In all prediction markets there is no such thing as actual short selling. Rather, what we have is a useful concept that is lending itself to an activity that is like shorting, but is not.
To recap, last week I talked about what “real” short selling is, and one of the points I made was that shorting, technically defined, does not occur in every market. Markets need to have appropriate assets, procedures and processes in place to accomplish shorting. These things exist in the stock and futures markets, but not in prediction markets.
Rather, in prediction markets what we have is the concept of shorting: to take a negative view on X and profit from it. But what does a “negative view” mean, and how does it express itself in processes and procedures? That is where it gets interesting.
The basics
To start with, in a prediction market there is no pre-defined set of contracts which can be traded. Rather, as many contracts as needed are created to satisfy the demands of the traders. If there are 100 traders in a market, they can create 50 contracts; a thousand, 500 contracts (assuming they trade one contract and pair perfectly with each other). No such magic exists in the stock market.
The odd thing about prediction markets is that a prediction is not based on any sort of physical asset, like copper, or a stock certificate, but rather on an opinion about the likelihood of an event occurring. And since you can not borrow an opinion to short — which would be ridiculous — you must find someone who feels differently than you, and together you can create (yes, out of thin air) a contract which you both agree to.
In a binary prediction market (and we’ll stick to binaries, since it’s the easiest), two people (or a person and a computer) come together with differing opinions about a specific outcome to a specific event – Hillary wins the presidency in 2008, for example, where “Hillary wins” is the outcome, and the “2008 Presidential election” is the event.
One person will agree with this outcome at a certain probability, while another person will disagree with this outcome, at the converse probability. This probability, and it’s converse, are the prices each participant pays to participate.
A graphic should help make this plain.
Once the two traders agree to the prices (or probabilities), they create a contract in which they agree to pay the other person if they are wrong. In this scenario there is no such thing as shorting, merely two people willing to bet on a specific outcome, albeit the opposite sides of that outcome, to a specific event.
It’s all just words!
So, how did shorting come into play in prediction markets?
As a useful concept, of course.
The more like a real futures or stock exchange a prediction market looks or aspires to be, the more one needs to rely on the terms of these markets to explain how trading works. And so enters the term “shorting” as a way to explain to traders who want to take the negative side of an outcome — in other words, that outcome X will not happen — what they need to do.
But of course one can accomplish the same thing using a variety of other terms. NewsFutures uses the phrase “opposite outcome,” which is a little wishy washy, but certainly more accurate to what you’re actually doing on the prediction market when you take a negative outcome than “shorting.” But of course, many more people have heard of shorting than “opposite outcome.”
Other options include going the colloquial route and using terms like “I agree,” or “I disagree.” Or you can have people judge chances of an outcome, ala Inkling, and derive whether they’d like to go short or long based on their best guess probability (where, if I thought Hillary had a better than 25% chance to be president, and the contract was priced at 25%, then I would buy, but if I felt she had less than a 25% chance I would go “short”).
Regardless of what you choose, though, at the end of the day you need to choose words that the people on your prediction market will understand. And if “shorting” works for them, then “shorting” you should use.
As always, thanks for listening.
~alex
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There is a difference between short-sale and buying the opposite outcome. Because when short-selling, you make the deal with the “bank”/website to borrow the outcome you know will turn out to be 0 (in a WTA-market), and immediately sell it to the market and agree to pay back at the outcome determination.
For example Bob borrows “pays $1 if nuclear strike” and sells at market price on time T for $0.6 with the agreement to pay back at the market price on time T2.
He knows that the nuclear strike will not happen on time T2 (the price will drop to $0), therefore he pays $0 to the bank. On the other hand, if the outcome happens, the price increases to $1 and he has to pay this.
If he was going to trade on the opposite outcome, he would pay the market price (say $0.4). So the trade at T1 is different when buying the opposite outcome than when doing a short-sale. In short-sale you receive everything at once, and it stays that way if you turn out to be right about the outcome.
I agree with Øyvind, though my terminology is different. I like to think in terms of assets and liabilities, and notice who pays whom. In a classical Prediction market, there are complementary assets. Usually only one will pay off, though sometimes, they’ll each pay off proportionally. In either case the market operator knows that the pair will eventually be paid off at $1.
Each trader pays a positive sum, and gets an asset with a positive expected value. It might turn out to be worthless, or it might have a positive value.
In short selling (which, BTW, InTrade/TradeSports supports), the trader accepts a payment at the time of the trade, and takes on a liability. The liability might turn out to be $0, or it might be up to $1. In any case, the trader gets an immediate payment, and has a conditional liability.
In the stock market, your broker will monitor your holdings, and if they aren’t sufficient to cover your potential liability, they may make you deposit extra money. TradeSports does the same thing, but additionally, they reserve some proportion of your cash (some of which may have resulted from the short trade) to cover your potential liability. You aren’t allowed to withdraw the reserves, or invest them in other issues.
TradeSports varies the amount of required reserve at their own discretion. The fact that you sometimes get to spend the proceeds shows that it is really a short sale, and not just funny bookkeeping.
Hi guys,
Thanks for your comments. I think you both make good points about following the money.
I would say two things. First, I just want to reiterate that part of the process of shorting on the stock market requires you to borrow something. While money is frozen in your account on InTrade, nothing is actually borrowed from anyone. The contract is created for you.
Secondly, when you buy something on InTrade, money is set aside (“frozen”) in the same manner as you describe when “shorting” on InTrade. While the percentages may differ, the process appears to be exactly the same. I may be wrong in some of the details, but I think that’s generally true, or at least that’s how it appears to me when I trade on InTrade.
To me (and perhaps to InTrade as well, since they sometimes refer to what they do as “person to person” betting), it’s better to think of the process on InTrade as two sides of bet, with InTrade just making sure that you have money on hand to cover the bet if you lose (regardless if you went “long” or “short”).
~alex
Midas Oracle .ORG » Blog Archive » Shorting on Prediction Markets // Aug 28, 2007 at 8:32 am
[...] My own view, fully expressed over at Usable Markets, is that no true shorting, as I understand the word, takes place in the world of prediction markets, although shorting at the conceptual level (as in, I want to bet against X), certainly does. [...]
Hi Alex,
Wouldn’t a market be more predictive (or volatile) if there really were assets pressuring the market with supply and demand. If I think Hillary will win and she’s selling at only 33%, then of course I’ll buy at 34% even if I’m willing to pay 66%. If there were limited shares then I’d have to convince an owner with some doubt and we’d negotiate a price very close to our perceived probability. Then again, maybe there’s no reason to ever sell a low position.
I can see that the system you describe gives liquidity and profit to the market but it seems too loose to me. Would it make a difference predictively? Do you have some a theoretical resource on this point?
Alex
On TradeSports/InTrade, buying and selling are different. I prefer markets where they are handled the same. The only advantage I know of for treating them differently is to be able to tell experienced traders that shorting is the same as on the stock market. I think experienced stock traders are sophisticated that you can teach them a new pattern. It’s the inexperienced traders who should have a path that’s easier to understand.
Anyway, when you buy on InTrade, you spend money, and get a conditional asset. If the asset pays off, you get some money when it closes. That’s the entire story for buying (going long.) There are no variable reserves in this story
When you sell, you get the proceeds up front, and have a conditional liability. If the bet goes against you, you have to cover the loss. InTrade reserves a portion of the potential liability to ensure you’ll be able to pay it back. If you read their FAQs, the one on What is trading on Margin says (in part) This basically means that the Exchange does not freeze the total worst case loss on all positions but rather a proportion of the total potential loss is frozen. This frees up funds for these members allowing them to trade on more contracts. The Exchange sets margin rates based on a statistical analysis of each market.
What you’ll find if you monitor your positions closely is that for long term contracts, the reserve increases over the period of the contract. If you have multiple positions on a many-outcome market (candidates in an election, or league champion) they don’t hold as much, since they know only one candidate can win, but many can lose, so most of the shorts will win. This effectively means that the reserves in a sports league is only taken once for whichever is your largest short position. But this is still quite different from the effect of betting long.
The difference between creating new contracts and borrowing existing contracts is interesting, but doesn’t seem like the essence of “going short” to me. Perhaps we should call this a matter of terminology and agree to disagree. My impression is that on commodities futures, contracts can be created by traders, and don’t require the existence of actual commodities. (Since the commodities may only be pumped, harvested, or manufactured later, this makes senses.) There’s still a short side and a long side. The short side has to make up the value at the close, regardless of whether they borrowed an existing share or created a contract out of whole cloth.
Hi Alex,
That’s an interesting question. I don’t have a good theoretical resource on that point. Anyone else?
~alex