Prediction Markets: What They Are, How They Work and Risks

In the lead-up to the 2024 presidential election, prediction markets such as Polymarket, PredictIt and ForecastEx expected Donald Trump to win, despite election models and poll aggregators showing a virtual coin toss.

Now we know: The prediction markets were right.

Last year’s election outcome could be a turning point for these platforms, some of which have been operating in a legal gray area. A Trump presidency may result in a more lax regulatory environment going forward.

Prediction markets are online platforms where people can bet on future events.

These events can involve elections, financial markets (for example, whether or not the S&P 500 index will close above a specific level by year end), or even pop culture (for example, which film will win the Academy Award for best picture). They just have to involve binary, “yes or no” or “one or the other” questions that will be resolved by a specific date.

Prediction markets run on a type of financial instrument known as an event contract. An event contract has a nominal value — often $1 — and traders can buy “yes” or “no” positions on it for some fraction of that value. When the event happens, the contract pays out to whoever was right.

For example, imagine an event contract on whether or not the S&P 500 will close above 7,000 points by the end of 2025. If a trader buys “yes” positions on 1,000 contracts for 25 cents each, and then the index does close above that level for the year, the trader would earn $1 per contract, quadrupling their money — a return of $1,000 on an initial investment of $250. But if the trader were wrong, they’d get nothing and would lose their $250.

There are three major prediction markets currently operating in the U.S.: Kalshi, PredictIt and ForecastEx, the latter of which is a subsidiary of Interactive Brokers.

Fees, minimums and structures vary. Some platforms charge as little as $.01 per contract, while others take a cut of profits. The range of contracts available on each platform also varies widely.

The legal status of prediction markets is complicated, but regulators seem to be getting more relaxed about them over time.

Historically, regulators have generally taken a firm stance against unlicensed online betting platforms — especially those that allow election betting. In 2022, the Commodity Futures Trading Commission (CFTC) prohibited Polymarket from taking bets in the U.S.

However, things have changed in the last two years. While the CFTC has attempted to enforce similar bans against PredictIt and Kalshi, PredictIt won its case in July 2023.

The CFTC’s case against Kalshi is ongoing. However, an October 2024 injunction that allowed it to continue operating while the case was decided was widely interpreted as a legal green light for prediction markets, including election-related prediction markets. In the weeks after that ruling, Interactive Brokers added ForecastEx contracts to its trading platform. Robinhood also launched an election betting market that uses ForecastEx contracts.

Trump campaigned on loosening business regulations, including in the financial sector — and there are already some indications that the incoming administration (and Congress) will be more lenient in its regulation of prediction markets.

On Nov. 14, 2024, the Judiciary Committee of the Republican-majority House of Representatives published an open letter demanding that the CFTC cease its legal action against Kalshi and suggested the incoming administration is not interested in pursuing the case further ^[0].

Prediction markets are a relatively new financial technology, and their tax treatment may evolve in the years ahead. For now, many prediction markets, such as PredictIt and Kalshi, send their users annual 1099-MISC forms that list their net profits for the year as ordinary income.

That means that prediction market winnings are likely to be subject to ordinary income tax rates. Even if they are given a more specific tax status in the future, prediction market winnings are likely to be subject to short-term capital gains tax rates — which are the same as ordinary income rates — as they involve trading assets (event contracts) that are typically held for less than one year.

Part of the CFTC’s legal argument against Kalshi is that its markets constitute a form of gambling. Even if that argument doesn’t ultimately win in court, investors should consider it when deciding whether or not to put money into prediction markets.

Event contracts are short-term, everything-or-nothing bets based on uncertain future events. That makes them riskier than most other types of investments and generally unsuitable for building wealth over the long term — much like sports betting.

Gambling can be addictive — and prediction markets may provide a new medium for that addiction. If you feel that you may have a gambling problem, the National Council on Problem Gambling offers a phone helpline at 1-800-GAMBLER.

But if you’re already on track to meet your financial goals and you have extra money that you’d like to play with in prediction markets, there are a few common-sense guidelines worth following:

• Don’t bet money that you can’t afford to lose.

• Limit betting to special occasions; don’t do it habitually.

• Budget out a certain amount of money to bet, and don’t exceed it.

• Treat your bets as entertainment expenses, not investments.