Adverse Selection in Betting Markets
Level 2 - DEEP DIVER
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Ping!
Your Bot just sent an order to the exchange.
Ping!
Bet went unmatched, a competing Bot claimed the offer. Outstanding order removed.
A shame you missed out on it. Well, back at it… Next time you’ll be quicker!
Ping!
A new opportunity! Your Bot just sent another order.
Ping!
Successful match, bet went through.
“Ha, there we go! Easy.”
Peacefully you move on with your life. However, as you check in on the bets a few hours later, you notice an interesting thing: the first bet turned out to be significantly better than the second one.
‘Ah, just variance’, you think. ‘Tomorrow I’ll be back to being Lady Luck’s favourite bettor.’
Not so fast.
What is Adverse Selection?
Adverse selection refers to situations where either you or your counterparty [a bookie, another bettor, the market] possess information [broadly speaking] the other part of the trade is missing and use this informational asymmetry to create advantageous positions, oftentimes in a way that goes past the adversely selected market actor.
More concisely: your counterparty’s willingness to enter a trade/deal/contract with you is negatively related to the true value of the trade [from your perspective]. In a zero-sum game an excellent proposition for you is necessarily a terrible one for your counterparty. Thus, the only real reason for him to trade with you, is that he considers the price a good one & consequently there’s great signal in his desire to enter the deal.
Note: these are *theoretical claims*, there are plenty of players in actual, real-world markets that act on vague ‘yeah I really think this horse will win today’-instincts or simply overestimates their level of sophistication [pseudo-sharps].
Spotting situations where you might potentially be/become a victim of adverse selection can often be difficult due to the subtle nature of the concept. Unlike standard fees/charges ‘adverse selection fees’ aren’t well documented but rather hidden behind game theoretical reasoning and unless you develop a proper understanding of markets, counterparties & what the game and its structure is really all about there’s a good chance you’ll simply fail to notice what’s happening [&, as usual, pay for your lack of knowledge].
To illustrate the many shapes & forms adverse selection may take in betting markets we’ll share and dive into a list of examples we’ve encountered during our time in the world of prediction.
The best trades & why you keep missing them
Any procedure you’ll ever run will consist of several groups of bets:
-EV bets.
Slight +EV ones.
Good bets.
& finally:
The Excellent Ones.
Your final EV/ROI, what you’ll actually observe, will be a volume-weighted combination of these subsets. The goal is to get enough money on in the last three [two?] categories to make up for the -EV positions you’ll inevitably acquire [no matter how sophisticated your methodology].
Now here’s the problem: in most cases you won’t catch [or even see ;)] the absolute best ones. Why?
A liquid, perfect bet/trade usually match the condition of many different strategies, effectively generating a much larger group of competitors than what you usually observe in your day-to-day action. You can have 10 sharp bettors operating in the same market without too much collision on an everyday basis [they look for different things, bet during different ‘limit periods’ etc.], but whenever an outstanding bet appears on the screen the likelihood of such a collision increases rapidly → all sharps [even average gamblers] enter the same bet → trade gets very crowded → time until the mispricing is taken care of [your opportunity window] goes down dramatically.
Think of a horse race being fully determined by three features. Bettor A successfully trades the first feature, Bettor B the second & Bettor C the third. Along comes a super bet that ticks all boxes, sending signals to all three. Competition up, probability of you being the first to click it down.
On the other hand, what do you think will happen when the next -EV bet [as for the horse racing example, looks profitable if zooming in on feature A but left -EV if including the effect of B & C] pops up? Yep, plenty of time for you to take it!
Result: Easy to invest in the unprofitable subset, significantly harder in the profitable one.
Autist note: We love to think in distributions. A perfect illustration of adverse selection using probability distributions: imagine plotting your naive expectations [before considering the goals of your counterparties] of how your EV will be distributed over future bets/trades. Let’s say most of the probability mass will be located close to 0.13, your 'long-term EV’, & more or less all of it contained between -0.09 & 0.29. Now, if dropping the naive assumptions of competitors being indifferent towards you winning [i.e. allowing for the strategic aspects of a market with competing actors] you’ll likely observe a shift in the distribution [to the left, negative direction]. Perhaps you may even notice a fatter left tail [trivial to acquire all of the terrible positions], and a smaller right one [miss most of the great opportunities]. This is the effect of adverse selection.
Peer-to-peer: there’s information in you being matched
One of the main homes for adverse selection in gambling markets are P2P markets & a popular phrase illustrating its omnipresence at the exchanges is that ‘you only get filled when you don’t want to’. Due to exchanges’ natural matching of [skilled] individuals with different opinions and/or asymmetric info & their clarity in providing a [often unique and well informed] direct, single counterparty, they become an excellent playground for learning & embracing the concept.
Counterparties in other markets are usually not as explicit [standard sportsbooks rarely actual bookmakers, usually just uninformed copy pasta machines [far from the ‘real’ source behind potentially opposing information] & weighted averages of customers’ insights, parimutuels a volume weighted average of clients/customers opinions], making them somewhat more difficult to break down. On the other hand, the mechanics of the exchange markets make it clear as day that it’s Player A vs Player B.
Note: Often hearing marketing companies [also known as sportsbooks] complain ‘ah, of course we can’t keep taking your action if too much of it is just steam/value vs other shops’. In fact, they’ve even managed to psyop some bettors into agreeing with the statement, lol. Find it pretty funny since these companies’ entire business models [appended with a couple of additional scam products] are built upon the very same concept of moving according to/listening to action at [predominantly] sharper places, baking some extra margin into everything & letting highly uninformed counterparties enjoy these terrible propositions. A bookmaker learns from the market & you applaud him: ‘impressive bookmaking’. A bettor learns from the market & you conclude: ‘parasitic behaviour’. Bookie Derangement Syndrome.
Below we list a couple of exchange market examples where adverse selection plays a huge role.
If you’re planning on becoming an active P2P market participant: best think long & hard about the reasons/models/frameworks behind the opinions & decisions the people you’re being matched against chooses to go with. Well, either that or enjoy being humbled, fren.
Liquifying illiquid markets
The 1v1 aspect of the exchange game is as clear as it gets in early markets, where you generally observe high spreads, low liquidity & low amounts of information.
High spreads & low liquidity may create an illusion of a perfect market to deal/make/provide liquidity to and pick up easy dollars from [quote wide, let the degens pick their favourite soccer teams]. However, in practice, especially at platforms such as Betfair with a bunch of sophisticated actors, you run a real risk of only getting matched on outcomes you’ve quoted incorrectly.
Generally two ways around this:
Minimal offers only [no one good will care about looking].
Brutally wide quotes [good traders ignore the market].
However, none of them are fancy solutions since they heavily restrict the amount of money the what-looked-like-a-free-lunch-strategy can generate. Nevertheless better than posting real offers that you’ll just get picked off on [oh, did we just figure out why the early markets were illiquid with huge spreads in the first place?].
To get rid of poor liquidity you need some participants to be able to run profitable strategies, & since the obvious solution here is one that’ll get slaughtered by adverse selection, it shouldn’t come as a surprise that people prefer to wait a bit before ‘posting their thoughts’, especially the ones that are wrapped into more sizeable offers [need higher confidence & the attention of non-professional participants].
Note: If you’re a bookmaker with access to plenty of retard $’s this ‘liquifying illiquid markets’-strategy works perfectly fine, provided you’re actually able to get the sharks out of your pool of bettors. Like being a Betfair market maker with ‘only dumb counterparties’ coded into your Bot. Of course it’ll make money.
Maker meets maker
Trivial. You’re both making a market & thus compete against each other. You post an offer, he posts another one right before you, you continue and on it goes. At one point he stops posting new offers. So you win. Front of the queue! And wow, you just got matched! Great news.
Well, at least until you realise that it was nothing but the very same guy turning around and picking you off as a result of him having sharper fairs & [probably] a passion for psyop.
If there are several makers in your market and you’re posting offers they aren’t interested in competing with, be cautious. Unless you know the reason [e.g. you’re in possession of an excellent fee structure], total silence contains tons of information.
Bettors awaiting sufficient liquidity
Common phenomenon. Several bettors waiting for increased liquidity on the same horse/outcome. If it’s actually a good bet, there will be a quick race for the available offers as liquidity comes in, and you'll only get a fraction of what you'd like to have. If it’s a poor one, you’ll be free to take however much you want. Simple really, good bets move quick & lack a crowd of counterparties, bad bets tend to meet a neverending stream of happy takers.
What will happen in practice [think of having an edge you’re sharing with a few others]:
Usually: as more liquid players come in they’ll do so at lower & more correct prices. Current price nothing but an illusion.
Less frequent: liquidity pops up at the current price & there’ll be a brutal race to get it.
Note: Compare with limit increases in fixed odds/standard sportsbook betting. If limits are raised from $250 to $2 000 “to win” at 9AM, you better be quick at taking decisions & clicking buttons if your goal is to get any of the value. [Especially if competitors employ machines for clicking the buttons for them…]
The above relates to another important intersection between adverse selection and betting, bet movements. You'll generally see counterparties move their offers on your action, and if they don't, what do you think that means? Only the naive bettor fails to realise that if you're betting into a ‘hidden wall’ the likelihood of it being a good bet automatically decreases.
If the bet is as ‘perfect’ as you hope it to be, the price *will* move. As an example, perfect bets often a result of an uncertain bookmaker *forced* to take action on an outcome despite insufficient knowledge. Such a counterparty is well aware of their unawareness & will adjust heavily and quickly to your action, especially if you’ve been profiled [rare since your average bookmaker takes three bets then bans your account] and/or deploy decent size.
5-15 secs spinner, then denied or accepted
Ah, the good old spinning wheel after requesting a bet! An excellent example of adverse selection.
So what’s the idea behind the ‘your bet is being processed, please wait‘-spinner? Usually a light ban on the account. Can think of it as a bookie hedge for betting accounts they haven’t confirmed will be profitable, but have great suspicion will [remember false positives are terrible for bookies as their livelihood depends on robbing degenerate problem gambler prospects [no, not how they'll frame it in next week’s ads]].
Your bet is sent to them, they either just put you on hold or 'refer to trader' & what happens in practice is the following: the extra time window induced by the spinning wheel gives your counterparty [the bookie] an opportunity to level up their information levels & in some cases even acquire more info than what you could possible have had at the time of your bet [especially for time-sensitive stuff such as in-play betting/just before post/steam chasing]. Essentially, they're using time to skew the rules against you:
Deny all bets that seem +EV after a brief analysis of both the event and/or possible market movements. Of course steal the bettor’s information by adjusting your odds accordingly.
Happily accept the ones that turn out bad/seem to have been a result of a ‘fake’ market move [rapidly reversed].
Imagine being allowed to put up prices on everything with an option to cancel your offers as soon as someone hits them. Then adding an additional 5-15 seconds ‘thought window’ to the already rigged setup.
& STILL losing to some customers.
Bookmakers truly are impressive.
Example I: You place a fixed odds bet ~10 seconds to post on a horse -> 15 secs spinner -> horses jump & your horse is off to a TERRIBLE start [e.g. breaks stride in harness racing] -> bet goes through.
Example II: You place a fixed odds bet ~10 seconds to post on a horse -> 15 secs spinner -> horses jump & your horse is off to a FANTASTIC start -> bet denied, market closed.
You ask for internal logs after being scammed in a similar fashion for the fourth time this year. Referred to customer support, ‘hey there Cartoon sorry you seem to be a bit upset, can’t share that, highly confidential information, any other questions today?’.
Managed to get heaps down?
Note: This point is largely irrelevant for gamblers that aren’t operating at or around max market capacity.
One of the main struggles for a serious bettor is to get liquidity down on favorable opportunities. By design, this *must* be a difficulty problem to solve since building such a position is entirely dependent on another actor taking the other side of the trade. & why would they be fine with that, unless they themselves believe the trade they’re taking is in fact in their favor? Again, there’s [negative] information in the fact you’re finding people to trade good size against you. Generally the more you get on *without a proper reason for it*, the worse the bet. As the ‘without a proper reason for it’-statement suggests, there are exceptions:
You construct a well-sized bet by betting max limit from 5-10 bookmaker accounts/shops in parallel. In such cases it’s extremely difficult [impossible] for the bookie/s to react until it’s too late. Risk of having all accounts banned of course so not necessarily an optimal kind of execution, that said a Degen Gambler needs some real action every now & then.
Counterparty [bookmaker/platform/bettor] is stressed & needs to move out of a position.
Counterparty is closing an outstanding *great* trade & isn’t as careful as usual with the execution of the second leg.
Most of the sharps are all in on an outcome already & something irregular/unexpected takes place that forces weird price movements.
Related but not the exact same thing: if you’re betting into a market with max cap $2 500 to win & the intelligent segment of the market ‘empties their limits’ at open, what could this [potentially] mean for price movements taking place later on during the betting period?
Counterparty is running some sort of marketing campaign that you’ve properly decomposed & built a clever strategy around.
Conclusion: Get heaps down → most likely a bad position. Price moves just as you start building your bet → probably a good position. Again easy to invest in unprofitable ‘assets’, significantly harder in profitable ones. Adverse selection.
An amazing edge? Won’t last long…
Again it all boils down to analyzing what your P&L means for your counterparty’s profits/losses. If you continuously keep robbing a single counterparty on decent dollars day in day out, it won’t be long until it’s well noticed by him/them [and if it isn’t, please start pondering the probability of not being paid at all]. When [not if] it’s noticed, the part of their operation that give rise to the bulk of your profits will be well investigated & likely cut off/heavily adjusted → edge vanishes. This is *by design*.
As mentioned earlier, EV’s/ROI’s are generally generated by volume weighted averages of different strategies/subsets of bets. This is of course just as applicable to your counterparty as it is for you. Hence, your mission is to find & hit such players on subsets they’re grouping with other stuff & empty their pockets at a ‘perfect pace’, i.e. one that makes it well worth it for you but at the same time doesn’t have them perform deep investigative analysis on what’s happening.
A scalable, long-term edge/angle is one that cuts into the profits of *otherwise profitable* operations in subtle ways that are difficult to decipher.
Example: You’ve spotted an incredible ‘manipulation’ opportunity in a certain kind of tote pool. If you go full retard & launch your new strategy by pushing prices 50 % back & forth in a matter of seconds you’re guaranteed to attract unwanted, intelligent attention within a few trades. If instead you handle things responsibly might get away with what you’re doing for quite some time.
Disagreeing with the market? A point estimate is always wrong, but in which direction?
Numbers give you a false sense of security. Behind every number there's a probability distribution. [Why we’ll always keep shilling Bayes].
The more experienced you become, the more you notice the following phenomenon: - whenever you/your model [think of a non-market-based one] disagrees with the market you're always wrong [in terms of the size of the inefficiency] & always in the wrong direction.
I.e. if the market says 0.50, you say 0.60, the distribution [yes, there is one whether you choose to see it or not] around your estimate should 100 % be shifted & skewed towards the market’s estimate.
No better example of this than the below from Benter’s “Computer Based Horse Race Handicapping and Wagering Systems: A Report” paper [read it here].
Wrap up & an explanation of the first part
Now that we’ve handled a good bunch of different examples of adverse selection, it’s time to return to the subject of the initial section of this post, a Betting Bot that’s missing out on certain trades. Recall the situation:
Ping!
Your Bot just sent an order to the exchange.
Ping!
Bet went unmatched, a competing Bot claimed the offer. Outstanding order removed.
A shame you missed out on it. Well, back at it… Next time you’ll be quicker!
Ping!
A new opportunity! Your Bot just sent another order.
Ping!
Successful match, bet went through.
“Ha, there we go! Easy.”
Peacefully you move on with your life but then, as you check in a few hours later, you notice an interesting thing: the first bet turned out to be significantly better than the second.
‘Ah, just variance’, you think. ‘Tomorrow I’ll be back to being Lady Luck’s favourite bettor.’
At this point the issue should stare at you: the reason our Bot is ‘faster’ in some situations isn’t really due to it being particularly fast, but rather a result of the competing Bot being *turned off* for those trades. The other Bot is probably built on better infrastructure [perhaps even backed by more precise/accurate fairs] and therefore quicker than ours, so whenever we actually get a match it’s due to our competitor *actively skipping it*.
& by now I guess we all realise what that means…
All for today.
Until next time…
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are *opinions* written by an anonymous group of mathematicians who moved into betting.
Great post my friend.