PredictIt Trading Strategy Analysis and Ideas Pt 1 - Setting the Stage

This is the first post in a series exploring potential trading strategies and market characteristics of the online political prediction market PredictIt.

This series is not intended to be investment advice, but is rather an on-going summary of my thoughts and research regarding the PredictIt trading markets, and what, if any, insight they can provide on trading, markets, politics, finance, and decision making under uncertainty. I’m doing this because its fun, interesting, and because the risk limits imposed by PredictIt on each contract mean that it’s unlikely James Simons or David Shaw have already built qaunt funds that have figured all of this out. If you’re looking for Secrets to the Hidden World of Political Prediction Markets that those Rich Bankers Don’t Want You to Know, and of course you are, you’ve come to the right place.

Markets and Shares

The following is a relatively brief background and summary of the marketplace: PredictIt is an online, legal, political prediction market available to U.S. residents. Traders can buy and sell shares relating to the outcome of political events in the U.S. and around the world (e.g., “Who will be the 2016 Republican nominee?”, “Will the turnout in the South Carolina Democratic primary be over 22%?”, “Putin in power through 2016?”). There are two types of shares - “Yes” or “No”, relating the specified event. “Yes” shares are a bet that the event in question will occur, while “No” shares are a bet that the event in question will not occur. So for instance, in the market of “Who will be the 2016 Republican nominee?” there are Trump Yes, Trump No, Rubio Yes, Rubio No, Cruz Yes, Cruz No, etc. shares available for all of the possible nominees, all trading at different prices. Shares range in price from $0.01 to $0.99, and are traded in penny increments (no sub-penny trades are possible).

Trading

Trading of shares is fairly simple and straightforward. When you want to buy or sell shares of a particular contract, you click buy or sell and PredictIt lists the five best prices available and the aggregate amount of shares available for purchase/sale at each price. After you submit an order consisting of a number of shares to buy/sell at a specified price, PredictIt will tell you if your order has matched with an existing offer. If so, then the purchase/sale amount (net of fees, as discussed below) is credited/debited from your trading account. The purchased amount will then be display as “Invested” in a trader’s account. Traders can also make outstanding offers (i.e., limit orders) that will remain outstanding until executed by a matching offer or manually cancelled by the trader. You can only make outstanding offers up to the amount of shares of the contract you currently hold (i.e., no short selling). You cannot trade if you do not have sufficient funds in your account to execute the order (again, no short selling).

Determination of Outcomes and Final Settlement

When the event in question for the contract is finally resolved (i.e., a nominee is selected), trading in the relevant market is halted and all of the contracts in the market are redeemed (meaning removed from the traders’ accounts) and finally settled as follows: holders of shares which are true/accurate at the end receive $1.00 from PredictIt for each true/accurate share they held, while holders of shares that are false/inaccurate receive nothing , i.e. those shares go to $0.00. To illustrate, if Trump is the 2016 Republican nominee, trading in all of the shares relating to question of who will be the Republican nominee is halted and all traders in the market will lose their shares. Traders who held Trump Yes are receive $1.00 for each share, Traders who held Trump No receive nothing, Traders who held Rubio Yes shares receive nothing, and traders who held Rubio No share receive $1.00 (and so on for all of the contracts in the market). PredictIt discloses the rules by which the contracts will be finally determined and the closing date of the market. An example of the disclosure is: “The candidate named in the question will win the 2016 nomination of the Republican Party for U.S. president. This Market will close at the conclusion of the Republican National Convention.”

Implied Probabilities of Events

The central idea behind PredictIt, and the reason political prediction markets are interesting, is that the relative prices of shares shares should indicate the degree of confidence the market ascribes to a particular event occurring or not occurring. Lower prices should indicate the market believes the specified event is not as likely while higher prices should indicate the market believes the specified event is more likely. The logic behind these assumptions is that, since traders are at risk of losing all of their investment amount if they purchase shares and the specified event does not occur, they will only purchase those shares if there is a counter-weighing benefit to compensate for this risk. The counter-weighing benefit is the chance of profit. The less likely the trader views the outcome, the more risky the shares, and accordingly the higher the potential profit the trader will require in order to compensate for this risk. Therefore, the trader should only purchase the contract at a price low enough that the trader will make an acceptable return if the outcome in question occurs and the shares purchased are redeemed at $1.00 each.

The price range restriction of shares is meant to simply the comparison to the imputed odds of the outcome occurring, such that a contract trading at $0.50 should mean that the market believes the outcome has a 50% chance of occurring.

As we will see in later installments, due to fees and other aspects of the marketplace, prices must be adjusted before a probability of occurrence can be ascribed to the particular event. The assumptions above may also not hold in many instances where trading is driven by price speculation and not an evaluation of the probability of the underlying event.

Screenshots of Sample Markets, Shares, and Purchase Screen

For reference below are screenshots showing a sample of the markets available, some of the shares available under the 2016 U.S. Presidential Election market, and the options available to a trader if they wish to purchase shares of a particular contract:

Sample of National U.S. Election Markets
Contracts Available in the 2016 U.S. Presidential Election Market
Open offers for Trump Yes shares

Position Limits and Fees

The final thing to know about PredictIt are the position limits and fees. PredictIt limits each trader’s maximum risk of loss in a particular contract to $850. This limit is mandated by the CFTC No-Action Letter which allowed PredictIt to operate while other U.S. online gambling sites were forced to close. For our purposes, the maximum risk of loss in a particular contract is the net amount invested in a contract, which can be determined by multiplying the total number of shares of the contract a trader currently owns by the average purchase price of those shares. The maximum risk of loss therefore does not vary as prices of the contract vary.

The fees are as follows: there are no fees for depositing money into a trading account, and there are no fees simply for trading, unless you make a profit on a trade. If you lose money on a trade, there are no fees associated with that trade. If you make a profit on a trade, PredictIt takes 10% of the profit of the trade. When you want to withdraw money from your trading account, PredictIt will take 5% of the total amount you remove and will send you a check for the remainder of that amount.

Wrapping it up: Illustration of fees from start to finish

Below I illustrate how the fees work at each step of the trading process from the very beginning to the end by way of a trader who starts with $5.00, makes one trade, and then withdraws the total amount. This ignores minimum deposit and withdraw amounts for clarity.

Let’s say you initially deposit $5.00 from your credit card into PredictIt. You now have $5.00 available for investment on the PredictIt platform, $0.00 currently invested on the PredictIt platform, and of course -$5.00 was charged to your bank/credit line. You see a contract trading at $0.50 that you think will go up, so you purchase 10 shares of the contract at $0.50 each. You now have $0.00 available for investment, and $5.00 currently invested on the PredictIt platform. The shares go up in value to $0.70, so you decide to sell all 10 shares at $0.70. Since you made a $2.00 profit on this trade, PredictIt will take $0.20 (10% of $2.00), leaving you with $1.80 in profit. This means that after you execute the sale sell, you will have $0.00 currently invested, and $6.80 available for investment (the initial $5.00 investment plus the $1.80 profit net of fees). You decide you’ve been lucky enough and want to withdraw the full $6.80 from your account. PredictIt will then send you a check for $6.46 ($6.80 minus the 5%, or $0.34, withdraw fee). In this instance, although the shares you traded increased in price by 40%, after the profit and withdraw fees, you only made a 29.20% profit on your initial $5.00 investment. These fees will have key implications for trading and pricing behavior in the market.

It’s important to reiterate that while the profit fee only applies if you make a profit, the withdraw fee applies any time you want to withdraw money, even if you’ve never made a profitable trade.

But you didn’t mention the most important thing!

There is one particularly important aspect of the PredictIt trading platform that I have not touched on at all in this post: the unique method debiting/crediting of trader’s accounts according to changes in at-risk capital. This involves the concept of “Linked” markets and will be important in further installments as it both fundamentally affects prices and allows for interesting ways for traders to maximize expected return percentages for certain strategies.

We’ll address all of that later, but this post should hopefully provide you dear reader with a working knowledge of the basics of the market.

On deck

Next time in Part 2 of our series, we will explore one basic trading strategy: capturing liquidity premiums for contracts nearing expiration.