The power of short selling

Prediction markets are mechanisms to accumulate information about the outcome of events that lie in the future and therefore are prone to uncertainty. The general idea is to accrue signals from market participants and, by wisdom of the crowd, form an efficient evaluation of the future events. This is achieved by receiving inputs from individual users, with their diverse knowledge and expectations about the outcomes, in the form of long or short orders. Generally, a long position increases the price (i.e., the likelihood of that event become true in the future) of a position, while a short position decreases it.

The notion of a long position is commonly known and simply refers to the process of users buying a position that they are expecting to win. However, short selling is less commonly known but still an important device to influence the markets. To give some more background, this post illustrates what short positions are, reasons to use them and how to actually open them on Zeitgeist.

Reasons to short:

  • Whenever users think that the probability of a position to win is overvalued (i.e. it’s probability is too high), they can earn money by opening a short position.
  • Especially in all-or-nothing markets it might be easier to predict which position is not winning, compared to the unique one that actually will be winning.
  • Some positions might be exhausted, meaning that the probability of a position is close to 100%, while others are still significantly above 0%. Betting against those positions could be considered rather safe and therefore money can be earned rather easily.

Generally, there are two ways to short a position. The first one is that users sell the respective tokens that they already accrued from previous long positions. However, sometimes that is not possible, because the users currently do not own those tokens. In this situation and the second way is to first acquire the tokens and then sell them. The problem with naively buying the token only to subsequently sell it is that, all things being equal, the participants would not change the state of the market (but actually incur transaction costs and thereby a loss). The trick is to buy all positions, effectively not changing the probabilities of any position and then only selling the tokens that the user wants to short. More efficiently, the user should buy all tokens except from those positions aimed to short.

There are currently two ways to do that. The first option is to manually buy all tokens except of the token(s) that the user wants to short. However, in larger markets, such as the Kusama Derby, that would require a substantial amount of manual labor as well as many transactions. Therefore, the more efficient way is to create a specific extrinsic offered by the Zeitgeist chain. When going to the developer/extrinsics tab in polkadot.js/apps (set to the Zeitgeist chain), the user can select the
PredictionMarket pallet and select the buyCompleteSet module. With that, users buy every token of a market in a single transaction, keeping both the prices in the market as well as the exposure of the own positions constant. After that, the user can simply sell the tokens that they want to short.

In conclusion, short selling is an advanced strategy (especially when not owning the token aimed to short), but crucial for the efficiency of every market. Frequent users of prediction markets should make themselves accustomed to shorting and thereby making better predictions leading to higher payoffs.