Now that we have a perfect way to make money, let’s look at the risks associated with it.
Here is a list of risks, and we’ll discuss how they affect the trading below:
- There is no change in behavior: the undersold contract stays undersold, and the oversold contract stays oversold until it matures
- Of the two components of the multiplied expected value we picked the wrong one
- Intrade finds out about this method
- Method trading becomes a large part of overall trading, skewing the values
- Intrade runs out of business
There is no change in behavior: the undersold contract stays undersold, and the oversold contract stays oversold until it matures
This would have been the case if Hillary had stayed overvalued until the last moment, depriving us of a chance to cash in in the short term. In this case, we have to look at the possible outcomes:
- Hillary wins the primary and the general election. Then all three contracts are won. We shorted 238 Hillarys (that are worth $23.80), and bought 178 Dems (that are worth $17.80). We lose $6.
- Hillary loses the primary, but the Democrats (presumably Obama) win the election. We shorted 238 Hillarys (that don’t cost us anything) and bought 178 Dems (worth $17.80). We win $17.80.
- Hillary loses the primary, and the Democrats lose the general election (presumably to John McCain). We shorted 238 Hillarys and bought 178 Dems, all worth nothing now.
The option of Hillary winning the elections and the Democrats not winning is of course impossible, so we don’t have to compute it here. As you see, the upside is much bigger than the downside, so it’s still worth trying.
Of the two components of the multiplied expected value we picked the wrong one
Let’s say in our example. that we chose to buy the contract Hillary to win the Democratic primaries instead of the Dems, and that then once things settle down, the Dems go up and Hillary goes down. We would have made a lot more money if we had bought Dems, of course, but can we actually get into the red?
Well, yes, that’s possible. This is a particular case of the case of a contract whose oversubscription gets worse over time. In that case, we find ourselves battling a public that just is irrational, and we have to wait until the bitter end to cash in. We might lose some money, but in the long run and with enough contracts we are bound to win.
Intrade finds out about this method
Interestingly, this method is not illegal. You might think there is something akin to insider trading going on here, but there actually isn’t. If anything, this method makes Intrade more efficient.
Insider trading, by the way, is to use privileged information to make buying and selling decision. You would have to use something that only few others know, because of ties to the company or contract, to be liable of insider trading. In this case, we are using publicly available information that anyone can get.
Method trading becomes a large part of overall trading, skewing the values
Right now, that’s probably the biggest risk. On average, the Hillary for President contract had 278 trades per day. Even in the hotter period of the last 60 days, that didn’t go any higher than 743 trades per day. With this few contracts, you can’t really trade a lot, because your contracts would flood the game. Imagine you decide that you need to buy 5000 Hillary for Prez and sell 4000 Dems winning the election – who is going to buy those if the average day yields only 750 trades? And even if you find someone that wants to buy or sell that many to you – the price is going to drop down or go way up.
This risk is a very real one, and one that cannot be traded away. As a matter of fact, maybe the reason for the disparity is that, indeed, the trading is so slow that the market is not efficient. You can though take a whole set of contracts (like all contracts for the presidential election, there are about 20 of them) and make the number work for you.
Intrade runs out of business
Well, if you don’t trust your network, don’t buy in the first place. There is always a real risk that something catastrophic might happen, and in my humble view it just might be more probably that Intrade gets into trouble than that a meteor hits Earth. Still, Intrade seems a good partner for now.
Of course, all of this is not advice on which you should base buying or selling decisions, because I am just a geek and not an investment advisor!