This October, as the presidential election nears, we witness the strange intersection of the worlds of the gambler and the policy wonk. Daily, our best political observers reference the current prices of the presidential betting market. Unfortunately, I think their lack of knowledge of gambling mechanics leads them astray.
For starters, why do we care about what gamblers think about the election? The power of simple consensus estimates is remarkably powerful in a wide variety of settings (see James Surowieki’s The Wisdom of Crowds for examples). Each individual’s guess contains a kernel of truth and a lot of idiosyncratic error; when we average together individual guesses, the idiosyncratic errors filter out. Market prices are a much more powerful form of consensus estimate in which the more informed participants tend to be given much greater weight in the market. Indeed, a stronger condition holds: one perfectly informed individual can fully determine price.
So, in theory, market prices can tell us quite a lot about the election. In practice, we have to look at the institutional peculiarities of the market to determine if it is in fact well functioning and informative. This is where you have to ask yourself some simple, common-sense questions. Is the market big enough to matter? Are people staking large amounts of money on the outcome? The answer to these questions, in the case of the presidential betting markets, is yes. The amount bet on this election is in the ballpark of $100 million.
In betting markets, it’s wise to be conspiracy-minded. We should ask: Is there an endogeneity to the market, such that movements in market prices actually influence the outcome? The answer to this is “yes, probably”. This opens up the possibility that there is gaming of the market. You then have to ask, “How costly is such gaming?” The answer is that it’s somewhat costly, but the dollars are quite small relative to total campaign spending, so we have to leave this open as a possibility. I personally think that market gaming is exceedingly unlikely, but it’s a possibility that one must consider in an examination of market mechanics.
Another crucial betting mechanics question is: can a lot of money be moved at relatively low spreads? You want a lot of money to be moved so that sophisticated speculators have an inventive to dig deeply in an attempt to understand the underlying reality; if it’s a small dollar market, no one can be bothered. A low friction, low spread market is going to react much more quickly to news. Day-to-day, hour-to-hour fluctuations will tend to have more meaning in a low spread market than a high spread market.
This brief introduction to betting mechanics brings us to the first uncomfortable tension between gamblers and policy wonks: policy wonks love to quote Intrade, and gamblers think it’s by far the least important and least informative presidential betting market. It’s easy to get a small amount of money on Intrade but hard to get a large amount of money on or off; as a result, you have a huge number of people betting small amounts, resulting in a middling level of total volume (some of the other sites I will discuss are far bigger). You don’t want the gambling to look like the voting, where everyone casts a vote and all votes count the same. You want the most sophisticated market participants to have more money on the site and much more influence in determining marginal price. Intrade lacks these high balance, sophisticated accounts. One way to see quickly that Intrade is lacking these large accounts is to note that a no-arbitrage condition does not hold between Intrade and sites such as Pinnacle and Betfair that are booking a huge amount of presidential action. The prices between Intrade and Pinnacle are often dramatically different; this remains true because it is difficult to get large amounts of money on or off Intrade.
The people that know the most about the presidential race are, presumably, American analysts, but, since operating online sites is illegal in the US, almost all the action is booked on offshore betting sites. These sites are difficult for Americans to deal with, and so the prices on US elections are much less informative than, for instance, the prices of British elections of comparable import (it’s very easy for Brits to get money on and off of betting sites).
There are three betting sites worth paying attention to: Pinnacle Sports, Betfair, and Matchbook. Betfair and Matchbook are both exchanges that match bets and take a commission. Pinnacle (www.pinnaclesports.com) is more of a traditional sports book. Among traditional sports books, Pinnacle takes the most action on the presidential race by a huge margin. All other sports books are anchoring their prices to Pinnacle.
When a sports book like Pinnacle is taking the lead on a market like the presidential race, they can choose to set their line with a heavy hand, where they have strong opinions about what the price should be and are slow to move the line as new money flows in (they will as a result sometimes accumulate big positions on one candidate or the other), or they can set their line with a light hand, where they are quick to move the line as new money flows in.
Pinnacle runs the presidential market with a light hand; they are probably close to market neutral at all times. As a result, the lines can move dramatically on relatively small amounts of betting action. For example, the line on Obama is currently (-233, +208). One can risk $23,300 on Obama to win $10,000, or one can risk $10,000 on Romney to win $20,800. The maximum major Pinnacle will take at the (-233, +208) price is $10,000. If you bet $10,000, Pinnacle will move the line by approximately 10 points (to -233, +208). Since Pinnacle is running the market with a relatively light hand and adjusting the line quickly as new money comes in, the line can move dramatically in response to betting demand. There is an active market of sophisticated traders looking to take advantage of pricing dislocations and (occasional) arbitrage opportunities, but the high frictions inherent in the market place mean that pricing distortions correct far more slowly than in traditional financial markets.
I believe that the presidential betting market in 2012 is far bigger than it has ever been before. I think that we might see some unique market dynamics play out as Election Day nears. One dynamic that my friend Nate Silver will find funny: Nate, being gambling savvy, frequently quotes betting odds from a variety of sites and treats them as a check of sort on his election models predictions, but little does he know that the gambling community weights his models’ opinions very highly in their betting decisions, such that there is immense circularity in the process! Another intriguing betting dynamic is the fact that the cumulative value of the outstanding positions in this market swamps, by a margin of at least fifty-to-one, the daily traded volume of the contract. This fact will increase in relevance as Election Day nears because there will be a lot of residual uncertainty on Election Day itself that speculators might not want to subject themselves to. This suggests the possibility that there could be a massive unwind (and consequent high price volatility) near Election Day itself.