There are a number of different types of prediction markets. They can differ in trading mechanics, as well the type of currency they use. In addition to the various types of prediction markets, there are also other types of crowdsourced forecasting tools that can be used to similar ends, but without the stock market mechanics.
A continuous double auction (often abbreviated as CDA) is a mechanism for matching buyers and sellers of a stock. In a CDA, the market maker keeps an order book that tracks bids and asks. If I come along and say that I'd like to buy a share stock A for $5, that is recorded in the order book as a bid for 1 share at $5. On the flip side, if you own a share of stock A and are willing to sell that share for $5, that is recorded as an ask. If the bid & ask for two traders match, like in our example (I want to buy stock A for $5, you want to sell it for $5), then the trade is executed. A continuous double auction is also used in traditional stock markets like the NYSE.
One issue with using a continuous double auction in a prediction market is that liquidity can be a problem. Most prediction markets have far fewer participants than an exchange like the NYSE. If I make a bid for $5 and there is no one out there selling the same stock for $5, then I can't make my trade. If there's no one to take the other side of my trade, the market would be said to have low or poor liquidity.
To alleviate this problem, platforms use what's known as an automated market maker. In this setup, the platform (such as Cultivate Forecasts) acts as the "house," taking the opposite side of all trades. Doing so ensures that participants are always able to make a trade, effectively creating or "making" the market. These market makers are not typically used in real money prediction markets, since taking the opposite side of all trades could result in losses for the "house." They are much more common in play money prediction markets, where house losses are much less detrimental.
In order to make the market, the platform must set a price for each stock. Prices are typically set using a market scoring rule, which is just a fancy term for a mathematical equation that produces a price for the stock and a cost for a trade. The most common market scoring rule was created by Robin Hanson and is known as the Logarithmic Market Scoring Rule Market Maker, or LMSR for short. A detailed examination of LMSR can be found in our article How does the Logarithmic Market Scoring Rule (LMSR) work?
Some prediction markets operate using real money, while others use "play" (aka. fantasy or virtual) currency. A real money prediction market operates much the same as we've described throughout this guide, including the basic mechanics and market resolution, but with real money at stake. Typically, real money markets will use a continuous double auction. Availability of such markets is fairly limited, especially in the US, where they are heavily regulated, similar to gambling.
Other prediction markets operate with "play" currency. In these types of markets, participants are granted an initial amount of currency upon joining the market, which he/she can then use to trade in the market. Frequently, these markets will use an automated market maker to ensure liquidity in the market. Any winnings result in the accumulation of more fantasy currency, more similar to a video game than gambling. AlphaCast is one example of a play money prediction market.
In addition to prediction markets, there are other crowdsourced forecasting methods, such as opinion pools. These methods also work by harnessing the "wisdom of the crowd," but without the stock market mechanism. You can read more about opinion pools in our article "What is an opinion pool?"
Go back to The Ultimate Guide to Prediction Markets.