What is Implied Probability?

In prediction markets, implied probability refers to the likelihood of a particular outcome occurring. 

This value can be inferred from the outcome’s “Yes” or “No” contract price, enabling you to quickly calculate risk and make more informed trading decisions.

In this guide, we’ll look at how you can calculate implied probability, and determine exactly what it means in terms of prediction market pricing.

Calculating and Understanding Implied Probability

Regardless of your chosen prediction market, there’s a simple formula that can be used to calculate implied probability. This reads as follows: 

Implied Probability (%) = Current Contract Price / Payout at Expiry * 100

For example, let’s say that you wanted to back the Oklahoma City Thunder to win the 2027 NBA Championship. 

You can buy “Yes” shares in this market at 22 cents, and each share will settle at a maximum of $1.00 if the Thunder go on to claim the title. That creates the following equation:

22% = $0.22 / $1.00 * 100

As such, Oklahoma City has a 22% win probability in this market. This may seem relatively low, but that has more to do with the competitive nature of the NBA and the sheer number of potential outcomes.

What Causes Discrepancies Between Price and Probability?

In the example above, the contract price and the implied probability match, which is common for standard markets, particularly those with relatively high levels of liquidity. 

However, even standard, binary markets introduce structural issues that create discrepancies between a contract’s price and the outcome’s implied probability value. These include:

• The Bid-Ask Spread: Probability is primarily impacted by the bid-ask spread, which represents the difference between the highest price a buyer is willing to pay for a contract and the lowest price a seller will accept. In instances where such a gap exists, operators like Polymarket will usually split the difference and create a midpoint probability value. However, you’ll still have to buy at the seller’s higher price.

• Trading Bias: Pricing discrepancies are also likely to occur at extreme ends of a particular market. Traders have a tendency to overvalue low-probability underdogs (due to the huge profit potential) and undervalue favorites.

• Low Liquidity Levels: Liquidity refers to the ease with which you can buy and sell contracts in real-time without disproportionately impacting prices. In low liquidity trades and markets, demand can drop significantly, creating a scenario where the price becomes increasingly detached from the outcome’s probability value. As liquidity increases, price and probability values usually become more closely aligned.

• Cost of Capital and Settlement: In long-term markets, traders are asked to commit a fixed amount of capital for an extended period of time. Buyers will then demand a discounted contract price in order to trade. This often occurs in markets that won’t settle for a year or more, causing the real-time gap between contract prices and implied probability values to increase.

What About Markets With Multiple Winning Outcomes?

Another interesting factor to consider is whether a market allows multiple winning outcomes to occur simultaneously.

In markets that aren’t mutually exclusive, pricing and implied probability values can often become skewed. This creates a scenario where the combined probability of yes and no outcomes can far exceed 100%, creating a more complex market to navigate.

For example, one current market lets you speculate on who Donald Trump will praise in August. “Yes” and “No” shares for singer Nicki Minaj are currently priced at $0.49 and $0.97 cents, respectively. Using the calculation formula above, the cumulative implied probability across both sides of the trade is 146%.

However, this isn’t necessarily indicative of poor value. Instead of focusing on the combined probability value, you should evaluate the outcome and contract price independently.

In this case, it would be more concerning that Minaj’s “Yes” price is $0.49 cents, while the true probability of a “yes” is much lower (44%).

The Last Word

While prediction market prices and implied probabilities often align, there are factors that can create noticeable discrepancies.

Understanding these is crucial, especially if you are going to make informed trades in real-time. Calculating implied probability can also help you determine the optimal capital outlay for each trade.