Key Facts
- Prediction markets are a middle ground between future derivatives in finance and online gambling.
- Customers can buy options on the outcome of an upcoming event that will pay off if the event occurs.
- Prediction markets are also considered a form of crowdsourcing.
Technology’s ability to make markets easily available to the general public has led to a blurring of the lines between certain financial investments and outright gambling. Take a futures derivative, mix it with an online offshore book, and add in a pinch of social media poll and crowdsourcing and you get one of these emerging areas—prediction markets.
What Is a Prediction Market?
The technical definition of a prediction market is using financial incentives to predict an outcome. Of course, that definition also fits investment in futures, as well as placing a bet on an upcoming event.
In a prediction market, an option is made available for sale on a future event. It could be anything from “Congress will pass a comprehensive gun control bill” to “Martin Scorsese will win Best Director at this year’s Oscars” to “A hurricane will strike South Florida in October.”
The price of this option is anywhere from 1 to 99 cents, and users can purchase any number of options. The price fluctuates based on market demand. The higher the demand, the higher the price goes, the lower the demand, the lower the price—similar to the way betting odds change.
Crowdsourcing?
This is similar to a crowdsourcing poll, because the theory behind a prediction market is that the input of a large number of people will eventually help the option price accurately reflect the probability of the event occurring.
Once the binary outcome of the event is known, the options will go to a value of either 0 or 100 cents. In the example of “A hurricane will strike South Florida in October,” let’s say you bought that option at 23 cents. That means that, at the time of your purchase, all available information to the people wagering on that option indicated that there was a 23% chance of a hurricane hitting the state.
Once October comes and goes, if there was no hurricane, the option you purchased is now worth nothing, and you lost the amount you paid. In other words, you’re out 23 cents. If, on the other hand, a hurricane does hit, your option price goes to $1, and you can cash in with a profit of 77 cents.
Not Just Betting
It may seem like a dressed-up version of betting. On the surface, there doesn’t seem to be much difference in buying an option on Scorsese winning best director and just placing a bet that he will win it. The payout and risk are the same. However, prediction markets are used by many agencies and organizations to gain knowledge through crowdsourcing.
Google, Eli Lilly, Microsoft and HP have all used prediction markets to help them make strategic decisions, using the option prices as forecasts of success of various strategies. The Department of Defense has even considered (though not implemented) the idea of using predictive markets to help forecast where terrorist attacks may occur in the future.
Playing the Predictive Markets
There are several predictive market platforms available, which allow option sales on any number of events. Among options available to purchase in November 2023 are “Taylor Swift and Travis Kelce will break up by the end of football season” (currently priced at 9 cents), will Artificial Intelligence be named Time Magazine’s 2023 person of the year (54 cents), will a nuclear weapon be detonated anywhere before the end of the year (6 cents), will the U.S. confirm alien contact this year (2 cents) and will The Marvels movie top $39 million on its opening weekend (95 cents). You can also bet on events in politics, the wars in Israel and Ukraine, NFL football scores and pop music album releases.
Legal Status
Predictive markets are regulated by government agencies in the United States, and many of them are considered too close to outright gambling to be sanctioned. There are also concerns about market manipulation. For example, several platforms have tried to allow sale of options on U.S. election outcomes, but they were rejected by the government, out of fear that there would be attempts to tamper with election results to cash in.
Most of the markets legal to operate in the U.S. are small, both in terms of bet limits and number of participants. The idea is to let them operate as educational tools—to obtain crowdsourced information—rather than as a full-blown financial market. This stance has been challenged in court, and the outcome of current cases should help clarify the market’s standing within the U.S.
