- An event is “retarded” when it is after the others on the timeline.

-

- I use the term “advanced, primary indicator” to talk about the leading sources of information that active traders rely on.

- Last time, in the title, I said that the InTrade traders were “retarded”, in the sense that they were late to compute that Israel will not attack Iran in the second semester of 2008. One InTrade trader (I presume he / she is) took strong exception with my wording. Sorry for that, man / woman.

-

RANDOM HOUSE UNABRIDGED DICTIONARY:

- retarded = to be delayed

-

-

Here’s the updated version of the story in question:

-

-

-

- US Military Chief Says Any Attack on Iran Would be Destabilizing.

- Israel has signaled the U.S. and other allies that air operations to destroy Iran’s nuclear facilities are not imminent.

- Pentagon chiefs fear that Israeli plans for an attack on Iran’s nuclear programme will fail to destroy the facilities because neither the CIA nor Mossad knows where every base is located.

-

-

Explainer On Prediction Markets

Prediction markets produce dynamic, objective probabilistic predictions on the outcomes of future events by aggregating disparate pieces of information that traders bring when they agree on prices. Prediction markets are meta forecasting tools that feed on the advanced indicators (i.e., the primary sources of information). Garbage in, garbage out… Intelligence in, intelligence out…

A prediction market is a market for a contract that yields payments based on the outcome of a partially uncertain future event, such as an election. A contract pays $100 only if candidate X wins the election, and $0 otherwise. When the market price of an X contract is $60, the prediction market believes that candidate X has a 60% chance of winning the election. The price of this event derivative can be interpreted as the objective probability of the future outcome (i.e., its most statistically accurate forecast). A 60% probability means that, in a series of events each with a 60% probability, then 6 times out of 10, the favored outcome will occur; and 4 times out of 10, the unfavored outcome will occur.

Each prediction exchange organizes its own set of real-money and/or play-money markets, using either a CDA or a MSR mechanism.

-

-

A recent article in the prestigious academic journal Science (May 16, 2008, Vol 320, p. 877-8) once again makes the case for regulated prediction markets, more commonly known as “betting exchanges” to online gamblers. The authors make the case that such markets are useful in forecasting future events with less error than traditional measures such as polling. This argument is hard to ignore, with the authors including 21 top economists from such esteemed institutions as Yale, Stanford, Berkeley, and the University of Pennsylvania. Notable among the authors is Justin Wolfers from the Wharton School of business at UPenn, an economist who has gained notoriety in gambling circles due to his work on such topics as NBA referee bias (highlighted in a May 2008 article from MajorWager: http://www.majorwager.com/index.cfm?page=27&show_column=660).

The concept behind using prediction markets as a decision-making tool is simple. “Shares” are made available on an open market, and the participants use their capital (and the promise of profits) to make predictions on future events, which is incorporated into the share price. In general, information tends to be widely dispersed, and a market allows wide-ranging opinions to be gathered and consolidated into a market-wide prediction. In other words, an infinite amount of opinions can be aggregated, and an open market with potential for profit provides an incentive for individuals to make their opinions publicly known.

Prediction markets always get more than their fair share of press near the end of the 4-year U.S. Presidential election cycle. The Iowa Electronics Market, housed at the University of Iowa, is perhaps the most well-known. The authors of the Science paper show that, in the week immediately preceding the Presidential elections from 1988 through 2000, the Iowa Electronic Markets erred by an average of only 1.5 percentage points from the actual vote results, while the traditional Gallup poll was off by 2.1%. Numerous other studies have shown the superiority of markets compared to other forecasting tools.

Of course, there have been some dust-ups regarding prediction markets in the past, most notably the “terrorist strike market”, unveiled a little too close to 9/11 to be palatable to the general public. The official name was the “Policy Analysis Market“, and it was established by the Pentagon to act as a prediction market for Middle East political events. It was quickly scuttled after heated comments from U.S. Senators, calling it “grotesque” and “stupid”, due to the perception of using catastrophic events such as assassinations as profit-making tools. Regardless of its political correctness (and the misinformed opinions of a few politicians), such a prediction market still holds value as a glimpse into the collective mindset of everyone with an understanding of political currents in the region. Utilizing such a prediction market as a component of foreign policy decisions may have ultimately spared the U.S. much grief in Iraq.

In recent years, prediction markets have grown beyond academic and government roles. Dublin-based InTrade is rapidly growing and provides many more options than the Iowa Electronic Markets. Others such as MatchBook have focused more on sporting contests, but provide coverage of other events as demand calls. Of course, those outside the U.S. have access to the largest betting exchange of them all, the massive European markets of BetFair. The success of these exchanges speaks to the public interest and feasibility of prediction markets.

One factor holding back the growth of online prediction markets is their close association with the quasi-legal world of sports betting and internet casinos. InTrade has been fairly proactive in this regard, spinning off from Tradesports to clean up its corporate slate, but it is still knee-deep in the legal sludge surrounding offshore “gambling”. All have to deal with the legal and financial hurdles of operating offshore.

The authors of the Science paper propose that clarification of internet gambling laws is needed to exploit the benefits of prediction markets within the United States. Clearly, the Unlawful Internet Gambling Enforcement Act (UIGEA) of 2006 is one such mechanism restricting the widespread use of prediction markets. Another is the Commodity Futures Trading Commission (CFTC), the regulatory agency which oversees futures markets in the U.S. The CFTC has provided a “no-action letter” to the Iowa Electronic Markets, an assurance that they will not seek any enforcement action against the exchange. However, this protection is not absolute and may not trump state and federal law if challenged. The Science authors propose a number of legal reforms which will allow prediction markets to begin to gain acceptance within the U.S. financial regulatory structure.

By no means does the Science article condone large-scale public markets, at least not initially. They take a (typically academic) conservative approach, recommending new legal framework to allow for the establishment of small markets with limited scope so as to evaluate the promise and use of prediction markets. But baby steps are going to be a necessity in the growth and acceptance of regulated public markets.

Clearly, there are negative aspects to financial markets, and regulation certainly has its place. Bear Sterns, Enron, the S&L scandal of the 80s, and the current housing bubble all caused tremendous loss of wealth resulting from missteps in the financial markets. The current oil crisis is due at least in part to speculation, leading to the introduction of no less than 9 separate bills in the U.S. Congress seeking tougher regulation over the trading of commodities. However, the existence of problems in the financial markets does not necessitate their dissolution. Likewise, prediction markets are sure to encounter bumps in the road, but their utility should far outweigh the risks.

Should prediction markets be legalized in the U.S.? Almost certainly. They would have benefit across numerous industries, from business decisions to political policies to financial forecasting. Unfortunately, this would require building an unlikely bridge over the Puritanical moral moat placed around gambling in the U.S. But there is no inherent difference in betting on who will win in an election than what the price of oil will be in 6 months, or what the S&P 500 will close at on a particular date. Distancing prediction markets from “illegal” gambling, and instead likening them to regulated financial markets, will be a necessary first step towards broader acceptance.

The academic groundwork on prediction markets has already been laid, and offshore exchanges have begun to turn these concepts into functioning businesses. As these markets grow and begin incorporating more diverse opinions, we can expect their success rate at predicting the future to only grow. To restrict such a promising tool simply due to its perception that it is a gambling outlet is silly indeed.

6-25-08
Jay Graziani
MajorWager.com
graziani@majorwager.com

-

[This article is cross-posted from Major Wager.]

-

I answer the first part of question 14, “No,” (and thus need not answer the second part). I doubt that the CFTC wants to hear that sort of reply, frankly; I instead suspect that it wants a legal excuse to avoid the sort of political firestorm that followed the Pentagon’s proposal to create a Policy Analysis Market that included claims about assassinations and terrorist events. My draft answer to question 14 explains why I’m willing to risk disappointing the CFTC:

The CFTC should not forbid trading in claims based on assassinations, terrorist activities, or other criminal acts. Because event markets would offer only relatively thin and traceable trading, they would not offer an attractive investment option to anybody planning to profit from wrongdoing. A would-be terrorist would risk revealing both his plans and his identity if, for instance, he invested in a contract predicting another 9/11. He would instead find it more safe and profitable to simply short certain publicly traded stocks.

Furthermore, event markets in terrorist or criminal acts might benefit the public by revealing life-saving information. Suppose, for instance, that an anthropologist’s study of corrido culture convinced her that narcoterrorists had begun planning military raids on border checkpoints in Arizona and California. If she had the opportunity to buy terrorist event claims, she might both profit from her research and tip us all off about looming trouble. Sound public policy suggests that we should encourage that sort of trading—not forbid it.

To judge from their reactions to the Policy Analysis Market proposed by the Pentagon in 2003, politicians might need to learn more about the benefits of using trading to help predict assassinations or other terrorist events. That poses a public relations problem, however—not a legal one. The CFTC thus has no sound reason to presumptively forbid trading in contracts related to such events.

Notably, my answer to question 14 differs sharply from the answer offered by Jed Christiansen. He said, “There should never be any incentive to break a law, so there should never be any contracts that would pay someone if a law was broken.” I disagree, of course, but I thank him for stimulating me to offer an alternative take.

[Crossposted at Agoraphilia and Midas Oracle.]

Consider that the criticism is a product of high expectations — people are complaining that, contrary to expectations, the markets were not better than the polls. People are noticing that prediction markets are not perfect. People all over the place are arguing about prediction markets.

It may look bad, but to me it appears as if there is a broad base of awareness and relatively high expectations out there that wasn’t evident in the press six months ago. Furthermore, a lot of people who hadn’t thought too much about prediction markets have now had the topic thrust in front of them.

It will turn out more than “just fine” for prediction markets – the market for prediction markets will continue to grow. It may look like a very public black eye, but that is because political prediction markets are now in the fight.

Thursday, April 26, 2007

On Stage:
Scott Cooper, MIT researcher with the Sloan School of Management, co-author of Coolhunting
Peter Gloor, MIT researcher with the Sloan School of Management, co-author of Coolhunting
Steve O’Keefe, moderator

Listening in from Sweden is one of the co-authors of the book

Leading the Coolhunt today is Peter Gloor.

PETER: Today, we’re going to talk about prediction markets. A really great example is InTrade.

WEB: http://www.intrade.com/

PETER: Prediction markets are a great way to tap into the wisdom of crowds. Instead of having an expert predicting the outcome of certain events, you have people placing bets on what’s going to happen.

SCOTT: This ties in with things we’ve discussed in previous days. The concept of collective intelligence to predict outcomes is similar to what we talked about with “Mutual Fun” at Rite Solutions. Essentially, anything that hits the news that has an outcome related to it can be bet on here. For example, right now bets are being placed on whether Paul Wolfowitz will be asked to resign at the World Bank. Whether the news items are actually bet on depends on what the swarm wants to do.

PETER: Let’s look at what the swarm wants to do by going to the U.S. Politics section of InTrade.

WEB: http://www.intrade.com/

PETER: For each potential candidate, you can place a bet. Right now, if you invest 30 cents, you will get $1 if Giuliani is selected as the Republican candidate for President.

MODERATOR: Is there “skin in the game,” as you say in the book? Does this use real money?

PETER: Yes, it uses real money. These are real bets. In one of our research projects, a group of students monitored web chatter to accurately predict Oscar winners. The closer an event gets, the more accurate the predictions get. The closer we get to the elections, these predictions get more accurate.

MODERATOR: Is there any analysis that compares the accuracy of prediction markets with other means of polling?

PETER: Usually, the prediction markets outperform traditional polling, by far. You have to look at how the prediction market is set up. It has to be a large crowd. It has to have a good mix of participants — different types of people. Private companies are also using prediction markets, such as HP, Google, and Microsoft. There is undeniable evidence that even small prediction markets are more accurate in predicting software delivery dates than managers or experts.

SCOTT: I’ve read interesting stories over the past year about businesses using prediction markets, partially precipitated by an article that appeared last spring in the New York Times Business section. The article said that while some high-tech companies were making breakthroughs trading on idea futures, most companies had not done it. Prediction markets threaten the hierarchal control of managers and would make it obvious that most managers are stupid, to paraphrase many bloggers.

MODERATOR: If the costs of setting up the mechanism are not prohibitive, it seems prediction markets would be preferred.

PETER: There are prediction markets for success of movies at the box office.

SCOTT: We talk about the Hollywood Stock Exchange in Coolhunting and how it’s useful to help determine the likelihood of a given release becoming a box office smash. There are 1.4 million people who trade on the Hollywood Stock Exchange as of a year ago when we wrote that section of Coolhunting.

WEB: http://hsx.com/

PETER: One interesting note is that people are not betting real money on this site. There are some rewards such as T-shirts and tickets for very successful predicters.

SCOTT: It’s expanded over the years, not just to predict success of movies. There are also star bonds — essentially, betting on the future success of a given entertainer.

MODERATOR: There is a leader board with top traders for the site. You’d think someone would recruit these people as movie reviewers?

SCOTT: It would be interesting to find out if anyone has parlayed their success on Hollywood Stock Exchange into becoming a paid movie critic.

PETER: Companies want successful predictors to participate in their prediction markets. It creates accuracy. Having people with a good track record of making predictions helps the hive. We’ve found that it is not just the number of people participating in the markets that counts, but also the quality of their prediction capabilities — and of course their “betweenness” factor — how well networked they are. We’d love to have a swarm full of Warren Buffets — the investor with a track record for accurately predicting markets. Now, let’s visit the grandfather of prediction markets sites, the Iowa Electronic Markets.

WEB: http://www.biz.uiowa.edu/iem/

PETER: This is a longstanding market for predicting presidential elections, run from the University of Iowa College of Business.

MODERATOR: You can make predictions on diseases as well. Can people really predict the outbreak of a disease better than medical professionals?

PETER: There has been research done in this field. If you have a mix of experts, ordinary people, and well-educated people, you get the best predictions. The mix is more accurate than the experts alone. Experts have really strong opinions.

SCOTT: There is a specific reason we refer back to collective wisdom and collective intelligence. They can mean two very different things, with respect to the combination of experts and “ordinary” people. It’s with the ordinary that you often get the wisdom part of the equation. They don’t have the bias associated with being an expert. That, mixed with real expertise, can be a powerful predictor. People making “bets” are informed non-experts. One has to assume that if you’re betting real money on InTrade on whether Barack Obama will get the nomination, you’re doing it based on some of your own intelligence applied in a wise way.

In our book, we make mention of the fact that a few years ago, the Pentagon proposed a market for anonymous bettors to predict when a terrorist attack would take place. They thought it’d be a worthwhile endeavor rather than an academic experiment. It didn’t happen because after the news of it went public, people were horrified by the concept of using a disaster as a “game.”

I worked at a firm a few years ago on an early version of a prediction market regarding the energy crisis. Consultants would get together once a week and make bets about certain aspects of the electricity market in the U.S. This was 15 years ago, and we were using collective wisdom plus a general information dump from the corporate librarian.

MODERATOR: Much like turning an office football pool into a powerful new business tool.

PETER: Let’s now look at how something that was really cool in the past is becoming less cool. The brand of Apple is mired in maintaining coolness. Right now, there is the controversy of the backdated stock options. Bloggers are suggesting that Steve Jobs knew about this all along. We can view the various comments on Slashdot to see some examples.

WEB: http://slashdot.org/

MODERATOR: By the way, Slashdot is a hugely popular blog for nerds and geeks. It’s a great place for cool farming.

PETER: Yes, it’s a great place for cool farming and even more so for coolhunting. Scroll through the comments on this particular blog post about the stock option crisis at Apple and see what respondents think about Jobs.

WEB: http://apple.slashdot.org/apple/07/04/24/2134257.shtml

We could go to InTrade and see if people are already placing bets on Jobs stepping down.

MODERATOR: These comments give us the sense of what’s happening with the hive.

PETER: Exactly. The wisdom of crowds is amazing for predicting these sorts of things.

MODERATOR: We are out of time. Thank you very much, Peter and Scott. Listeners, please post your comments to the blog — whether they’re about commentary on the subject of today’s coolhunt or any connection problems you experienced.

Join us tomorrow for the next installment of our live, online coolhunt with Peter Gloor and Scott Cooper.

Thank you.

Copyright Notice: Please feel free to duplicate or distribute this log as long as the contents are not altered and this notice is intact.

What are some examples of public prediction markets?

One of the first and oldest prediction markets [*] was run by the University of Iowa in 1998 [**] to predict the outcome of United States Presidential Elections. [***] In fact, those markets have been more accurate than the most accurate polls [****] in every election the University of Iowa has run their markets. Since then there have been numerous examples of companies using prediction markets to forecast product sales, revenues, and the completion dates of large projects. The Pentagon even tried prediction markets in 2003 to forecast economic indicators in the Middle East before it was shut down because of the discovery of other questions being asked about terrorist targets and war casualties (political hot potato.) [*****] Some public prediction market exchanges such as TradeSports, located in Ireland, even use real money and have contracts on sports and current events. Hedgestreet, a U.S. based exchange, received special permission [******] from the Commodities Futures Trading Commission (CFTC) to run a real-money exchange on economic events and price movements. There are also many play money prediction markets. Besides Inkling and our customers who have created several public marketplaces, the Hollywood Stock Exchange [*******] runs an exchange to predict box office performance of Hollywood movies, the Washington Stock Exchange is a prediction market dedicated to politics, and the simExchange is a new marketplace focused on the sales of video games.

[*] According to Paul Rhode and Koleman Strumpf, prediction markets almost never got it wrong forecasting the 19 elections that took place from 1868 to 1940. (PDF)

[**] 1988

[***] IEM also ran prediction markets on federal congressional and gubernatorial elections, and on foreign elections, too.

[****] Yeah, but I would be a bit prudent on this claim and wait for a consensus among economists.

[*****] Good description of the 2000–2003 US DoD’s DARPA‘s IAO’s FutureMAP/Policy Analysis Market project. Just a remark. Robin Hanson wrote: “[...] predict its military activity, political instability, economic growth, US military activity, and US financial involvement.”

[******] HedgeStreet is a designated contract market (DCM) and a registered derivatives clearing organization (DCO). HedgeStreet is subject to regulatory oversight by the Commodity Futures Trading Commission (CFTC).

[*******] The trading software of the Hollywood Stock Exchange emulates the Wall Street mechanisms so as to satisfy the sophisticated bettors —which is a different approach than Inkling’s one (not saying that Inkling is wrong, just remarking that Inkling is different).

Previous: Pinching Adam Siegel’s nose… gently.

HANSON: So on Monday morning two senators you know denounced the project and the very next morning the Secretary of Defense announced the project was canceled. There was basically no sort of consultation with us who were running the project. This was perceived as crossing a very simple moral boundary. It’s not about the details, it’s not about the consequences; it’s just about there’s a line and you don’t cross it.

HARFORD: The project that was so hastily cancelled was a proposal from the Pentagon’s research arm, on which Robin Hanson was an advisor… But just how far were Hanson and his colleagues planning to go? The headlines said they were taking bets on coups, assassinations and terrorist attacks.

HANSON: We were not planning to bet on the details of individual terrorist attacks. We had on our sample web page that went up a faint background screen and that showed various sort of things that might have been in the real market. And in one of those small corners was a miscellaneous section because we weren’t sure we could cover everything with our standard set of questions and some sample miscellaneous questions included Arafat assassination and North Korea missile strike. And unfortunately those were the basis for the claim that we were setting up a market on terrorist attacks.

HARFORD: So the controversy was based on something fairly flimsy….

Harford also talks markets for kidneys and other body parts, dwarf tossing, and life insurance in a discussion of markets for things or services some people find repugnant.

Here’s the New York Times news article on PAM , titled Pentagon Prepares A Futures Market On Terror Attacks. [Wrong. It was a prediction exchange on Mid-East issues. Market-generated predictions are objective probabilities of future outcomes, and so most economists love prediction markets. There were indeed four Armageddon-forecasting questions, but they were really an appendix of the program. Plus, if you're about strategic forecasting, it makes sense to try to forecast the worst, no?? No terrorists could have profited from speculating in the same ways as their acts, because, among others, there was a $100 trading cap. And the rumor that Bin Laden profited from the short-selling of US airlines stocks just before 9/11 was just that, a rumor, by the way. (The SEC and the FBI debunked this rumor, and the 9/11 Commission published a note on this rumor.)]

Here’s the New York Times’ public editor criticizing harshly a recent article published in “the newspaper of reference”.