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An Introduction to Kalshi

Jan. 30, 2024

Introducing Prediction Markets

I came across Kalshi early 2022 over lunch with my close friends. Up until this point, my scope of the financial world only lied as far as 0 DTE TSLA Call Options. Never had I considered that I could bet on the average attendance to a Taylor Swift concert or the liklihood of a measles outbreak in South Dakota but little did I know. After some late-night browsing and a scuffle through my 3rd year math notes, I wrote this to share the benefits that Prediction Markets have to offer and some basic arbitrage strategies.

The term “prediction Market” refers to Kalshi’s unique event-based contracts. Kalshi’s markets allow for trading based on the outcomes of specific events rather than the usual stocks and commodities. Until now, retail traders faced disadvantages when acting on predictions. For instance, an economist with insights into the coming inflation report might traditionally short or long the S&P. However, there are a myriad of factors that may unpredictably sway the market - ranging from natural disasters or political sentiment. Kalshi addresses this gap by simplifying the investment process.

The Advantages

  • Retail Focused - Markets are new - decentralized, untouched by financial institutions and ripe with inefficiencies
  • Alpha Gains - all gains are purely alpha - there is no beta exposure attached to a position at all
  • True Diversification - bets across multiple contracts are statistically independent - there is no market drawdown periods
  • Hedge Positions - events contracts can be used to hedge positions - whether that be stock portfolios or real-world assets

How Contracts Work

An event contract has two outcomes - a “yes” and a “no”. Each side of the contract is traded on the Kalshi exchange, similar to a stocks options’ “call” or “put”. The price of a contract ranges from 0-1 and is naturally priced to reflect the probability of the event. Ceteris paribus, the sum of the yes and no contracts should equal $1. There are instances where this is not the case but more on that later.

Common Terminology

Before diving into strategy, some terminology should first be defined.

  • Bid - an offer to buy a security at a specified price
  • Ask - an offer to sell a security at a specified price

It is also worth noting that limit orders do not come with a transaction cost on Kalshi and that higher bids and lower asks incur a higher change of fulfillment.

  • Market Order - events contracts can be used to hedge positions - whether that be stock portfolios or real-world assets
  • Limit Order - events contracts can be used to hedge positions - whether that be stock portfolios or real-world assets

Defining an Underpriced Event Contract

As mentioned before, if contracts are perfectly priced, the sum of the “yes” and “no” contracts will equal $1. However, since both sides of the contracts are bought and sold individually, price discrepancies can be found.

Let:
- C = cost of the contract
- P = probability of the event occurring

EV = p(1-c) - c(1-p) = p-c

When the event is correctly predicted, we profit (1-C) dollars. When we incorrectly predict the event, we lose C (the price of the contract). Therefore, to make a successful trade, the probability of the event occurring must be greater than the cost of the contract as demonstrated above. If correctly priced (where p=c), there is no arbitrage opportunity.

Market Making in Kalshi

Prices fluctuate when demand is greater than supply. In this event, this inequality creates market making opportunities.

Let:
- Yes = 54
- No = 42

Yes-No Spread = [1 - (0.56 + 0.40)] = 0.04

Here, you can place two limit orders on both sides of the event contract. A Yes Limit Order at 0.57 cents a contract and a No Order at 0.41 cents a contract. Now you are offering more compelling prices to the buyers and sellers. If the Yes-No Spread is re-calculated, the new spread is 0.02 cents a contract and with the orders fulfilled the net profit is 0.02, regardless of the direction of the trade.