Inside Prediction Markets: What the Pros Know (and You Don’t)

If you haven't heard of prediction markets, you soon will. Kelshi lets you legally trade on anything anywhere in the US. Koshi, Poly Market, and countless others are vying to get your business in this hot emerging space that could change the way you bet on sports. What are they? How do they work? Are they legal? I'm going to explain all that to you, as well as give you three big risks you need to consider before betting into them. Give me a few minutes and I'll get you up to speed. Hi, I'm Jack from Unabated, where we provide software tools and education to help people find and place sharper bets. I've been a professional gambler for over 20 years.

And I'm amazed at how fast prediction markets have evolved as a way to wager on the outcome of a sporting event. And let's start there. How did we get here? And how is this legal? The CFTC, which stands for the Commodity Futures Trading Commission, is a federal agency which oversees markets for futures, options, swaps, and other financial derivatives. Remember the movie The Big Short? And CDO has parts of CDOA, but then they both get put inside CDOC. Yeah, that one's called CDO Squared. CDO of a CDO. Well, the events that movie was based on resulted in the CFTC being given greater regulatory control. It's up to them to determine what is and isn't allowed to be traded.

An event contract, in other words, a bet that is based on the outcome of an event, is permitted. The only catch is that it can't involve or relate to terrorism, assassination, war, gaming, or an activity that is unlawful under any state or federal law. But Jack, you just said gaming. And isn't sports betting a form of gaming? Well, that's the debate. A few companies have argued that event contracts based on the outcome of a sporting event aren't gambling. They contend there are economic ripple effects to the outcome, such as increased spending around a stadium when the home team wins or a city looking to offset the cost of a parade by backing their team to win a championship.

In the last couple years, the CFTC has indicated they will take no action against licensed CFTC prediction markets who offer trading on sporting event contracts. And that's how we got here. Now, whether or not this is gambling isn't the point here. I'm not going to tiptoe around certain words to keep the illusion that you're not really betting. You're smarter than that. And the reason you're here is because you want to learn more about how this all works and if it's for you. These products do differ from a traditional sports book. Instead of betting against the house in a prediction market, you're betting against a counterparty.

That counterparty has put up an offer of what they'd like to bet at what price and for how much. You can choose to take the other side of their offer for however much you want to bet. Or you can choose to make your own offer of what you'd like to bet at what price and for how much. Then it's up to someone else to be your counterparty and take your offer or not. This part shouldn't be foreign at all. This is how all exchanges work, whether they be stock markets or sports prediction markets. They also differ from sports books in that they don't have the wide betting buffet that we typically see in sports books.

These prediction markets are a bit more limited in what they can offer to stay within the letter of the law. However, they're constantly pushing the envelope and competition is going to breed innovation. The exciting opportunity this creates is that it is regulated at the federal level. As a result, it's available in all 50 states, including some states that have been notoriously slow in legalizing sports betting. That also creates a massive pool of potential counterparties that you might be betting against. If you have a Robin Hood account, you may have noticed that you can now trade on prediction markets there.

With over 25 million active users of that app, the number of people who have quick access to these prediction markets is staggering. 200 million in annualized revenue run rate for our prediction markets business, which would make it number one of our fastest growing businesses of all time. You'll notice they also differ from sports books because you're betting in terms of probability on a scale from 0ero to 100. Of course, in a regular sports book, you're also doing that. Probability there is expressed in American odds, though. Here, the market settles at zero or $1. Zero if your bet loses, $1 if it wins.

You make your bet at a price, and the difference between that and $1 is how much you stand to win per contract. For instance, you bet on a team at 55. That's an implied probability of 55% and you buy 100 contracts. You're betting 55 cents 100 or $55. And the amount you stand to win is $1 minus 55 or 45 per contract. So $45. You're betting $55 to win 45. You may want to use an odds screen like the free one we have at Unabated. So you can compare apples to apples and either view prediction markets in American odds or view sports books in probability.

The big advantage that prediction markets afford you is the ability to trade out of your position at any time. As long as you can find a counterparty, you're free to sell your wager for whatever the market will bear. You'll find that this is far more advantageous than the cash out offer that most sports books would offer you. There are plenty of bettors who approach these prediction markets as day traders, speculating on the value of a wager and then selling out of it once they've reached their profit goal. Everything sounds great so far.

However, this isn't without risk. I'm going to provide you with my top three caveats that you need to consider before diving into prediction markets. Let's talk about risks. Should you be a market maker or a market taker? Some of you might be thinking you'd love to be the bookie and be the one all of these Robin Hood millennials are betting against. That's tempting, but I would strongly caution you that market taking is far safer than market making. You see, when you're a market taker, you get the price you've chosen for the amount you want as long as there's the liquidity available.

When you're a market maker, you subject yourself to the most dreaded phrase in exchange wagering, and it's number three on our list. Adverse selection. Here's how adverse selection works. If you put up an offer, but someone is not willing to bet into it right away, you're running the risk that someone will come along with more perfect information than you have. The longer your offer sits out there, the more likely adverse selection will bite you. That information imbalance means that they'll either take your offer only when it's good for them or you won't get filled at all. In other words, you're being freeolled. As an example of this, picture a close football game in the fourth quarter. The market is 50/50.

You put up an offer that implies a 40% probability that your team wins. You feel like you're getting the best of it because that is 10 cents better than the price currently being offered. However, a team's probability of winning could rise or fall dramatically on any play. If your team has a big play and the probability of winning shifts to 70%, nobody's going to take the other side of your 40% offer. Meanwhile, if your team gives up a big play, the odds are going to shift well below your price and you're going to get filled at 40%. Even though that's now a really bad bet.

Adverse selection in order to get a slightly bigger edge is one of the biggest mistakes that I see newers make on exchanges and prediction markets. I definitely recommend that if you're new to these markets, be a market taker instead of a market maker. If you're going to be a market maker, you need to have eyes on the market the whole time your offer is live. Now, if that's the case, who are the bettererss who are bold enough to make markets on these platforms? Well, that's the next caveat I want to cover. Number two on our list is going up against institutional market makers.

Prediction markets like Koshi, Poly Market, and others utilize institutional market makers to help provide two-sided liquidity in their markets. This concept isn't unique to sports event contracts. This is done in other financial markets as well. The companies build algorithms and automated systems to essentially be the bookie on these platforms. There are several known companies out there doing this service. Whether or not you can beat them, well, that isn't for me to say.

However, if you think it's always going to be you versus some bro on Robin Hood, you're mistaken. The more liquidity in a market, the less effect that these institutional market makers have. However, if you've watched the trading screen on Cali during a big college football game or a prime time NFL game, you'll see what I mean. The screen flies by with bets. Most are low denomination wagers under $100. That's recreational flow. It's a reason why you can often find a slightly better price on these exchanges on big events compared to a sports book.

Now, coming in at number one on our list is perhaps the biggest caveat of all, fees and commissions. You see, that's the major way that these exchanges can make money. They take a small percentage. Now, they may take it from just winning wages. They may take it from just market takers to incentivize market making, or they may take it from both makers and takers. However, they do it, you need to factor it in. Fees could really erode your edge. For example, a 3% commission could mean getting a price 5 cents better than DraftKings now becomes a worse bet than you would have had at DraftKings.

The good news for consumers is that as the prediction market space becomes more competitive, fees will drop. I'm just scratching the surface when it comes to prediction markets. This space is moving at hyper speed and each day new things are announced and new obstacles arise.