Game Theory of the Iran War & how to position
Paid subscriber analysis
I wrote an X article about the game theory of the Iran war so I’m sharing it with you here as well in case you missed it. However, in addition to the public version - in the paid section - I will talk about how best to position to all the different game theory scenarios if you are an investor seeking protection.
Reminder: our paid section is for all our regular paying subscribers (thank you!), our top 40 survey winners from last year (thank you, too!), and of course all our investors (obviously, thank you!). Become any of these categories and you get insights into what a hedge fund manager thinks about how to position for various market regimes. It gives you a mix of macro and TA most of the time, but I will be diving deep into options and vol regimes as well.
In the Tuesday post we will talk more about the technicals for this week, and the upcoming FOMC meeting where there is zero chance the Fed cuts rates. For now, just keep in mind that the 670 support is lost, and as I kept saying over and over, this opens the door to 650 on SPY, and about 560 to 570 on QQQ. Not looking good on the technical side, BUT, remember that we are one good news away from all-time highs (still only 5% away), as the short trade keeps getting super crowded:
In my view, the pain trade is to the upside when everyone keeps buying expensive protection.
That being said, it all depends on the swift resolution of the Iran war.
So let’s see the scenarios.
Game Theory of the Iran War
Two weeks into the US-Israel military campaign against Iran, the fog of war is thick, but the strategic logic underneath is surprisingly legible. Strip away the headlines about oil breaching $150 and the White House meme accounts (what is up with that?), and what you find is a textbook multi-player game with incomplete information, asymmetric payoffs, and a ticking clock that neither side can ignore. The question everyone is asking - “how does this resolve?” - is really a question about which equilibrium the players converge on first.
The Players and Their Payoff Structures
Start with the US-Israel coalition. The stated objectives are clear: end Iran’s nuclear weapons pursuit, destroy its ballistic missile infrastructure, and eliminate its ability to choke global commerce through the Strait of Hormuz. These are not modest aims. They amount to a demand for total strategic capitulation by Iran. In game theory terms, the coalition is playing for the maximum payoff, which is a complete denuclearization and the permanent removal of Iran’s primary leverage instrument, the Strait.
Iran, meanwhile, is playing a fundamentally different game. They do not need to ‘win’ in a conventional military sense. They need to impose enough cost on global energy markets, on the US-Israel coalition unity, and on domestic political support in Washington that the coalition’s payoff from continued fighting drops below its payoff from a negotiated settlement. Iran’s closure of the Strait of Hormuz is not just a military tactic; it is the single most powerful coercive economic lever any state has pulled in decades. Strategic petroleum reserves offer roughly 200 days of buffer against lost Iranian exports, but only about four days of total global consumption. The reserves are a band-aid, not a solution. If this drags on, the buffer becomes meaningless and the economic pain becomes the dominant variable in every capital from Washington to Beijing.
Here’s an example of a Strategic Payoff Matrix (Coalition vs Iran, Negotiate vs Escalate) with payoffs scored on an arbitrarily defined range -10 to +10 and outcome interpretations for all four quadrants:
However, keep in mind that the Hormuz closure is currently placing a much bigger strain on Asia than it is for the rest of the World. This great visualization from Reuters exemplifies this:
Yes, oil prices are increasing linearly across the board, causing economic issues for every single country, but they are asymmetrically affecting China, India, Japan, South Korea, and the rest of Asia which are the primary drivers of this demand for oil.
The problem here is that this may consequentially result in pressures across the financial spectrum, which explains why the US 10Y yield is ready to hit 4.3% again. It’s the reverse Yen carry trade (recall August 2024): rising oil prices widen Japan’s trade deficit and weaken the yen, creating a feedback loop of imported inflation. Because oil is priced in US dollars, a depreciating yen forces Japan to pay even more for energy, eventually compelling the Bank of Japan to hike interest rates to anchor inflation expectations and defend the currency. This policy shift effectively kills the yen carry trade by raising the cost of yen-denominated debt, triggering a massive unwind of global leveraged positions as capital flows back to Japan, resulting in systemic volatility across global equities, commodities, and emerging markets. This is what happened in August 2024
As for China and Korea and India, all of them, just like Japan, hold considerable amounts of US bonds, which brings us back to the reason why the Trump administration cave in on tariffs back in April 2025.
This is another risk factor that affects the payoffs to the Coalition, and is working in favor of Iran, whether they are aware of it or not.
The Asymmetry of Escalation
This is where the game theory gets interesting. Classical deterrence models assume rational actors with symmetric information. But the US-Iran conflict is radically asymmetric. The coalition has overwhelming conventional military superiority - nobody disputes that. But Iran has what strategists call “escalation dominance in the economic domain.” Every day the Strait stays closed, the cost to the global economy compounds. Oil above $100 is a nuisance. Oil at $120 starts bending GDP curves. Oil at $200, which Iran’s IRGC has explicitly threatened (although in my opinion it looks like wishful thinking rather than a credible threat), triggers recession across Europe and East Asia and does meaningful damage to the American economy heading into midterms.
This creates a paradox familiar to anyone who has studied the game of Chicken. The player who appears most willing to absorb mutual destruction gains leverage. Iran’s new supreme leader, Mojtaba Khamenei (or at least his cardboard cutout), has signaled exactly this posture, vowing that the Strait remains closed as a “tool to pressure the enemy.” The rational response from the coalition should be to take this threat seriously, because the downside risk of miscalculation is catastrophic for everyone.
On the other hand, Iran’s ability to successfully maintain the Strait closure is questionable to say the least. Disruption, sure, but complete closure is much more difficult to achieve. For now they can get away with a few drone strikes and mines, but fighting and winning the battle against the US Navy is unimaginable. For reference, this happened before. Google (or Grok/Claude/Gemini) Operation Praying Mantis in 1988. US Navy obliterated Iran’s Navy in half a day back then in retaliation for them hitting a US warship.
In short, if Iran blinks in this game - or are forced to blink - they lose for sure.
The Negotiation Window and Credible Commitment
President Trump has reportedly alluded to a four-week timeline for achieving a sustainable negotiation and regime change toward a “pragmatic ruler.” This framing reveals an important assumption: that the Coalition believes Iran’s domestic political structure can be fractured under pressure, producing a negotiating partner willing to accept terms the current leadership would reject.
Game theory has a name for this: a screening game. The Coalition is essentially testing whether Iran’s leadership type is hardline or pragmatic by applying escalating pressure and watching the response. If Iran’s new leadership blinks - reopens the Strait, signals willingness to discuss denuclearization - the coalition learns it is dealing with a pragmatic type and can offer a face-saving deal. If Iran holds firm and continues horizontal escalation (again, easier said than done as it involves fighting with the US Navy), the coalition faces the grim realization that it may be locked in a war of attrition with no clean exit.
The macro analysts watching this understand that the market itself is a player in this game. Every tick upward in Brent crude is a signal. Every uptick in the 10Y yield is a signal. Every stock market sell-off erodes political capital. The market is effectively running a parallel negotiation, pricing in the probability of various outcomes and punishing both sides for prolonging uncertainty. The volatility we have seen - oil swinging on deleted tweets and cabinet secretary interviews - shows how thin the information environment is, and how sensitive the equilibrium is to even small signals.
The Three Endgames
From a game theory perspective, there are three stable outcomes.
The first is a negotiated settlement some version of a new JCPOA-plus framework where Iran accepts verifiable constraints on its nuclear program and missile capabilities in exchange for sanctions relief, security guarantees, and an economic reconstruction package. This is the cooperative equilibrium. It requires both sides to accept less than their maximum payoff but avoids the catastrophic downside. The problem is credible commitment: Iran has no reason to trust that any deal will survive the next American administration, and the US has no reason to trust that Iran will not cheat. Without a credible enforcement mechanism, this equilibrium is fragile. This is also not the outcome Trump wanted, but if it happens he will surely claim victory, no doubt there.
The second is regime change, the coalition’s preferred outcome. This is the highest payoff for the US-Israel side but requires sustained military pressure (some version of “bombing the shit out of them“), intelligence dominance, and the assumption that a successor regime will be more compliant. This looked like the most likely outcome at the start of the war last week, when the Ayatollah was killed almost immediately. But his son (or the cardboard cutout of his son) is even more hardline than the Ayatollah was. It could all be a bluff, and the regime simply buying time (their public announcements sound veeery empty to me, but that’s just my hunch). Because of this, the probability of this outcome has gone down considerably this week. Although I am not discounting it yet.
The third is protracted stalemate, a frozen conflict where neither side achieves its objectives, the Strait eventually reopens under some ad hoc arrangement, and the nuclear question festers unresolved. This is the Nash equilibrium nobody wants but the one game theory suggests is most likely when both players have strong domestic audiences, high commitment costs, and limited ability to verify the other side’s intentions.
Where This Lands
In the end it all comes down to probabilities. If Iran can maintain the closure of the Strait long enough, their chances go up considerably as the pressure from oil prices and rising yields (yeah, and equity sell-offs) push Trump back. But if the Pentagon achieves a few swift victories on the sea and kills their main lever - the game is as good as over. Probability of regime change goes up significantly and oil and yields release the pressure. Markets shoot up to ATHs.
