The main purpose of an election stock market is to predict the election outcome, such as the share of the popular vote or share of seats each political party receives in a legislature or parliament. Efficient markets are very good at reflecting all available information, often reflecting information faster than opinion polls, which take several days to complete and process. Traders also have a strong financial incentive to reflect their true opinion about the election outcome regardless of their political preferences.
Election stock markets are also used for research and teaching purposes. Researchers can study trader behavior and market operations. Election stock markets also teach participants the fundamentals of trading, such as how to take a long or a short position. A list of related academic research papers appears below.
Privately run prediction markets have also emerged in recent years. Unlike their university counterparts, commercial prediction markets charge fees or commissions to cover their operating costs. Commercial markets may charge fees per transaction or commissions on net profits, and fees per transaction may be differentiated for price takers (those placing a market order) and price makers (those placing a limit order). Examples of commercial prediction markets include Intrade Prediction Markets and The Washington Stock Exchange; both track predictions for a a broad set of political events. Focusing more on sports events than politics, Tradesports also offers futures contracts for political events. Commercial prediction markets claim that they attract more investment and generate more trading volume than their academic counterparts as they don't limit a trader's capital investment. The prediction accuracy of commercial and academic election stock markets is an area of active research (see below).
Election stock markets typically cover the popular vote share of political parties or the seats share of political parties in a parliament. The seats distribution depends on the electoral system (such as first-past-the-post or proportional representation) that is used for the particular election. Predictions of seats distributions are therefore often more challenging than predictions of vote shares. The ultimate payoff in a votes share or seats share market is determined by the actual distribution of votes and seats as determined by the election. For example, if the Blue Party wins 32.3% of the popular vote, than the corresponding contract in the popular vote market would pay out 32.3 cents.
Election stock markets may also offer winner-take-all markets. In such markets only one contract will pay $1, and all other contracts pay $0. Winner-take-all markets are commonly used to predict outcomes such as the winner of a presidential election or the formation of a majority government by a particular party. Such markets may also be used to predict the outcome of a referendum.
Traders buy and sell contracts, which are typically quoted in 1/10-th of a cent corresponding to 1/10-th of a percentage point for the votes share or seats share of a political party. Traders make profits by buying undervalued contracts and selling overvalued contracts. If a trader expects the Blue Party to win 42.3% of the popular vote, the trader will find it profitable to buy a contract of the Blue Party if a seller offers it for less than 42.3 cents. The same trader will find it profitable to sell the same contract if another trader is willing to buy it for more than 42.3 cents.
A trader takes a long position by buying low and selling high. Consider an investor who considers the purchase of a contract in the Blue Party, which is currently offered for 39.3 cents in the market. The investor predicts that the Blue Party will win more than 41%, and buys a contract of the Blue Party for 39.3 cents. On election day the Blue Party wins 42.5% of the popular vote, and the trader realizes a profit of 3.2 cents, an 8.1% return on investment.
Contracts are put into circulation through the purchase of a unit portfolio. A trader purchases a set of all contracts in a particular market worth $1. Consider an election in which three parties compete, a Red Party, a Blue Party, and a Green Party. The share of popular votes for each party must sum to 100% by definition, so holding on to one contract for each of the three parties will always be worth $1 no matter what the election outcome. Buying unit portfolios allows trader to take a short position by selling contracts that they think are overvalued.
Consider a trader who has bought a unit portfolio consisting of one contract each for the Red Party, the Blue Party, and the Green Party, at a cost of $1. Now the trader sells one contract of the Blue Party for 30 cents. On election day the Red Party wins 55% of the vote, the Blue Party wins 25% of the vote, and the Green Party wins 20%. The trader now receives 75 cents in total for the Red Party and Green Party contracts, and has an additional 30 cents from the sale of the Blue Party contract. The trader has now $1.05 and has made a profit of 5 cents on an investment of $1.
Election stock markets typically cease trading the day before the election is held. The markets are liquidated after the election based on the election outcome. In markets for the popular vote share and the parliamentary seats share, each contract is valued precisely equal to the corresponding percentage share. In winner-takes-all markets, the winning contract pays $1, while the losing contracts pay $0.
Election stock markets are prediction markets for a particular purpose: elections. Even though election stock markets have been conducted for almost twenty years, the accuracy of these markets is nearly always judged by comparing the election stock market prediction (closing prices) on election eve with final pre-election polls and actual outcomes. Evidence that election stock markets perform remarkably well predicting election outcomes is found in a string of academic papers, mostly based on data from the Iowa Electronic Markets and the UBC Election Stock Market. Accuracy is typically measured as the average absolute forecast error for vote shares and seat shares. A more rigorous attempt to assess the performance of election stock markets is found in Berg et al. (2008); they report that for five recent elections covered by the Iowa Electronic Markets, the average absolute error in the market's prediction of the major-party presidential vote share across the 5 days prior to the election was 1.20 percentage points, while opinion polls conducted during that same time had an average error of 1.62 percentage points. Berg et al. (2008) also report evidence that election stock markets outperform polls for longer time periods before the election date.
Erikson and Wlezien (2008) challenge the view that election stock markets outperform polls. They argue that polls only measure preferences on the polling day, whereas election stock markets forecast the outcome on election day. When poll leads are discounted using statistical techniques, they find that poll-based forecasts outperform vote-share market prices.
A critical feature for the proper functioning of election stock markets is market liquidity. As prediction markets function through aggregation of beliefs and opinions into market prices, high trading volume and/or a continuous stream of new investments are essential for prices to provide an accurate forecast of the election outcome. Signs that liquidity is lacking in an election stock market include wide spreads (large differences between bid and ask prices) and arbitrage opportunities (where the sum of bid prices exceeds the value of a unit portfolio, or where the sum of ask prices is lower than the value of a unit portfolio). As election stock markets are opinion aggregators, the accuracy of such markets can be expected to increase with the number of market participants. Investment caps (as maintained by the Iowa Electronic Markets and the UBC Election Stock Market) level the trading opportunities among traders. Whether investment caps help with prediction accuracy has not yet been determined conclusively. However, without an investment cap, commercial election stock markets may be dominated by a small number of traders. The existence of transaction costs for investing and trading in commercial election stock markets may also reduce their efficiency.