A Primer on Prediction Markets

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Markets have always captivated us humans. One of the earliest examples involved the Dutch East India Company in 1608. Think massive, pirate ship-looking boats taking dangerous trips from the Netherlands to Indonesia and bringing back spices.

It was the first company that offered what we know as stock ownership today. If a ship returned with spice onboard, a part of the profits was yours. Traders would gather on a bridge in Amsterdam and chaotically exchange shares in the company.

Fast forward to today, markets offer opportunities to bet on the success of sports teams, the rise of companies, and the fluctuations of our planet’s resources.

But what if we could take it a step further? What if we could wager on the very outcomes of the events that shape our world?

Kalshi is on the cutting edge of this space. It is the first federally-regulated exchange where you can trade on the outcome of events. Federally-regulated is critical for many reasons, but one being, there are no markets for bad things like war, terrorism, and assassinations.

Here are some events you can bet on:

• The S&P 500’s closing price on a given day.

• NYC’s highest recorded temperature on a given day.

• The average number of TSA airport screenings in a given week.

• Joe Biden’s approval rating at a given time.

• Will NASA land humans on the moon before December 31, 2024?

In a prediction market, payoffs are tied to the outcomes of future events. Each outcome is broken into ‘Yes’ and ‘No’ contracts that can range in price from $0.01 to $0.99.

The price of each contract represents the market’s belief about the likelihood of the event. So each event is essentially distilled into a basic probability measure.

For example, there is a market for “Congressional stock trading ban” where ‘Yes’ trades for $0.13. The market essentially believes there’s a 13% chance a Congressional stock trading ban becomes law by the end of the year.

Once the event’s outcome has been determined, Kalshi pays out $1 for each correct contract and $0 for the rest.

If you’re interested in how the world works, some of these make for great intellectual stimulation. It’s fun to ask whether NASA will send humans to the moon.

But the process of getting to that answer points to larger questions about the state of American innovation, what contracts NASA is working on, and how their money is being spent.

Traders predict to the best of their ability because they have skin in the game and stand to profit or lose based on the quality of their forecasts. The market incentivizes a diverse crowd to weigh all of their knowledge and do so as soon as possible.

When there are thousands of people going through this exercise, you start to see why Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Markets are the crossroads of information. They act as a magnet that pulls in swaths of data that’s then rigorously interpreted in pursuit of a cherished alpha. This collective rigor rolls up to a single price that beautifully and elegantly reflects the world’s knowledge.

As the price fluctuates over time, it leaves peaks and valleys containing the influence of millions of minds bringing new information to the market.

Prediction markets can lead to better discourse and decision-making. We all have unexamined ideas about the world. Ideas where you’d trip over your words if someone pressed you about them. In everyday conversations, we tend to make overconfident claims, misremember facts, and adjust them to fit our narratives. It's just human nature.

A friend could be going on about how there couldn’t possibly be a recession this year — job numbers look good, covid is much better, and inflation is coming down. Calling people on their BS will usually get you shunned quickly. But there’s something about saying “Put a number on it” that seems to make people smarter.

Trying to learn about how people behave, respond to risk, and grapple with uncertainty has hidden benefits even if you don’t take any immediate action with what you learn.

I recently wrote about how thinking probabilistically seems unintuitive to many people. By putting a number on your conviction, you are forced into an unforgiving arena where your brain must translate vague opinions into logical points that calibrate the strength of your belief.

Here’s where it gets interesting. Prediction markets can be used not only to predict the future, but to prepare for the future by hedging risk. You can think of event contracts as functioning a bit like insurance.

Let’s say you live in New Orleans and want to hedge yourself against hurricane damage. Traditionally, an insurance company says “Here’s insurance, you need to buy at this price.” And they command a hefty premium for it.

Kalshi takes that over-the-counter transaction and puts it on an exchange in the form of something like “Will a Category 4 or higher hurricane hit New Orleans in 2023?” Once you have an idea of potential damages, you can buy the financial equivalent through ‘Yes’ contracts, on a cheaper, more transparent marketplace.

Or imagine that you have tickets to a concert at Red Rocks that you bought for $200. The night before, you look at the forecast and see there’s a 20% chance of thunderstorms. There’s a good chance things will work out, but you still don’t want to risk being struck by lightning on a sandstone monolith while listening to John Mayer. Although there are worse places for that to happen.

You go to Kalshi and spend $20 to buy 200 contracts on the ‘Yes’ side of “Will it rain in Denver tomorrow?” Now you can rest easy: If there’s great weather, you’ll lose the $20 you spent on Kalshi’s contracts, but you’ll be able to enjoy New Light without nature’s light. If there are storms, you can chill at home having recouped the cost of your tickets and avoided a potentially unfortunate situation.

Prediction markets aren't just for individuals; businesses can also benefit from hedging risks. Take Apple, for example. They're already hedging currency exposure, but in the future, they could use prediction markets to hedge against events in supply chains and geopolitics. No more relying on custom products with arbitrary prices from places like Goldman Sachs.

Just as you can anticipate the outcome of a sporting event based on implied probabilities, these markets offer valuable insights into the future of global happenings. Financial incentives motivate the production of new knowledge, new opportunities, and new perspectives.

As a fascinated user, it’s super interesting to see an ecosystem like Kalshi being built. I’m excited to see what the future holds in this space.

- Sam

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