Table of Contents
Infographic: Prediction Markets Explained for Beginners
Prediction Markets Explained for Beginners: How They Really Work
A prediction market lets you put money on whether a future event will happen. But did you know you can end up losing money even if you’re right most of the time?
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years.
In the next few minutes, I’ll explain what prediction markets are, how they actually work, and where they should fit in to your finances.
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What Is a Prediction Market
A prediction market is a marketplace where you can buy contracts tied to future events – like elections, sports, weather, celebrity news, or almost anything else – before the outcome is known.
And you get paid based on whether your prediction about the outcome is correct.
Many prediction market contracts use a binary format, where a single contract’s value goes to $1 if the event happens, and $0 if it does not.
The cost to buy a contract fluctuates between $0.01 and $0.99 based on supply and demand, and you can sell at any time before the actual event.
Let’s say you buy 100 YES contracts on it raining tomorrow for 60 cents each. So your position costs $60.
If it does rain tomorrow, each contract settles at $1. You’ll receive $100, making a $40 profit before fees.
If it doesn’t rain tomorrow, those contracts settle at $0 and you lose the $60 you put in.
Why is it Called “Prediction” Market
It’s called a prediction market because the price of the contract is commonly interpreted as a rough probability of the event happening.
In our example, a 60-cent price can be interpreted like the market collectively “predicted” that there’s a 60% chance of rain tomorrow.
If the wind changes and clouds move closer, then the chance of it raining tomorrow will increase and the price will go up to match it.
You could sell early after the price goes up and then earn some profit, or you could hold it until the end and hopefully get the full dollar. But of course, it’s possible that you end up getting nothing if it doesn’t rain.
And this is where a lot of people get prediction markets wrong: they often assume predicting the winner is enough.
But you can be right most of the time and still lose money if the price isn’t favorable. Because you could earn, say 20 cents, per win but lose 80 cents per loss – and that’s all before fees.
But if it’s so easy to lose money, are prediction markets just gambling?
Are Prediction Markets Gambling or Investing
The legal answer to what exactly prediction markets are is still evolving.
Right now, most US prediction markets are regulated as investments at the federal level – not gambling. But there are court cases challenging this, especially for sports-related contracts.
From a personal-finance perspective, the distinction is simpler.
While studying for the CFP® exam, I learned that what matters is where your return comes from.
Stocks give you ownership in businesses that can earn profits and grow over time, while prediction market contracts get their value from speculation on a future event.
So trading on prediction markets is a lot more like day trading or gambling than actual long-term investing – even if many prediction market platforms have UI that looks just like a brokerage app!
The exception is using event contracts to hedge against a specific risk, like a business owner who buys a weather contract to help cover financial losses if a hurricane forces it to shut down.
But this doesn’t really apply to most individuals.
Should You Use Prediction Markets
For most people, prediction markets should be occasional entertainment – like gambling at a casino – or just avoided completely, because the risks far outweigh the potential payoff.
A contract can settle at zero and wipe out your entire position, and just like with gambling, losses can make you risk more money to win back what you already lost.
Say you lose $50, then risk $100, then $200, then $400 – just trying to recover it. You could easily end up losing all $750.
Even if you know a lot about a topic, that doesn’t guarantee profits, because other traders may already know it too.
And even if you win, fees, taxes, and limited liquidity can reduce your returns.
The biggest cost though is what this money could have been doing instead.
Investing just a dollar a day for 40 years in the stock market will grow to over $200,000. Using that money in prediction markets could easily leave you with nothing.
If you still want to participate, first make sure you have an emergency fund and are on track with long-term investing.
Then, you can use prediction markets as entertainment by setting a fixed amount that you’re comfortable losing and never increasing it after a bad trade.
Once you understand why prediction markets are entertainment, the next step is to build your actual investment portfolio.
Check this out for a completely jargon-free explanation of investing, so you can start growing your money and build long-term wealth without the guesswork: Investing Explained: A Beginner’s Guide to Wealth Building