Investoid

I’ve been interested in prediction exchanges for the past couple of years. Quite simply, prediction exchanges are markets whereby the market players buy and sell event-driven futures contracts. These contracts are typically valued between 0 and 100. If the event occurs in the affirmative, then the contract is worth 100 at expiry, otherwise it is worth 0. They trade at values in between these extremes prior to their expiration.

These markets have gained some mainstream media attention, mostly for their supposed quality of predictions (some believe that the value of such contracts prior to an event is a better indicator of the probability of the event occurring over other methods such as sample polling). They have also gained some notoriety for their use as sport-betting mechanisms, since they allow people to make wagers with each other rather than have to pay a bookie a hefty middle-man fee. As a result the US frowns upon many of the current markets out there, due to their heavy sports orientation.

There are two both real money and play money prediction exchanges in existence. Chris Masse’s site is a comprehensive information portal on prediction exchanges, including a listing of the major markets in existence, which include:

• InTrade, a market that focuses on current events and some financial market outcomes.
• HedgeStreet, a US-only market that currently focuses on housing and economic derivatives (and was bought by the CBOE)

Both markets make their money off of trading fees, which are typically charged to those that accept prices rather than dictate them. InTrade also has contract expiry fees, meaning the party for whom the contract expired as expected, they will be charged a percentage of the amount they receive.

I think prediction exchanges have great potential for individual investors. These markets can come up with innovative contracts that you could use to hedge against other positions, or just contracts that you will have a knowledge advantage in (or at the very least you can reasonably assume to have the same level of knowledge as the other market players). Some are just for fun (for example, you can wager on whether Conrad Black will be found guilty of some or all charges), while others are serious (like the ones tied to the end of year Federal Funds rate).

There are some very interesting short-term contracts available. For instance, I like InTrade’s end of day contracts for whether the Dow (and other major indices) will close higher or lower than the previous day. I think day traders could do very well with this contract.

These markets are in their infancy, and with that comes some major risks:

• Many of the contracts have very light volume, so pricing and liquidity are major concerns. Even the most liquid contracts can have large spreads at any given point in time (upwards of 4 or 5 points). Furthermore, the amounts traded in dollar volume is pretty low, ranging from a few hundred dollars to a few hundred thousand dollars over the life of the contracts.
• None of the markets are regulated in Canada yet, so you run the risk of the government trying to clamp down on their use by its citizens. Even in the States HedgeStreet is the only money-based prediction exchange at the moment.
• The available types of contracts is small right now, and is controlled by the exchanges. Ideally, you will be able to create your own contracts and see if others are willing to trade them. Some of the play-money exchanges do this, but none of the real money ones do.
• Volatility is quite high, partially due to the nature of the underlying events and partially due to the lack of sophistication in the markets. For instance, the daily higher/lower contract can swing violently towards the end of a trading day if the Dow is close to even. This means you can make a killing if you guess correctly, or lose a fortune if you guess wrongly. As more tools come out to analyze the pricing movements and tie them into the underlying market data, this will be somewhat mitigated (and if you’re the first to do it, you’ll be way ahead of the game and create a fortune).

Overall prediction markets are quite an interesting phenomena that regular investors should be watching. As they mature, they will present new investment opportunities for you, which should be evaluated in the overall context of your portfolio allocation. If you’re interested in following the happenings of prediction markets, I recommend subscribing to the Midas Oracle blog.