffin shouted a warning to his underling:
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10 TH E Q UANTS
“Andrei, don’t bother coming into work next week if you don’t knock
Pete out.” Some in the crowd wondered if he meant it. With Griffin,
you never knew.
The room went quiet again. Paraschivescu lifted a corner of the
two cards facedown on the table before him. Pair of fours. Not bad.
Muller bent the corner of his two cards and eyed a pair of kings. He
decided to go all in, sweeping his chips into the pot. Suspecting a
bluff, Paraschivescu pushed his mound of chips forward and called,
flipping over his pair of fours. Muller showed his kings, his only show
of emotion a winsome glint in his blue eyes. A groan went up from the
crowd, the loudest from Griffin. The other cards dealt in the hand
couldn’t help Paraschivescu, and he was out.
It was down to Muller and Asness, quant versus quant. Asness was
at a huge disadvantage. Muller outchipped him eight to one after hav-
ing taken Paraschivescu to the cleaners. Asness would have to win sev-
eral hands in a row to even have a chance. He was at Muller’s mercy.
Griffin, still smarting from his ace trader’s loss, promised to do-
nate $10,000 to Asness’s favorite charity if he beat Muller. “Aren’t you
a billionaire?” Asness chortled. “That’s a little chintzy, Ken.”
After the deal, Muller had a king and a seven. Not bad, but not great.
He decided to go all in anyway. He had plenty of chips. It looked like a
bad move: Asness had a better hand, an ace and a ten. As each succes-
sive card was dealt, it looked as though Asness was sure to take the pot.
But on the final card, Muller drew another king. Odds were against it,
but he won anyway. The real world works like that sometimes.
The crowd applauded as Griffin rained catcalls on Muller. After-
ward Muller and Asness posed for photos with their silver trophies
and with Clonie Gowen flashing a million-dollar smile between them.
The biggest grin belonged to Muller.
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12 TH E Q UANTS
billion in assets. By 2000, the amount had leapt to $490 billion, and by
2007 it had exploded to $2 trillion. And those figures didn’t capture the
hundreds of billions of hedge fund dollars marshaled by banks such as
Morgan Stanley, Goldman Sachs, Citigroup, Lehman Brothers, Bear
Stearns, and Deutsche Bank, which were rapidly transforming from
staid white-shoe bank companies into hot-rod hedge fund vehicles
fixated on the fast buck—or the trillions more in leverage that juiced
their returns like anabolic steroids.
The Great Hedge Fund Bubble—for it was a true bubble—was
one of the most frenzied gold rushes of all time. Thousands of hedge
fund jockeys became wealthy beyond their wildest dreams. One of the
quickest tickets to the party was a background in math and computer
science. On Wall Street Poker Night in 2006, Simons, Griffin, Asness,
Muller, and Weinstein sat at the top of the heap, living outsized lives
of private jets, luxury yachts, and sprawling mansions.
A year later, each of the players in the room that night would find
himself in the crosshairs of one of the most brutal market meltdowns
ever seen, one they had helped to create. Indeed, in their search for
Truth, in their quest for alpha, the quants had unwittingly primed the
bomb and lit the fuse for the financial catastrophe that began to ex-
plode in spectacular fashion in August 2007.
The result was possibly the biggest, fastest, and strangest financial
collapse ever seen, and the starting point for the worst global eco-
nomic crisis since the Great Depression.
Amazingly, not one of the quants, despite their chart-topping IQs,
their walls of degrees, their impressive Ph.D.’s, their billions of wealth
earned by anticipating every bob and weave the market threw their
way, their decades studying every statistical quirk of the market under
the sun, saw the train wreck coming.
How could they have missed it? What went wrong?
A hint to the answer was captured centuries ago by a man whose
name emblazoned the poker chips the quants wagered with that
night: Isaac Newton. After losing £20,000 on a vast Ponzi scheme
known as the South Sea Bubble in 1720, Newton observed: “I can cal-
culate the motion of heavenly bodies but not the madness of people.”
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THE
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Just past 5:00 a.m. on a spring Saturday in 1961, the sun was about to
dawn on a small, ratty casino in Reno, Nevada. But inside there was
perpetual darkness punctuated by the glow of neon lights. A blackjack
player sat at an otherwise empty table, down $100 and exhausted. Ed
Thorp was running on fumes but unwilling to quit.
“Can you deal me two hands at once?” he asked the dealer, want-
ing to speed up play.
“No can do,” she said. “House policy.”
Thorp stiffened. “I’ve been playing two hands all night with other
dealers,” he shot back.
“Two hands would crowd out other players,” she snapped, shuf-
fling the deck.
Thorp looked around at the empty casino. She’ll do whatever it
takes to keep me from winning.
13
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14 TH E Q UANTS
The dealer started rapidly shooting out cards, trying to rattle him.
At last, Thorp spied the edge he’d been waiting for. Finally—maybe—
he’d have a chance to prove the merits of his blackjack system in the
real-world crucible of a casino. Twenty-eight, with dark hair and a
tendency to talk out of the corner of his mouth, Thorp resembled
hordes of young men who passed through Nevada’s casinos hoping to
line their pockets with stacks of chips. But Thorp was different. He
was a full-blown genius, holder of a Ph.D. in physics from UCLA, a
professor at the Massachusetts Institute of Technology, and an expert
in devising strategies to beat all kinds of games, from baccarat to
blackjack.
As night stretched into morning, Thorp had kept his bets small,
wagering $1 or $2 at a time, as he fished for flaws in his system. None
was apparent, yet his pile of chips kept shrinking. Lady Luck was run-
ning against him. But that was about to change. It had nothing to do
with luck and everything to do with math.
Thorp’s system, based on complex mathematics and hundreds of
hours of computer time, relied primarily on counting the number of ten
cards that had been dealt. In blackjack, all face cards—kings, queens,
and jacks—count as tens along with the four natural tens in every deck
of fifty-two cards. Thorp had calculated that when the ratio of tens left
in the deck relative to other cards increased, the odds turned in his
favor. For one thing, it increased the odds that the dealer would bust,
since dealers always had to “hit,” or take another card, when their hand
totaled sixteen or less. In other words, the more heavily a deck was
stacked with ten cards, the better Thorp’s chances of beating the
dealer’s hand and winning his bet. Thorp’s tens strategy, otherwise
known as the hi-lo strategy, was a revolutionary breakthrough in card
counting.
While he could never be certain about which card would come
next, he did know that statistically he had an edge according to one of
the most fundamental rules in probability theory: the law of large
numbers. The rule states that as a sample of random events, such as
coin flips—or hands in a game of blackjack—increases, the expected
average also becomes more certain. Ten flips of a coin could produce
seven heads and three tails, 70 percent heads, 30 percent tails. But ten
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• • •
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16 TH E Q UANTS
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18 TH E Q UANTS
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20 TH E Q UANTS
Thorp started paying regular visits to Shannon’s home later that No-
vember as the two scientists set to work on the roulette problem.
Shannon called his home “Entropy House,” a nod to a core concept in
information theory, borrowed from the second law of thermo-
dynamics. The law of entropy essentially means everything in the uni-
verse will eventually turn into a homogenous, undifferentiated goop. In
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22 TH E Q UANTS
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24 TH E Q UANTS
gamblers always on the make for a new system. Thorp fielded a flood
of requests about the nature of his system, as well as offers to back
him. One of the most generous came from a New York businessman
who promised to pony up $100,000. Thorp was eager to test his the-
ory, but he didn’t think he needed that much cash. He decided to ac-
cept $10,000 and promptly headed for Reno.
The same day Thorp beat the dealer in that ratty Reno casino at
five in the morning, he awoke in the afternoon eager to continue his
experiment. After a hearty meal, he met with one of his financial back-
ers, known as the mysterious “Mr. X” in the book he would later write
detailing his system, Beat the Dealer. Later that day, a “Mr. Y” arrived.
Mr. X was, in fact, a New York businessman with connections to
organized crime. His name was Emmanuel “Manny” Kimmel, a short,
white-haired racketeer with his fingers in everything from numbers
games in Newark, New Jersey, to East Coast horse tracks. He was also
part owner of a company called Kinney Parking, which owned sixty-
four parking lots in New York City. A 1965 FBI memo on Kimmel said
he was “a lifetime associate of several internationally known hood-
lums.” Mr. Y was Eddie Hand, a car-shipping magnate and Kimmel’s
regular high-stakes gambling pal.
After Hand arrived, they went to Harold’s Club, a famous casino
located in an enormous building in the center of downtown Reno. It
was a significant step up from the second-rate casino Thorp had
played in the night before, and it would represent an even more rigor-
ous test of his system.
They sat down at the $500-maximum tables, the highest amount
possible. Within fifteen minutes they’d won $500, playing hands rang-
ing from $25 to $250.
The dealer hit a concealed button with her foot. Thorp watched
as the casino’s owner, Harold Smith, marched toward them across the
casino’s floor.
“Good evening, gentlemen,” Smith said, all smiles and glad-
handing. Thorp wasn’t fooled for a second. He’s out to stop me.
After a few more hands, the deck had about fifteen cards left. Typ-
ically, dealers play out a deck until only a few cards are left. One way
to trip up card counters is to shuffle the deck early.
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“Shuffle,” Smith said to the dealer. With the newly shuffled deck,
Thorp and Kimmel kept winning, since the tens strategy can start
paying off after only four cards are dealt, though the odds remain rel-
atively slim, mandating careful bets. As the next deck was about
halfway through, Smith nodded at the dealer.
“Shuffle.”
Thorp’s system still kept picking up favorable odds after several
hands. The dealer started shuffling after dealing only two hands.
While the system still worked, the repeated shuffling significantly
curbed favorable opportunities. Thorp and Kimmel finally left, but
they’d already pocketed several thousand dollars.
The combination of Thorp’s winning blackjack model and Kelly’s
optimal betting system was powerful. Thorp and Kimmel continued to
beat the dealer, despite a number of hurdles thrown their way. After
several days, they had more than doubled their initial $10,000 stake.
Soon after Thorp announced his results in Washington, D.C., he
was watching a TV program about gambling. A reporter asked a
casino owner whether gambling ever paid off.
“When a lamb goes to the slaughter, the lamb might kill the
butcher,” the owner said. “But we always bet on the butcher.”
Thorp smiled. He knew that he’d beaten the butcher. As he would
later write: “The day of the lamb had come.”
After his first excursion to Vegas, Thorp began work on Beat the
Dealer. Published in 1962, the book quickly became a New York Times
bestseller—and struck terror into the heart of casino bigwigs every-
where.
Thorp continued to rack up gains at blackjack tables on several
return trips to Las Vegas. Dealers were on the lookout for the gambling
professor. He began wearing disguises, well aware of stories about
card counters getting hauled into side alleys or casino basements for
brutal beatings.
One day in 1964, when he was playing at a baccarat table in Las
Vegas, he was offered a cup of coffee with cream and sugar. He took a
few sips, then started feeling odd.
A friend who’d traveled to Las Vegas with Thorp and his wife
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26 TH E Q UANTS
happened to be a nurse. She peered into his eyes and recognized the
look of drugged-out patients who landed in the emergency room. He
walked it off, but the episode unnerved him. He decided he needed to
find a fresh venue to test his strategies.
Thorp immediately set his sights on the biggest casino of all: Wall
Street.
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