Prediction Markets: Strategies for Alpha Generation

Much like financial markets, prediction markets (PM) have existed in some informal capacity for hundreds of years; the earliest known records, dating back to 1503, describe the practice of betting upon papal succession. Much like traditional financial markets, the process of centralization took many hundreds of years, as the value of centralized exchanges slowly began to impress itself upon the participants. The start of the contemporary era of PM and political betting, perhaps the foremost type of PM, was heralded by the Iowa Electronic Markets, established during the 1988 presidential election by the University of Iowa. Since then, many sites and markets have come and gone in the relatively unregulated and nascent field. Currently, PredictIt, run by the Victoria University of Wellington, dominates the space in both trade volume and number of independent markets. Other markets include betfair, augur, and others.

In this post we will give an overview of how PredictIt markets are structured and a non-exhaustive list of commonly used strategies for alpha generation in order to give the reader a better understanding of how these markets work and how to potentially profit from them.

Overview of PredictIt

The basic building block of PredictIt is a market, with each market containing at least two brackets and an expiration; where each bracket represents a distinct outcome and the expiration setting the date of when the owners of shares are paid out and the market settled. For each bracket, traders can buy or sell only two types of shares: yes shares or no shares. By purchasing a yes share, the buyer is acquiring the right to be paid $1 if the event happens; conversely, a no share gives the buyer the right to be paid $1 if the event does not occur. For every bracket, two distinct order books are used: one for the yes shares and one for the no shares. When placing the order, only one order type can be used, akin to a limit order in financial markets that is good until cancelled or the market expires. Traders can either wait for their contract to expire or list it on the order book for any price between 1 and 99 cents, exclusive. If a contract expires or is executed on the order book for a profit, a 10% tax is taken by PredictIt in order to fund the site's operations. When buying into or selling out of multiple brackets that are not mutally exclusive with each other, the trader's total exposure to the market is taken into account and their cash balance is credited or debited appropriately. This is often surprising for new PredictIt traders, as it is possible to actually receive money for the purchase of new shares (and conversely, to pay money when selling shares); this usually happens when no shares are bought on subsequent brackets in the same market as the trader's total market exposure is often reduced the more no shares are bought across different brackets in the same markets (click HERE for more information about the rules). Take the example market described in the table below:

Bracket Best No Ask
A 50¢
B 50¢

When the trader buys one no of bracket A, she will be debited 50¢, as that is her total exposure to the market: she cannot lose any more than that. If she then buys one no on B, her account will be credited 50¢ on execution as she has zeroed out her exposure to the market, since in both outcomes she will make $1, cancelling out the combined value of both contracts. In practice, the math is slightly more complicated as PredictIt accounts for the 10% tax in these credit and debit calculations.

Savvy traders can use this mechanism to build up very large positions with little capital and in certain cases, actually realize cash profits when the shares are bought. Consider the following market:

Bracket Best No Ask
A
B

As before, the trader when buying one no of A will pay the full cost of the contract, which in this case is 1¢. The interesting part comes when the trader purchases the second contract: she will immediately get credited 99¢ (for a profit of 98¢) and her exposure will, as before, be zeroed out. Of course, this isn't a very realistic example as the efficient market sharks will quickly devour all the chum in the water and move the prices until the sum of the no ask prices is equal to or greater than $1.

Index of Strategies

Below is the list of strategies we will discuss, ordered from low risk to high risk:

  1. Bracket Arbitrage
  2. Yes/No Arbitrage
  3. Information Arbitrage
  4. Carry
  5. Rule Arbitrage
  6. Statistical Arbitrage
  7. Momentum
  8. Mean-Reversion
  9. Expert Knowledge

The next sections will describe each strategy in detail, explain the conceptual background, and advise you on how and when to apply each in the markets.

Bracket Arbitrage

Perhaps the most straightforward and least risky strategy is bracket arbitrage, which we discussed brefily above. Simple bracket arbitrage means buying an equal number shares in all brackets if the sum of all prices is below some amount. For yes shares, this amount is $1, as the sum of the probabilities of all events for well-formed probability mass function (PMF) must equal 1. Therefore, if the sum of all yes prices is less than one, we can make a completely risk-free profit, provided that we are able to find the opportunity in the first place. Also note that theoretically we could short the share if the sum is greater than one and also make a risk-free profit but unfortunately PredictIt does not allow the shorting of shares. For clarity, consider the following market:

Bracket Yes Ask
A 52¢
B 17¢
C 29¢

Since the sum of all brackets is less than $1 (98¢), we can buy an equal amount of shares of each bracket and realize a ~2% return (pre-tax).

The same general idea works for the no side of the market as well, except that the sum of the shares must equal the number of brackets (in dollars) minus $1. For example:

Bracket No Ask
A 98¢
B 70¢
C 29¢

For no arbitrage to be possible, the sum of the no prices must add up to $2 (instead they add up to $1.97), allowing us to buy an equal amount of each bracket and net a ~1.5% return.

While bracket arbitrage is a risk-free strategy, finding opportunities to exploit is exceedingly difficult. In fact, it's possible that you'll never find such an opportunity by just perusing different markets manually. Instead, one should use PredictIt's market data API (described HERE) to receive automated alerts on arbitrage opportunities. Alternatively, one could write a fully automated bot to exploit these inefficiencies; take caution though, as this is both difficult to do and against PredictIt's TOS.

A slightly riskier version of arbitrage involves excluding outcomes that are clearly foreclosed before performing the summation. This strategy involves some judgement sense but can be profitable. Arbitrage opportunities that span all outcomes are easier to recognize mathematically, and so they are usually fixed quickly. Bracket exclusion is sometimes quite recognizable and can net triple the profits with little additional risk. For example, take this market from March 7, 2020, "Who will be the Democratic Nominee for President?"

Bracket Yes Ask
Biden 84¢
Sanders 11¢
Clinton

At a glance, there is no arbitrage opportunity here, as the brackets sum to 1. Clearly Hilllary Clinton is not a candidate in the 2020 primary, and it is impossible for her to enter the race at this point. Filing deadlines for all states have closed. Theoretically, the democrats could settle on her after a contested convention but any casual observer would agree the probability of this outcome is essentially 0. A good rule of thumb is that if any bracket has a last transaction price is 99 cents or 1 cent and no offers available on the corresponding side of the order book, it is safe to count it as $1 or 0 for the purposes of bracket arbitrage. In the case of the market above, the unusual price of 5 cents for Hillary Clinton is probably related to liquidity issues, as holders of no shares created months ago struggle to get their money out at 96 cents in order to reinvest it elsewhere for better returns before the market resolves. Mispricings for nearly certain outcomes like this are common when expiration dates are far in the future or rules of resolution are unclear. Traders prefer not to be exposed to the time and risk, so they accept unfair prices to convert their investments back into (liquid) cash.

Yes/No Arbitrage

Despite my inability to come up with a better name, yes/no arbitrage is a reasonable way to make risk-free profits on PredictIt. Implementing this strategy requires multiple accounts which represents the only risk associated with it: only one account per individual is allowed as per PredictIt's TOS so successfully using this strategy could lead to the banning of your account. Fortunately, if PredictIt decides to ban your account, they will first liquidate all of your positions and then wire the total balance to an account of your choosing. Instead of arbitraging between multiple brackets of the same type (yes or no) as with bracket arbitrage, we arbitrage between the yes and no side for each bracket. If the sum of the yes and no ask is less than $1, we can take advantage of the opportunity by purchasing an equal number of each kind of share. For example, consider the following market:

Bracket Yes Ask No Ask
A 63¢ 40¢
B 32¢ 64¢

We are unable to take advantage of the mispricing of bracket A (since we are unable to short shares), but we can purchase both sides for B and make a risk-free profit. In this case, we purchase one share of each for a total cost of 96¢ and receive a profit of 4¢, thus netting a pre-tax return of ~4.1%. Note that the reason this strategy requires multiple accounts is that PredictIt does not allow traders to buy both yes and no shares on the same bracket under a single account, one kind of shares must be sold prior to the purchase of the other.

Opportunities for this strategy are easier to find than for bracket arbitrage since it necessitates multiple accounts, but even so, automated and constant monitoring of the market data feed is necessary to reliably find the mispricing. Caution is needed because of the TOS and as such, it's advisable to create a pair of accounts purely for this strategy in order to minimize the downside if the accounts are frozen.

Information Arbitrage

Information arbitrage is the bread and butter of many PredictIt traders and perhaps the most commonly used strategy on the site. The mechanics are straightforward but the amount of work and time required can be prohibitive: simply read and trade on new information faster than anyone else. Personally I find this strategy to be time-consuming and boring, but for those who are either are already reading the news or diligant about monitoring settlement sources, this strategy can be incredibly profitable. Beware though that since most markets incorporate new information reasonably quickly (under 30 minutes), it's necessary to react fast, preferably under 5 minutes.

Carry

Another classic and popular PredictIt strategy, exploiting a positive carry is an ideal way to earn a return on capital while waiting for new intermittant opportunities. The basic idea is to buy shares (either yes's or no's) in markets and brackets that have a positive carry. For those unfamiliar with the concept, this means that whatever you're buying becomes more valuable over time, thus allowing you to hold it and make a profit day after day. In the context of PredictIt, this usually manifests in one of two ways:

  1. The market expires at a certain date and the event that you are buying shares of has not yet occured. The trader then buys whichever bracket and type of share that represents the status quo. If the status quo is not disrupted, the time decay of the non-status quo bracket or share will push up the price of the status uo bracket or share. An example might be: "Will John Smith run for office before the end of 2020." By purchasing no shares the trader is betting on the status quo and the price will rise consistently until expiration, assuming John Smith does not, in fact, ever run for office. Of course, the risk associated with this trade is that John Smith may run for office before 2020; even so, it's possible to use this strategy in combination with information arbitrage to make money on the carry and quickly get out (or switch the trade to the other side) before much profit is lost.
  2. The event has already occured and the price has risen, usually to 99¢. Many traders sell contracts at 99¢ before settlement in order to deploy the capital to other opportunities that have a higher expected value. By buying these shares, a trader can net a risk=free 1% return over the remaining duration. Note that even when a share is priced at 99¢ it does not necessarily mean the event has already occured, reading the actual settlement rules of the market is critical in order to make well informed trades.

An important criteria for identifying opportunities is the ratio between the total potential profit and the expiration date of the contract: a 99¢ share on a market that expires in one month is significantly more valuable than one that expires in a year.

Mispricings can sometimes occur because only one market exists to speculate on a particular eventuality, but the deadline for resolution is approaching. When new information emerges making such an eventuality more likely, buyers look for a way to act on the information and the prices move dramatically. However they may fail to notice that the resolution date is too soon. For example the market "Will the World Health Organization Declare Coronavirus a Pandemic by March 6 2020?" moved dramatically in early March as more cases were reported. However by March 3, each passing day had such a high carry that the news was irrelevant.

Rule Arbitrage

Though not something that a trader can reliably exploit, the potential windfalls from this strategy can be absolutely massive. By reading the settlement rules for each market very carefully, a trader can profit off of those who have not (the majority). I've seen cases where a contract is priced at 97¢ after an event happens that most traders think qualifies as a yes but actually, according to a close reading of the settlement rules, is a no. These events are rare, but a 10-50x profit is not out of the question. Beware though, in many markets the setttlement rules stipulate that PredictIt has discretion to decide the outcome in certain situations, usually pertaining to the unavailability of settlement sources (if the settlement website goes down, for example).

Statistical Arbitrage

Statistical arbitrage in the context of prediction markets is a type of strategy that aims to profit off of price deviations relative to some reference model. Instead of developing their own models, a time consuming and difficult task, many traders arbitrage prices with publically posted predictions, such as those on Nate Silver's 538, a political forecasting website. While small profits can be made consistently using public predictions, a proprietary model can be much more profitable.

Momentum

As with financial markets, momentum trading simply involves trading on a trend with the hope that the trend continues. This strategy carries the risk of the trend ending, but can often be used as a proxy for an information arbitrage strategy. A common way for traders to generate a monetum signal is for them to buy a single share in all interested markets and put a sell order at a pre-determined price, maybe 5-10% greater than the current price. When the trade executes, the trader receives a notification which signals that there has been a significant price move. The trader can now manually place a bigger order and hope for the trend to continue.

Mean-Reversion

The opposite of momentum, the mean-reversion strategy involves betting on the reversion of price. It's common for traders to overbuy or oversell on new information, allowing mean-reversion traders to buy up the relatively cheap shares and profit after sentiment becomes more measured.

Expert Knowledge

As in much of our politics nowadays, traders sometimes seem to use PredictIt less as a way to make money and more as a way to express their identity/personal beliefs. This might be analogous to the way wishful thinking can create unreasonable odds of a famous horse or a well-loved home team. Readers will not be surprised to learn that these fan-boy traders tend to skew left, with a few exceptions.

Inside information can be recognized from drastic and unexplained price swings. It is very risky and difficult to make money by joining these careening bandwagons, but dramatic price moves should be a reason to consider downsizing bets you already have open in such markets.

Identifying these irrational prices is hard to quantify, but intuition and common sense can help to identify these opportunities.

Conclusion

Hopefully this post has gotten you thinking about the standard strategies in use and how and when to apply them. The best trading results often occur when multiple signals or strategies are used to together to inform the buying or selling of shares. Good luck and hang in there! Prediction markets are often frustrating, but can be quite profitable and satisfying given a certain level of dedication!