Deep dive: Strategy – arbitrage and hedging

How to make money while limiting your risk

I was slowly melting in the hot summer sun and purposefully put off writing an article to the time I am back in my current home. While I was enjoying a proper time off and taking good advantage of the current slow news cycle, I was looking at the next topic on the more trading side that I could write about. Having touched on EV and making EV+ bets it seemed fitting to touch upon the next fundamental concept that allows you to make money on prediction markets.

While EV+ bets make you money in the long run, they are subject to variance (you can lose money in the short term) and EV+ is actually hard to pinpoint in prediction markets. For example, in poker, especially the No Limit Texas Hold’em we now have solvers that for each play can determine the best possible action and spit out a complete EV calculation. This is because in poker there is a limited number of cards and thus a limited number of possible outcomes. We do not have such comfort in global events. While the resolution is limited to Yes / No there are countless scenarios on what can happen in between. Additionally, the benefit of each action is not immediately clear. You as a bettor have no real impact on the situation, you are just an observer.

Luckily, there is another way to maximize your earnings on prediction markets – arbitrage. Arbitrage is a bet or a trade that pays you out regardless of the outcome. Imagine earning profit on US elections result when either candidate wins. While sometimes difficult, it is possible, and many traders utilize this strategy. Aside from arbitrage, that by definition offers you profit regardless of outcome, there is also hedging. Hedging is more loosely defined and involves any trade that limits your downside in case of bad outcome.

In today’s deep dive we will cover both of these and explain how to utilize them to your advantage. There are several benefits that come with them so remember to subscribe and let’s dive into the topic.

---

Arbitrage

I have already put out the proper definition of an arbitrage. The question is how to actually use it on prediction markets. After all, on each market the price of Yes + the price of No usually equals a bit over 100 cents. This is done by design – order book can be an order book as long as the bid and ask price do not match. If they match (meaning the Yes + No price equals 100 cents) the transaction takes place and two traders and up holding a position. If when the price matches, the transaction takes place, then it is impossible for the Yes + No price to equal less than 100 cents. So how do you actually do arbitrage – there are several ways.

Inter market arbitrage

One of the simplest (and safest) ways to find and purchase arbitrage positions is to bet on similar event on different markets. Especially on Polymarket, there are often several markets that touch on the same event. In the long term, savvy traders will buy up the mispriced shares and eliminate the arbitrage opportunity, but in the short term, and especially with high volatility, these opportunities exist. You can be this savvy trader that takes the opportunity. Let’s have an example: