Shorting contracts perceived as jointly overvalued

As market director I sometimes get asked about the feasibility of individual trading strategies. I am happy to discuss the mechanics of trading, although I cannot comment on any prices. Whether prices are overvalued or undervalued is a matter for traders to decide. When I use the terms "overvalued" and "undervalued" I mean "as perceived by the trader". Different traders will have different opinions about what is undervalued and overvalued, and of course that is what leads to trades in the market.

Most traders intuitively understand the buy-and-hold strategy for undervalued contracts. However, taking a short position in a prediction market is equally simple, albeit not as intuitive. To take a short position against an overvalued contract, simply buy a $1 unit portfolio and sell the overvalued contract. Upon market liquidiation, the value of the remaining contracts plus the revenue from the earlier-sold contract will be worth more than the $1 of the cost of the unit contract.

The shorting strategy works, by extension, also for a set of contracts that you believe is jointly overvalued. Let's take our current seats market, where contracts for the Bloc Quebecois (CA15SM.BLQ), Green Party (CA15SM.GRN), and Other Parties and Independents (CA15SM.OTR) all show bids for 1.5 cents each. If you add together these three bids, they amount to 4.5 cents, or a prediction of 15.21 seats—that is three times as many seats as BLQ+GRN+OTR held in the current parliament. You can take a position on whether these three smaller parties together will achieve 15 seats or less. If you believe that these three parties together will obtain no more than 15 seats, you can buy a $1 unit portfolio and sell these three contracts (BLQ, GRN, and OTR). You receive 4.5 cents in revenue, and if your hunch is right, your remaning three contracts (CPC, NDP, LIB) together will be worth more than 95.5 cents upon liquidation.

In pointing out the above trading strategy I merely want to illustrate the mechanics of taking a short position in a set of contracts. I do not mean to imply that the example above is profitable, or that you should consider this particular example for your own portfolio.

Posted Monday, August 24, 2015 at 18:00