Tuesday, September 29, 2015

The Price Impact of Margin-Linked Shorts

The real money peer-to-peer prediction market PredictIt just made a major announcement: they plan to margin-link short positions. This will lead to an across-the board decline in the prices of many contracts, especially in the two nominee markets. Given that the prices in these markets are already being referenced by the campaigns, this change could well have an impact on the race.

What margin-linking short positions does is to make it substantially cheaper to bet simultaneously against multiple candidates. Instead of a trader's worst-case loss being computed separately for each position, it is computed based on the recognition that only one candidate can eventually win. So a bet against both Bush and Rubio ought to require less cash than a bet against just one of the two, since we know that a loss on one bet implies a win on the other.

In an earlier post I argued that a failure to margin-link short positions was a design flaw that results in artificially inflated prices for all contracts in a given market, making the interpretation of these prices as probabilities untenable. The problem can be seen by looking at some of the current prices in the GOP nominee market:


The "Buy No" column tells us the price per contract of betting against a candidate for the nomination, with each contract paying out a dollar if the named individual fails to secure the nomination. One could buy five of these contracts (Rubio, Bush, Trump, Fiorina, and Carson) for a total of $3.91, and even of one of these were to win, the payoff from the bet would be $4. If, on the other hand, Cruz or Kasich were to be nominated, the bet would pay $5. There is no risk of loss involved.

Margin-linking shorts recognizes this fact, and would make this basket of five bets collectively cost nothing at all. This would be about as pure an arbitrage opportunity as one is likely to find in real money markets. Aggressive bets would be placed on all contracts simultaneously, with consequent price declines.

A useful effect of this change in design is that manipulating the market becomes much harder. Buying contracts to push up a price would be met by a wall of resistance as long as the sum of all contract prices yields an opportunity for arbitrage. To sustain manipulation would require a trader not only to put a floor on the favored contract, but a ceiling on all others. This has been done before, but would be considerably more costly than under the current market design.

I'd be interested to see which prices are affected most as the transition occurs, and how much prices move in anticipation of the change. But no matter how the aggregate decline is distributed across contracts, this example illustrates one important fact about financial markets in general: prices depend not just on beliefs about the likelihood of future events, but also on detailed features of market design. Too uncritical an acceptance of the efficient markets hypothesis can lead us to overlook this somewhat obvious but quite important point.

17 comments:

  1. Hadn't considered the protection this provides against manipulation. How much does the $850 limit affect that?

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  2. The limit makes manipulation less likely since no trader is large relative to the rest of the market. I suspect this is part of the reason why the CFTC allowed the market to launch.

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    1. Yes, I'm sure the limit helped the CFTC decide to let this happen.

      You noted that buying contracts to push up a price would be met by a wall of resistance, making manipulation harder. But the limit limits manipulation at least as much as this wall, while the wall itself is limited by what's generated from limited purchases. Not really a big point, other than to note that these two limits seem to create a more democratic market that is probably more predictive than no-limit markets where one person can lose $7 million on Romney...



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  3. Hey Rajiv,

    This is a great post and I appreciate your contributions to making PredictIt better. The academic discussions of prediction markets are fascinating to read, and is the reason why I tried out PredictIt as a trader.

    After I saw their update I purchased a # of shares of the Republican nominees in order to benefit no matter which way the market swings. I'm hoping this leads to a more efficient market.

    What other changes do you think PredictIt should make to become a better market?

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  4. There are many other frictions in trading which are limits to arbitrage: http://blog.rossry.net/predictit/

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    1. Very nice. The large double vig at PredictIt was often mentioned when the arbitrage was mentioned in the comments.

      Since the DoJ has said they won't mess with online gambling in the states that allow it (NJ, NV, et al) I wonder why some Casino magnate hasn't come up with a model closer to Intrades ($5 a month flat fee from all players). After all, the interest they make on the money market accounts holding the cash must've been substantial.

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    2. Nice post, but two points:
      1) They take deposits on credit card so with points you get 1% or so back depending on how you value points.
      2) S&P risk is higher (I would say).

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  5. Unknown: implementation of margin-linking is going to be a slow process so it may take a while for your cash to be freed up. But it will happen.

    D Mac: yes, there are fees and other frictions but I am absolutely certain that margin-linking will cause prices to drop sharply across the board as any arbitrage opportunity will be algorithmically exploited as soon as it arises. This happens virtually instantaneously already on IEM and iPredict, and used to happen on Intrade.

    By the way, I should have added a disclaimer that nothing in this post (or on this blog) constitutes investment advice.

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  6. Will margin linking affect the paired markets, like the governor's races, where we have two markets (Republican win and Democratic win) that should reflect each other but often don't?

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  7. Rajiv: How long do you expect it to take for them to roll out margin-linking to the Republican Nomination market? Also, are you in contact with PredictIt and advising them on these changes?

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  8. Rajiv,

    I must have missed something, isn't 3.94 vs a 4 or 5 payoff already an arbitrage? Why does the size of the arbitrage actually matter?

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  9. Ian, my understanding (based only on the announcement) is that they will introduce new margin-linked markets first, then start extending to existing markets. I don't know the schedule. I was in contact with them when they first launched, and recommended this change (both in private conversation and in a public blog post). I have also been in contact with them about data sharing. But I found out about the change through the standard email and don't have access to any non-public information regarding timing.

    Scott, I'm expecting that any market with a set of mutually exclusive and exhaustive contracts will eventually be margin-linked (including governors races).

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    1. I'm hoping so, since they're a lot of work to keep square. Thanks.

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  10. Adam, it's not a zero investment portfolio with a sure profit, the technical definition of arbitrage. If a risk-free return on capital were arbitrage then buying T-bills would be arbitrage.

    However, if you can borrow at a low enough rate to finance the purchase and end up with a sure profit you could construct an arbitrage portfolio. It all depends on your borrowing cost.

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    1. yes, of course. silly question, thanks.

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  11. Great news! Margin linking is a good start. IMO the "right" market design is not to make eliminating arbitrage easier, but to eliminate arbitrage altogether. Let people focus on providing actual information, and let the market do the logical inference. For small numbers of outcomes this is tractable. Here is my argument: http://blog.oddhead.com/2008/02/19/the-right-way-to-implement-a-multi-outcome-prediction-market-linear-programming/

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    1. Thanks Dave, that's a great post.

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