Friday, November 19, 2010

Note about Intrade Mechanics

I recently received a comment about my link to Intrade, a prediction market where people are able to make money by placing bets on the likelihood of certain events occurring in the future.  The mechanics of placing bets can be a little confusing because Intrade uses the language of "buy" and "sell".  Actually, anybody is able to make bets on either side of an event without previously owning a contract.  In other words, you can "sell" a contract without owning it first.  Let me explain.

Take the market currently at the top of Intrade's homepage, "Sarah Palin to formally announce a run for President before midnight ET on Dec 2011."  The price is currently at about 70, which means the market predicts that there is a 70% chance that this statement will come true.  If you think the likelihood of Palin running is greater than 70%, click "buy".  If you think the likelihood is less than 70% (I certainly do), click "sell".

If Palin ends up formally announcing, the price closes at 100.  If she doesn't, the price closes at 0.  If you purchase a "sell" position at 70 and Palin doesn't run, you get $7.00.  If she does run, you'll lose $3.00.  Conversely, if you purchased a "buy" position you'll lose $7.00 if she doesn't run, and gain $3.00 if she runs.  This system works because for every bet there is always two people: one betting that the price will go up (to 100), and one betting that the price will go down (to 0).

Prediction markets have proved to be stunningly accurate at predicting certain types of events.  Internal markets set up by companies to predict the completion dates of big projects seem to be one of the most accurate and useful applications.  For more information about this sort of idea, check out Infotopia by Cass Sunstein, or The Wisdom of Crowds by James Surowiecki.

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