How Political Prediction Markets Can Teach You To Trade Stocks And Options

May 17, 2020 9:29 AM ETNSA, NSA.PA10 Comments14 Likes
Logan Kane profile picture
Logan Kane
17.35K Followers

Summary

  • Political prediction markets are small-dollar, inefficient, and beatable.
  • By mastering key concepts in political prediction markets, you can learn to make money in other financial markets.
  • An introduction to immediacy costs, adverse selection, and other market-making concepts that help you make money in the financial markets.

Profiting From Political Prediction Markets

Those of you who are long-time readers of mine know that I like to study other markets to understand investing in stocks. NFL betting markets and political prediction markets are examples of markets that can be beaten by savvy participants, whether by acting as the "house" or by predicting outcomes better than other participants. I decided to put some market theory to the test on predictit.org, a political prediction market run by Victoria University of Wellington, a research university in New Zealand.

Political prediction markets are nice to trade/study for a few reasons.

1. There are limits to arbitrage, such as the $850 trade limit on PredictIt. This limits the opportunity for big arbitrage players to make enough money to move the needle on their income. This means that competition is effectively prevented from taking away blatant market inefficiencies.

2. Political prediction markets are a total shitshow from an efficiency standpoint, and the academic research agrees. Most of the people using the site don't do basic math to compare bets against each other. For example, you could usually bet "no" on Bernie Sanders in Democratic primaries and get a better price than betting Biden "yes", even though if you pencil it out, they're the same outcome. Additionally, in open field markets like the Democratic Vice Presidential nomination, I would bet "no" on every outcome until I had no money at risk, and subsequently pocketed cash with each new candidate, since the exchange only held enough cash in escrow to pay out the one winner. There are fewer limits to arbitrage in the financial markets, but this type of trade happens from time to time in the equity options markets, due to put/call parity violations.

3. Political prediction markets teach you how an order book works. I made the majority of my money in political prediction markets by market-making in them, meaning I would simultaneously offer a price below the market price to buy and above the market price to sell. This process would typically take somewhere between 15-30 minutes per round-trip trade.

In light of some of what I learned from political prediction markets, I'd like to share several concepts that can help you make money in the financial markets. You'll never hear a thing about any of this from the mainstream media, but you need it to trade successfully.

Transactions Costs and Immediacy Costs

When you trade in the financial markets, there is a cost associated with immediacy. In small-cap stocks, your round-trip bid/ask spread can be as high as 0.5 percent, sometimes 1 percent in times of high volatility. A lot of people trading on Robinhood and similar platforms think that trading is free, but commission-free does not necessarily mean cost-free.

Here's an example of a small-cap stock I trade, National Storage (NSA).

I pulled NSA up on Etrade for kicks while writing this article. The bid/ask spread is 9 cents, which works out to a little less than 0.4 percent in transaction costs to trade the stock. Therefore, if you use a market order on both the buy and sell, your profit (loss) on the trade will be whatever the stock moves, minus 0.4 percent. This is a fairly high bar to clear for any trading system.

How to reduce transaction costs:

  • It's typical for bid/ask spreads to shrink throughout the day for small-cap stocks. Even waiting until 10 am eastern to execute trades helps. In the case of National Storage, the spreads are typically around 1 percent of the stock price around the opening bell. Most investors don't even look! If you don't know what your transaction cost is, you're doomed to paying more than you have to.
  • Limit orders are good for reducing transaction costs. Instead of paying 24.56, you can and should offer a price around the midpoint of the bid/ask. More often than not, you'll be filled.
  • Transaction costs are not universal. One group of market participants pays them, and one group earns them. To effectively earn transaction costs on a large scale requires significant investment in infrastructure (data feeds, exchange colocation, etc.) Therefore, your focus as an individual investor should be to reduce transaction costs. In my opinion, it's not possible for individual investors to earn transaction costs in the financial markets due to the speed advantage that HFT and market makers have, but I think you can get your transaction costs to almost zero.
  • Ed Thorp, the man who invented blackjack card counting, once wrote that the optimal order size is around 100k on most liquid large-cap stocks. High net worth investors tend to pay a surprising amount of transaction costs that they're not aware of their inefficient order execution. The solution is to use custom algorithms that transact multiple times per minute at the optimal trade size, replacing the role that human execution traders used to play in reducing transaction costs.
  • Limit orders subject you to adverse selection, which you need to understand to trade actively and avoid getting picked off.

Adverse Selection

Adverse selection is a common issue in life and business, but few people fully understand it. Simply put, adverse selection occurs when one party in a transaction has better information than the other party.

Real-life examples of adverse selection:

  • All-you-can-eat-buffets. If you're a restaurant owner (before coronavirus) and you advertise an all-you-can-eat buffet, you suddenly get the hungriest customers in town. You've just been adversely selected against.
  • Life insurance. If you know your health is deteriorating, what do you have to lose by trying to buy a $1,000,000 life insurance policy? As such, insurance companies are constantly having to deal with adverse selection.
  • Used cars. If you're buying a used car, how do you know why the previous owner sold? In some cases, the car will be a total lemon. What's true for the used-car market is also true for online dating, which attracts its fair share of sketchy people. This will depress the economic market value that dealers will pay you for your used car, and your social market value on dating websites and apps.
  • The big kahuna for adverse selection, however, is investment opportunities. If you get a random email promising "explosive investment opportunities," then chances are you've just been adversely selected. This extends into personal life as well. You really need to ask yourself why deals have landed in your corner, and what the motivations and conflicts of interest are of those presenting them. The wealthier you are, the more adverse selection you can expect to occur in opportunities pitched to you.

By posting bid and offer quotes, market makers are vulnerable to traders with better information than them picking them off over short timeframes. I used this to full effect in political prediction markets in the market they offered on "debate speaking time." The market participants buying and selling on predictit may not have even known that they were making a market, but their posted limit orders were immediately stale when the moderators would ask a question to a new candidate. This would fundamentally change the odds of each candidate having the most speaking time.

So, I sat with my PredictIt account pulled up, a timer, a notebook, and a beer to watch the later Democratic debates and picked off stale limit orders.

For an example of my workflow– on TV the question goes to Michael Bloomberg, so I hit the asking price for Bloomberg. When he finishes talking and CNN updates their debate timer, I've already sold for the bid. I paid the bid/ask spread, but since I was able to predict the movements in the share prices, I was taking their money from people who thought they were being smart by letting orders go stale. If you want to make money with limit orders, you need the bid/ask spread you deal to be greater than the losses you will incur from adverse selection, and you need someone willing to take the other side to consummate. If other market participants are faster than you with access to information, the best you can do is break even with transaction costs, and you can do much worse if you're not careful. In the political prediction markets, and in the financial markets, I like to use small-dollar limit orders when noise/volatility is high and the risk of news is low and hit other people's limit orders when the opposite is true.

How to reduce adverse selection:

  • You shouldn't let limit orders sit for more than 15-30 minutes, or they'll get stale if news or order flow comes out, and you'll be adversely selected. If there is news pending (especially earnings releases), you shouldn't use limit orders at all. Either use market orders if you're not bigger in trade size than the quoted bid/ask and it's reasonable or use immediate or cancel orders (IOC orders are better). Retail investors lose billions of dollars per year by placing limit orders around earnings announcements.
  • Investment opportunities (especially private ones) are like used cars. You should due sufficient due diligence to know what you're in for, or you'll buy some lemons.
  • Due to the implicit leverage involved, selling options as a strategy (both puts and calls) exposes you to the most adverse selection of any asset class or trading strategy. You might have thought you were clever selling puts on airline stocks at elevated implied volatility in February, but the person who bought those options from you had significantly better information than you did, as the coronavirus forced the industry to basically shut down, which sent the stocks down 80+ percent and the put options up for 100-1 payoffs. If you're going to be successful selling covered calls or puts, the first thing you need to know is what kind of premium you're receiving, and the second thing you need to know is how much adverse selection you're exposed to. Most investors know about neither of these, so they think there is historically a 12 percent chance of snow on the ground in Chicago and make a prediction off that, without paying attention to whether it's summer or winter.

Conclusion

Market dynamics are not something that we teach our kids in school. However, there is an incredibly strong tendency for money to flow from those who don't understand markets to those who do. By learning the principles, you can improve your investment processes and make more money from the financial markets. The act of buying and selling is how Wall Street makes its money. For my readers looking for a little entertainment, here's how Twitter personality and Barstool Sports founder Dave Portnoy got crushed in his foray into day trading on max-margin. He said on CNBC recently he’s down $1.1 million and counting, but he seemed to be a good sport about it!

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This article was written by

Logan Kane profile picture
17.35K Followers
Author and entreprenuer. My articles typically cover portfolio strategy, value investing, and behavioral finance. I like to profit from the biases and constraints of other investors. Feel free to read more of my work here.
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Disclosure: I am/we are long NSA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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