How Prediction Markets Work

# How Prediction Markets Work Prediction markets are financial exchanges where you trade contracts based on the outcomes of real-world events. Instead of buying shares in a company, you are buying a position on whether something will or will not happen. The price of each contract reflects the collective wisdom of all market participants -- and historically, prediction markets have been among the most accurate forecasting tools available. ## The Yes/No Contract Every prediction market contract boils down to a binary question. Will event X happen? You can buy "Yes" (you think it will happen) or "No" (you think it will not). On Kalshi, contracts are priced in cents from $0.01 to $0.99. Here is the key insight: **the price IS the probability**. A Yes contract trading at $0.65 means the market is pricing a 65% chance the event occurs. If you think the true probability is higher, you buy Yes. If you think it is lower, you buy No (or sell Yes). ## Settlement When the event's resolution date arrives, every contract settles at one of two values: - **$1.00** if the event happened (Yes wins) - **$0.00** if the event did not happen (No wins) Your profit on a winning Yes position: $1.00 minus what you paid. If you bought Yes at $0.35 and the event happened, you make $0.65 per contract. Your maximum loss is what you paid -- $0.35 per contract. For No positions, the math is the mirror image. Buy No at $0.35, event does not happen, you collect $0.65 per contract. ## Price Discovery Prediction market prices move for the same reason stock prices move: new information enters the market. When a breaking news story shifts the probability of an event, traders rush to buy or sell, and the price adjusts in real time. This is what makes prediction markets valuable as an information tool. The price at any moment represents an aggregated, money-weighted consensus of all available information. Academic research consistently shows that prediction markets outperform polls, expert panels, and statistical models for many types of forecasting. ## The Order Book Kalshi uses a standard limit order book. Every market has: - **Bids**: prices at which buyers want to purchase contracts - **Asks**: prices at which sellers want to sell contracts - **Spread**: the gap between the best bid and best ask A tight spread (e.g., $0.64 bid / $0.66 ask) indicates a liquid market with lots of trading activity. A wide spread (e.g., $0.40 bid / $0.60 ask) suggests thin liquidity -- you might not get the price you want. ## Market Orders vs Limit Orders A **market order** executes immediately at the best available price. Fast, but you might pay a worse price in thin markets. A **limit order** specifies exactly the price you are willing to pay. It only fills if someone is willing to trade at that price. Slower, but you control your entry point. ## Why Prices Add Up to $1 In a standard two-outcome market, the Yes price and No price should approximately sum to $1.00. If Yes is trading at $0.72, No should be around $0.28. When these prices drift apart, arbitrageurs step in to capture the free money, pushing prices back into alignment. If the prices sum to more than $1.00, there is an implied fee or friction. If they sum to less than $1.00, there is a momentary arbitrage opportunity. ## The Efficient Market Hypothesis -- Applied Prediction markets are a pure expression of market efficiency. Every piece of public information gets priced in almost immediately. This does not mean markets are always right -- a 70% probability means the event still fails to happen 30% of the time. But it means the prices are the best estimate available given current information. The traders who profit consistently are those who identify mispricings before the rest of the market catches on. This is where research, domain expertise, and speed all matter.