How Prediction Markets Work
Understanding the mechanics of prediction markets helps you trade more effectively. This guide covers the complete lifecycle of a trade, from market creation to payout.
This is educational content explaining market mechanics. Trading involves financial risk. Always read platform-specific rules, as implementations vary between Polymarket, Kalshi, and other platforms.
The Trade Lifecycle
Every prediction market trade follows the same basic process:
Market Creation
A platform creates a market around a specific question with clear resolution criteria. For example: "Will the Federal Reserve raise rates in March 2025?" The rules specify exactly how the outcome will be determined.
Trading Opens
Traders begin buying and selling Yes and No shares. Initial prices may be set by the platform or emerge from early trading activity. Market makers often provide initial liquidity.
Price Discovery
As more traders participate, the price converges toward the market's collective estimate of the probability. Prices fluctuate as new information becomes available or as sentiment shifts.
Event Occurs
The real-world event takes place. The Federal Reserve announces its rate decision, an election concludes, or the specified date arrives.
Resolution
The platform determines the outcome based on predefined rules and sources. This might involve checking official announcements, news reports, or oracle systems.
Payout
Winning shares pay $1. Losing shares pay $0. Winners receive their payouts, and the market closes permanently.
Binary Markets Explained
Most prediction markets use a binary (Yes/No) structure:
Example Trade
Suppose you believe the Fed will raise rates (currently priced at 65% probability):
| Action | You Buy | Cost | If Yes Wins | If No Wins |
|---|---|---|---|---|
| Buy Yes | 100 Yes shares | $65 | Receive $100 | Receive $0 |
| Buy No | 100 No shares | $35 | Receive $0 | Receive $100 |
Your potential profit depends on your cost basis and the final outcome.
Trading Mechanisms
Different platforms use different systems to match buyers and sellers:
Used by: Polymarket, Kalshi
An order book displays all buy orders (bids) and sell orders (asks) at different prices.
How it works:
- Buyers place bids at prices they are willing to pay
- Sellers place asks at prices they are willing to accept
- When a bid and ask match, a trade executes
- The difference between best bid and best ask is the "spread"
Advantages:
- Price transparency
- Competitive pricing
- Rewards liquidity providers
Example:
- Best bid: 100 shares at $0.64
- Best ask: 50 shares at $0.66
- Spread: $0.02
Order Types
Market Order
Buy or sell immediately at the best available price. Fast execution, but you may pay more (or receive less) than expected if liquidity is thin.
Limit Order
Set a specific price at which you want to buy or sell. Your order waits until someone matches your price. Better prices, but no guarantee of execution.
When to Use Each
Use market orders when you need immediate execution and the spread is small. Use limit orders when the spread is wide or you are not in a hurry. Limit orders often get better prices but may not fill.
Understanding Shares
When you trade prediction markets, you buy and sell shares that represent claims on the outcome:
Buy Yes at $0.40 → Event resolves Yes → Receive $1.00 → Profit: $0.60
Buy Yes at $0.40 → Event resolves No → Receive $0.00 → Loss: $0.40
Buy No at $0.60 → Event resolves No → Receive $1.00 → Profit: $0.40
Buy No at $0.60 → Event resolves Yes → Receive $0.00 → Loss: $0.60
Settlement and Resolution
How Outcomes Are Determined
Each market has predefined resolution criteria. These specify:
- What sources will be used (official announcements, specific websites)
- How edge cases will be handled
- The exact timing of resolution
Always read the resolution rules before trading. Ambiguous rules can lead to unexpected outcomes.
Resolution Sources
Kalshi uses official sources (government agencies, news organizations) and internal research teams.
Polymarket uses oracles, primarily the UMA Protocol, which relies on dispute resolution mechanisms to determine outcomes.
Edge Cases and Disputes
Sometimes events are unclear:
- Elections with contested results
- Events canceled or postponed
- Ambiguous interpretation of rules
Each platform has dispute processes. Kalshi has internal appeals. Polymarket uses UMA's decentralized oracle with economic dispute resolution.
Resolution Timing
Markets typically resolve shortly after the event occurs. Political markets may wait for official certifications. Some markets specify exact resolution dates.
Once resolved, payouts usually process within hours to days depending on the platform.
Payout Examples
Scenario 1
Cost: $40 | Payout: $100 | Profit: $60
Bought 100 Yes at $0.40, event resolved Yes
Scenario 2
Cost: $40 | Payout: $0 | Loss: $40
Bought 100 Yes at $0.40, event resolved No
Scenario 3
Cost: $25 | Payout: $50 | Profit: $25
Bought 50 No at $0.50, event resolved No
Scenario 4
Sold before resolution for profit
Sold 100 Yes at $0.55 (bought at $0.40)
Selling Before Resolution
You do not have to hold until resolution. You can sell your shares at any time if there is a willing buyer. This lets you lock in profits or cut losses early.
Platform Comparison: Mechanics
| Feature | Polymarket | Kalshi |
|---|---|---|
| Trading Mechanism | Order Book (CLOB) | Order Book |
| Settlement | Blockchain (Polygon) | Centralized |
| Currency | USDC (stablecoin) | USD |
| Oracle | UMA Protocol | Internal + Official Sources |
| Payout Speed | Minutes to hours | Hours to days |
| Minimum Trade | ~$1 | $1 |
Data verified January 2025. Sources: Polymarket Docs, Kalshi Help Center
Key Takeaways
Next Steps
Key Concepts
Master essential terminology before trading
Choosing a Platform
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