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How Intrade Works

What is a prediction market?

Intrade is a prediction market. What is a prediction market? It's a market that allows you to make predictions on the outcome of hundreds of real-world events. Stock exchanges find the price of stocks, and futures markets find the price of commodities. Prediction markets find the probability of something happening - a predefined, uncertain future event.

Will the financial markets be up today? Will a certain candidate win the next election? Who will win the Academy Awards? If you have an opinion on what will happen then you can make a prediction on Intrade. Predict correctly and you can win real money profits.

An Intrade market - always YES or NO

Intrade is a platform where you make predictions by buying and selling shares on the outcome of real-world events. These events are always defined on Intrade as a YES/NO proposition. For example, here are a few of the markets currently available:

  • The Dow Jones to close on or above 13,000 on 30 Dec 2012
  • Barack Obama to be re-elected President in 2012
  • The United States or Israel to bomb Iran before the end of 2013

There are two possible outcomes to each of these events - yes, the event will happen as described, or no, it will not happen. The Dow Jones will either close on or above 13,000 or it won't. Barack Obama will either be re-elected President in 2012 or he won't. You get the idea.

This allows you take a clear position on each event - you can either predict the event will happen, or it won't happen. You then back up your prediction by buying or selling shares in the market.

When do I buy? When do I sell?

As described above, there are two possible outcomes to each event - yes, the event will happen, or no, the event won't happen. Your opinion on what the outcome will be determines whether you buy shares or sell shares:

  • If you predict the market event will happen then you BUY shares
  • If you predict the market event will not happen then you SELL shares.

(Yes, you can sell shares before you own them. This is known as "short selling" and is explained further below in Short Selling - selling shares that you don't own.)

As an example, let's say you want to make a prediction on the following market: The Dow Jones to close on or above 13,000 on 30 Dec 2011. If you predict the Dow Jones will close on or above 13,000 then you will BUY shares. If you predict the Dow Jones will not close on or above 13,000 (i.e. close lower than 13,000) then you will SELL shares.

Who am I buying from? Who am I selling to?

Intrade is an exchange - like the New York or London stock exchanges for example. When you buy shares you are buying them from another member of Intrade. And when you sell shares, another member of the exchange is buying them from you. You do not buy shares from Intrade, and Intrade does not buy shares from you. You are always trading shares with other members of the exchange - other people who are making predictions, just like you.

It is important to remember that Intrade is a market. This means you may not always be able to get what you want. If you are looking to buy some shares, but nobody is selling, then you can't buy the shares that you want.

Market Settlement - always $0.00 or $10.00

When the outcome of an event is known, the market is settled. The market will always be settled at either $0.00 or $10.00 according to the actual real-life outcome:

  • YES, the market event has happened - the market will be settled at $10.00.
  • NO, the market event has not happened - the market will be settled at $0.00.

For example, we currently have a market for Barack Obama to be re-elected President in 2012. If Obama is re-elected then the market will settle at $10.00. If he is not re-elected the market will settle at $0.00.

Let's say you predict Obama will win re-election, so you buy shares. If Obama is re-elected the market will settle at $10.00 and you will have a profit. How much of a profit will depend on the price you paid for the shares. But if Obama loses the election the market will settle at $0.00 and you will lose.

The opposite applies if you sold shares because you predict Obama will not be re-elected. If he is re-elected then the market will settle at $10.00 and you will lose. But if he fails to be re-elected the market will settle at $0.00 and you will have a profit.

What is my potential profit? What is my potential loss?

Because a market will always settle at either $0.00 or $10.00, all shares are bought or sold at prices somewhere in between. The price at which you buy or sell shares will determine how much you can win, and how much you can lose.

When you buy shares you make a profit if the price of the market goes up. Your profit is maximised if the market is settled at $10.00. If you sell shares then you make a profit if the price of the market goes down. Your profit is maximised if the market is settled at $0.00.

Let's look at a couple of examples...

You buy shares at a price of $7.00. If the market settles at $10.00 then you have a profit $3.00 per share. If the market settles at $0.00 then your loss is $7.00 per share.

Let's say you sell shares at $4.50. If the market settles at $10.00 then you lose $5.50 per share. If the market settles at $0.00 then you have a profit of $4.50 per share.

Where do my profits come from?

Your profits come from the losses of those on the other side of your prediction.

There are always two sides to every prediction. If you make a prediction by buying shares, then someone is making the opposite prediction by selling you those shares - you are saying yes, the event will happen, they are saying, no it won't. If you predict correctly your profits come for the person who sold you the shares - the person who predicted wrongly.

Let's look at an example. Trader A buys shares from Trader B at a price of $6.50.

If the market event happens the market is settled at $10.00:

  • Trader A will have a profit of $3.50 per share
  • Trader B will have a loss of $3.50 per share

If the market event does not happen the market is settled at $0.00:

  • Trader A will have a loss of $6.50 per share
  • Trader B will have a profit of $6.50 per share

As you can see, the profits of those who predicted correctly always match the losses of those that predict incorrectly. Those losses are simply transferred to the winners as profit.

If the market settles at $10.00 then the profits for the buyers comes from the losses of the sellers. If the market settles at $0.00 then the profits of the sellers come from the losses of the buyers.

Because a prediction always requires a buyer and a seller there is always the exact same number of shares sold as there are bought. Therefore there is always a perfect balance between profits and losses.

How do I cover my losses?

Whenever you buy or sell shares you have to cover your potential loss. Intrade does this by freezing the maximum amount you can lose whenever you make a prediction. If you don't have enough available cash in your account to cover this potential loss, then you cannot make the prediction.

For example, let's say you buy 10 shares at a price of $6.00. The maximum amount you can lose per share is $6.00 (if the market settles at $0.00), so your total potential loss is $60.00 (10 shares x $6.00). When you buy these shares $60.00 is frozen in your account to prevent you using the same funds to cover other predictions. If you don't have $60.00 in your account, you can't buy those shares.

By doing this your potential losses are always covered, which means the profits of those who you have predicted against are always assured. There is no way you can default on your losses because if you can't cover the loss, you can't make the prediction in the first place.

If you win then the funds frozen to cover your potential loss are unfrozen and any profit credited to your account. If you lose, the frozen funds are debited from your account balance as a loss.

Short Selling - selling shares that you don't own

It is possible to sell shares that you don't yet own. This is known as short selling. You are essentially "borrowing" the shares and selling them with the intention of buying them back again later. If you predict the market event will not happen then you will (short) sell shares. You can then cover this sale at a later time by buying back the shares, or hold until the market is settled.

So don't be put off selling shares because you don't own any - you can sell shares without owning them first.

Can I sell my shares early for a profit (or to minimise a loss)?

Yes. If you buy shares and the price increases, you can sell these shares for a profit. For example:

You buy shares at a price of $6.00. The next day the price has increased to $7.50. You can sell these shares and take a profit of $1.50 per share.

If however you sell your shares for a lower price you will make a loss. For example:

You buy shares at a price of $6.00. The next day the price has dropped to $4.90. If you sell these shares you will suffer a loss of $1.10 per share.

(Why would you sell for a loss? You may want to sell your shares if you think the market will drop further, to help minimise your potential loss.)

Because you also have the option of short selling shares you can sell the shares first and then buy them back later at a lower price to make a profit. You have still bought low and sold high, only you did the selling part of the equation first. For example:

You short sell shares at a price of $8.00. The price of the shares slips to $5.30 later in the day. You can now buy back these shares for a profit of $2.70 per share (i.e. you bought at $5.30 and sold for $8.00).

But if you buy back your shares for a higher price then you make a loss. For example:
You short sell shares at a price of $8.00. The price of the shares increases to $9.25 later in the day. If you buy back these shares you will suffer a loss of $1.25 per share (i.e. you bought at $9.25 and sold for $8.00).

(You may want to do this in order to minimise a potential loss if you think the price of the market will continue to rise.)

What is the "chance" of an event happening?

The market prices of shares also indicate the probability of the event happening. For example, a market price of $3.63 indicates a 36.3% probability the event will actually happen, according to the market. In other words, the market is predicting a 36.3% probability.

At various places on Intrade you will see the "chance" of something happening. This figure is the current percentage probability of the event happening, as predicted by the market, and is calculated using the last price at which shares were bought or sold.

The golden rules - a summary

In summary, here are a few of the golden rules when it comes to understanding Intrade:

  • Each market is a YES/NO proposition - yes, the event will happen, or no, the event will not happen.
  • If the event does happen, the market will settle at $10.00.
  • If the event does not happen, the market will settle at $0.00.
  • If you predict the event will happen then you BUY shares.
  • If you predict the event will not happen then you SELL shares.
  • If you buy shares you profit if the market value of the shares goes up. Your profit is maximised if the market settled at $10.00.
  • If you sell shares you profit if the market value of the shares goes down. Your profit is maximised if the market settled at $0.00.

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