Chapter 10 Key Takeaways

The Big Picture

Transaction costs are the silent killer of prediction market strategies. A trade that appears profitable based on the price difference between your model and the market may actually lose money once you account for spreads, fees, slippage, and market impact. Understanding and minimizing these costs is not optional — it is essential for any serious trader.

Core Concepts

1. The Bid-Ask Spread Is Your Primary Cost

The bid-ask spread — the difference between the best buy and sell price — is the most significant transaction cost in prediction markets. Typical spreads range from 1-3 cents on liquid markets to 10+ cents on illiquid ones. You pay half the spread each time you cross it with a market order.

2. Spreads Exist for Three Reasons

  • Adverse selection: Liquidity providers must be compensated for the risk of trading against better-informed counterparties
  • Inventory risk: Holding directional positions exposes market makers to loss
  • Order processing costs: The operational cost of providing liquidity

Of these, adverse selection is typically the dominant driver in prediction markets.

3. There Are Three Spread Measures

  • Quoted spread: The snapshot difference between best bid and ask
  • Effective spread: The actual cost of your trade relative to the midpoint (usually larger than quoted)
  • Realized spread: The market maker's actual profit after accounting for price movement (usually smaller than effective)

The gap between effective and realized spread measures adverse selection.

4. Transaction Costs Have Many Components

Total cost = Half the spread + Slippage + Platform fees + Gas fees + Market impact. Never look at just one component in isolation.

5. Platform Fee Structures Vary Dramatically

  • Polymarket: Zero trading fees (cost comes from spread only)
  • Kalshi: Maker-taker model ($0 maker, up to $0.01 taker)
  • PredictIt: 10% profit fee + 5% withdrawal fee (extremely expensive for profitable trades)

The difference between platforms can turn a profitable strategy into an unprofitable one.

6. Breakeven Edge Must Account for All Costs

The breakeven probability for buying at the ask price $P$ with total costs $C$ is simply $p_{\text{BE}} = P + C$. For profit-fee platforms, the formula is more complex and the breakeven is significantly higher.

7. The Overround Measures Aggregate Market Cost

In multi-outcome markets, the overround (sum of all prices minus 1) represents the total "tax" extracted from traders. In binary markets, the overround equals exactly the bid-ask spread.

8. Market Impact Follows a Square-Root Law

Price impact scales with the square root of order size relative to volume: $\Delta P \propto \sqrt{Q/V}$. This means splitting large orders reduces total impact cost.

9. Limit Orders Are Your Best Cost-Reduction Tool

Switching from market orders (taker) to limit orders (maker) can eliminate: - The half-spread cost (you earn it instead) - Taker fees (often replaced by zero fees or rebates) - Slippage (you get your exact price)

The trade-off is execution risk — your order may not fill.

10. The Glosten-Milgrom Model Explains Spread Economics

Spreads arise because the market maker must set prices that protect against informed traders. The ask equals the expected value conditional on a buy order arriving; the bid equals the expected value conditional on a sell order. More informed trading means wider spreads.

Key Formulas

Formula What It Calculates
$S = P_{\text{ask}} - P_{\text{bid}}$ Quoted spread
$S_{\text{eff}} = 2\|P_{\text{trade}} - M\|$ Effective spread
$S_{\text{real}} = 2 \cdot D \cdot (P_{\text{trade}} - M_{t+\tau})$ Realized spread
$S_{\text{rel}} = S / M$ Relative spread
$p_{\text{BE}} = P_{\text{ask}} + C$ Breakeven probability (simple fees)
$p_{\text{BE}} = P / (1 - f + fP)$ Breakeven probability (profit fee $f$)
$\Delta P = \alpha\sigma\sqrt{Q/V}$ Square-root impact model
$\text{Overround} = \sum P_i - 1$ Market overround/vig
$\hat{p}_i = P_i / \sum P_j$ Proportional normalization

Practical Rules of Thumb

  1. Always calculate your breakeven edge before trading. If you cannot articulate why your edge exceeds the total cost, do not trade.

  2. Use limit orders whenever your edge is not time-sensitive. The savings from earning the spread instead of paying it typically exceed the opportunity cost of missed fills.

  3. Avoid trading markets where the spread exceeds 5 cents unless your edge is proportionally large.

  4. Split orders larger than 10% of daily volume across multiple time periods to reduce market impact.

  5. Require 1.5x the breakeven edge as a minimum threshold to provide a buffer against estimation error.

  6. Track your actual transaction costs and compare them to your estimates. Most traders underestimate their costs.

  7. Factor in the exit cost when entering a position. The total round-trip cost is what matters, not just the entry cost.

  8. Choose your platform based on your trading style. Patient traders should use platforms with maker rebates; impatient traders should use platforms with the tightest spreads.

Common Pitfalls

  • Calculating edge relative to the midpoint but executing at the ask
  • Ignoring the compounding effect of costs over many trades
  • Treating gas fees as negligible without checking the math for your trade sizes
  • Using market orders in thin order books
  • Not accounting for the asymmetric impact of profit fees (they only apply to wins, but wins are what make you money)
  • Over-trading: each marginal trade has costs, and low-edge trades destroy value after costs