As mentioned previously at the Knowledge Problem, Inkling offers a public play-money prediction market. I stumbled across them a year or so ago, and because I’m interested in market design and prediction markets, I decided to try them out. Partly because playing the Inkling markets amuses me and partly because I started doing well, I’ve continue to play on Inkling. Eventually I wormed my way onto their Top Traders list, where I’ve remained for several months.

In the process of amassing my play-money riches, I’ve learned a few useful things about Inkling’s markets. Here I am “giving back” to the Inkling user community by sharing one of my secrets.

This is it: when a market offers you free, riskless profits, take them.

Obvious, right? The trick is in spotting the riskless profits. I recently was able to take some free, riskless profits when Inkling allowed two markets to be set up for the same event: the UEFA Champions League. It isn’t necessary for there to be two markets on the same event for arbitrage to work – I did something similar in the NCAA men’s basketball final four market – but the two market case makes the arbitrage process easier to understand.

By the way, as I write the markets are still live, and I have existing risky holdings in these markets. These stakes are standard bet-I-know-better-than-the-market plays which may or may not pay off. None of what I am about the explain involves taking risks, just taking profits.

The standard multiple result market at Inkling pays off at 100 units for each share of the winning outcome you hold at the closing of the market, and pays off at 0 for all other outcomes. In this case both markets will pay 100 in play-money units for picking the eventual winner in the 2006-07 UEFA Champions League, and 0 for shares in all other outcomes. Because two separate markets are running over the same event, when the prices of the markets diverge, there is a simple and obvious arbitrage opportunity. Of a pair of matching outcomes (Say “Chelsea wins”), buy the lower priced of the two and sell short the same number of shares in the higher priced market.

The final outcome doesn’t matter, because whatever you win on one you will lose on the other. Your entire profit is captured in the net proceeds of the buy low-sell high pair of transactions. Here is a simple example drawn from my trading report:

I sold into the first market at an average price of about $13.72 and bought in the second market at an average price of $10.91. The result: a $140.11 profit for a minute or two of effort. Not a lot of profit, but not too bad for riskless trading. (The short sale does tie up some credit, but since we’re dealing in a play-money exchange that doesn’t pay even play-money interest on your holdings of pretend cash, the only thing you sacrifice is other trading opportunities.)

Outside of the rare pair of auctions covering the same event, I’ve found similar riskless trading opportunities in the recent market to pick the final four teams in the NCAA men’s basketball tournament. The market would pay 100 for each of the four teams that reached the final four weekend. The market started even before the tournament seedings were announced, with a large number of possible teams, and shares traded on various market expectations. Curiously, early on the total value of all of the stocks summed to more than 400 even though owning one of each share was guaranteed to pay off exactly 400. (This is a clue that arbitrage opportunities are available.)

Once the tournament seedings were announced, it is clear that owning one of each share of all 16 teams in a single region would payoff exactly 100. If the share prices summed to less than 100, then buying one share of each team generates a payoff at the difference between the cost of the shares and 100. If the share prices for all teams in a region sum to more than 100, then selling one share each will generate profit to you at the difference between the proceeds of the sales and 100.

For simplicity, say that there are just two teams left in the “West Region.” Let’s call them, hypothetically, “UCLA” and “Kansas.” Buying one share of UCLA and one share of Kansas, will lock in a payoff of 100, so if the prices of the two teams sum to less than 100 then you can obtain riskless profits by making the purchase. (Or sell short if the prices sum to more than 100.)

While it may be less obvious, the underlying arbitrage is similar to the AC Milan example. At this stage of the contest, a share of “UCLA wins” is the logical equivalent of “Kansas loses.” Buying one share of UCLA and one share of Kansas is the logical equivalent of buying a stake in “Kansas loses” and a simultaneous stake in “Kansas wins” – with offsetting holdings your payoff doesn’t change based upon the outcome of the event, and your profit is risklessly captured from arbitraging the market at the time of the transactions.

Many Inkling markets are self-arbitraging in the sense that they automatically account for these interrelationships in pricing multiple outcome prediction markets. For example in the separate market to pick the eventual champion of the NCAA men’s basketball tournament, all prices automatically adjusted in response to any purchase or sale such that the sum of the prices always totaled exactly 100. (In fact, both of the two UEFA Champions League markets are self-abitraging within the markets, but I profitted by arbitraging between the two markets.

As an economist, my opinion is that such self-arbitraging markets likely exhibit superior efficiency properties that would make them desirable in real-money practice. (As a sometime experimentalist and aspiring prediction-market geek, I’d love to test that conjecture in an econ lab.) As an Inkling trader, however, I love to discover and exploit riskless trading opportunities in non-self-arbitraging markets.

[Okay, I’ll admit that I didn’t become an Inkling Top Trader via riskless arbitrage. I took many risky steps along the way, some of which paid off handsomely. But explaining that I often got lucky doesn’t appeal to my inner aspiring PM-geek.

BTW, in addition to pulling riskless profits out of the UEFA Champions League markets I was also carrying very substantial risky holdings in both Chelsea and Man U. Surely one or the other would win it all, right?

Ouch.]

#1. FEED READERS. I renew my advice: read your site feeds with a Web-based feed reader as opposed to a PC-based feed reader. Let another machine (other than your PC) deal with the downloading and organizing of the site feeds. Plus, you can access it from anywhere on the Earth (your office, your home, your hotel, or your conference room). As for the best Web-based feed reader, it’s Google Reader. (For more information, here’s a detailed comparison between Google Reader, BlogLines and Internet Explorer 7.)

#2. BLOGGING PROFESSORS. Professor Steve Bainbridge explains how and why he publishes some class materials on his blogs.

#3. FREE NEWS SITES vs. SUBSCRIPTION NEWS SITES. The Wall Street Journal earned more money with its online website than its print publication. (Related: Jakob Nielsen on micro-payments.)