Price Discovery in the Stock Market and Traditional Sportsbooks
Thank you so much for expressing interest in our posts and encouraging what we are working on. Many sports bettors asked how automated market makers work, so we wanted to respond properly here. The goal of the next two posts is to introduce automated market makers and how they work in general.
Before we get into automated market makers, let’s go over how traditional sportsbooks set the odds, how price discovery and market-making works in the stock market, and finally contrast the two worlds.
Basics
In sports betting, bookies display odds in their betting lines, and the bettors decide which bet to make based on these odds.
Let’s consider this Moneyline: 2.290 for Tottenham, 3.180 for Leicester City, and 3.540 for a draw. Then,
Bettors can actually calculate the implied probability of a specific outcome in a sporting event. By taking the inverse of odds and normalizing the sum of probabilities to one, we get 42.2%, 30.4%, and 27.3% implied probabilities for Tottenham, Leicester City, and a draw. The reason why the sum of the inverse of odds doesn’t add up to one is that there is vigorish or vig, which is like a service fee that is charged by the sportsbook.
Tottenham at 3.180 fixed odds does not mean that you can wager large amounts at the 3.180 odds. Typically there will be a wager size limit depending on the event and time.
Obviously, you guys already know this. Here, we want to point out these two aspects — the vig and size limit. We will now compare how these things are dealt with in stock market trading.
What is market making?
In the stock market, there are buyers and sellers who bid and ask at certain prices. The order transaction is only executed when the bid and ask price match. Any orders that do not match remain on the exchange, to hopefully match an order that comes along later. These orders are all buyers who bid at a lower price than all the sellers are willing to sell for, and vice versa. This forms the “order book” — all unmatched orders on the exchange. This is the “liquidity” you interact with when you place a market order.
Notice that in the order book (all the unmatched orders), there is a gap between the highest price of any buy order and the lowest price of any sell order. This gap is called “the spread”. You must overcome this spread if you want your order to be executed immediately — your buy price must reach across the spread and match a sell order. The larger the spread, the higher the cost of buying (or selling) immediately.
This is where the market makers come into play. Market makers help to ensure that there is enough liquidity in the market. They compete against each other to offer the best bid and ask price and tighten the spread. Without market makers the spread would be much larger and it would make it that much harder to trade with others.
Similarly in the sports betting market, there are bookmakers who will set the betting odds and accept bets. I.e., provide liquidity to the sports betting market. And yet, because a sportsbook has a monopoly on setting the odds, they control the spread, better known in sports betting as the vigorish, or “the vig”. Having control of the spread means they can increase it to guarantee extra profits. Spread and vig are equivalent, but notice that in the stock market the spread is determined by competition among many market makers, whereas the vig in a sportsbook is set entirely by the operators.
The price offering and “slippage”
There is a key difference in pricing/betting odds between the stock market and sports betting market. In the stock market, although the chart shows the prices of past transactions, your purchase price depends on the size of your trade, market resilience (thickness of orderbook), and the order type (market or limit order). Here, we focus on the market order comparison since limit orders do not exist in traditional sports betting. It then comes down to how much you want to purchase and the liquidity on the opposite side of the market.
When a trader on the stock market wants to buy some shares, they enter the quantity that they would like and send the order to the market. It then gets matched with other orders in the book starting with the lowest price and making its way through until all the shares are filled. As an example, if I want to buy 10000 shares of Apple stock (AAPL), and the current best asking price is $169.80, it does not mean the entire 10000 shares will match that price. Perhaps only 2000 match at $169.80, 4000 at $169.81, and the last 4000 at $169.82. This is called “slippage”.
Slippage is the difference between the expected and executed price on a trade. The slippage will be small when liquidity in the market is thick (lots of orders resting on the book), and the slippage will be large when liquidity in the market is thin. Therefore the slippage is determined by the market maker and the market. Besides slippage, just the amount of volume and activity on a stock market means the price you see now will most likely not apply a moment later. To limit your risk, limit orders are required to not exceed a certain price.
In sports betting, the concept of slippage and limit orders does not exist because the odds are fixed when you purchase, however, the liquidity in the market is controlled by the bookies instead. There are pros and cons here. It is good in the sense that you know what exact odds you are betting at. However, a bad thing is there is huge centralized control in terms of setting odds and wager size limits. Ideally, you want the price/betting odds to be solely determined by the market and the limit doesn’t exist.
Perhaps, you can think about what your preference is. Would you be interested in sports trading instead of sports betting?
In the next post, we will introduce you to the concept of automated market makers (AMM). AMMs are a relatively new concept that is applied in the decentralized finance / blockchain world. Stay with us for the “AMMs for sports prediction market” post!
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Disclaimer: The above content is intended for information purposes only and is not intended to be gambling, trading, nor investment advice. Please perform your own analysis before making any betting, trading, or investments based on your own personal circumstances or seek a duly licensed professional for gambling and trading advice. Accordingly, neither UBet nor its partners, directors, shareholders or employees are liable for any damage, expense, or other loss that you may incur out of reliance on the above information.
Reference:
[1] The second figure is a snapshot from Bitfinex exchange: https://bitfinex.com/
