Position Sizing, Liquidity & Spreads

Risk Management Essentials for Prediction Markets

Successful prediction market trading requires more than accurate forecasts. You must size positions appropriately, navigate liquidity constraints, and minimize transaction costs. Over-sizing positions leads to ruin even with positive expected value. Ignoring spreads and slippage erodes profits.

This module teaches you systematic position sizing, liquidity assessment, and spread analysis to optimize risk-adjusted returns.

Position Sizing Fundamentals

The Core Problem

You have $1,000 to trade. You find a binary market priced at $0.60 (60% implied probability), but your analysis suggests 75% actual probability—a 15-percentage-point edge.

Questions:

  1. How much should you risk on this trade?
  2. Should you bet the full $1,000 for maximum profit?
  3. What if you're wrong?

Answer: Position sizing balances edge (expected profit) against risk (potential loss).

Kelly Criterion: Mathematical Optimal Sizing

Formula:

f = (bp - q) / b

Where:

Simplified for Prediction Markets:

Kelly % = (Estimated Probability - Market Price) / (1 - Market Price)

Example:

Market: YES at $0.60 (60% implied probability) Your Estimate: 75% probability Calculation: (0.75 - 0.60) / (1 - 0.60) = 0.15 / 0.40 = 37.5% of capital

Position: With $1,000 capital, bet $375 on YES at $0.60

Payoff:

Expected Value: (0.75 × $625) + (0.25 × $0) - $375 = $468.75 - $375 = +$93.75

The Problem with Full Kelly

Full Kelly (37.5% in example above) is aggressive. If your probability estimate is slightly wrong (actual is 70%, not 75%), you're over-betting and risk large drawdowns.

Solution: Fractional Kelly

Most professional traders use 1/4 Kelly or 1/2 Kelly:

1/2 Kelly = 37.5% / 2 = 18.75% of capital ($187.50 bet) 1/4 Kelly = 37.5% / 4 = 9.4% of capital ($94 bet)

Trade-off:

Recommendation: Start with 1/4 Kelly until you've validated your forecasting accuracy over 20+ trades.

Practical Position Sizing Rules

Rule 1: Never Risk More Than 5-10% on Single Trade

Even with 90% confidence, cap position at 10% of capital. Unexpected outcomes happen (port strikes, data errors, geopolitical shocks).

Rule 2: Diversify Across Uncorrelated Markets

Don't put 40% of capital into four 10% positions on LA Port, Long Beach, Oakland, and Seattle—they're highly correlated (same supply chain). Instead, spread across:

Rule 3: Adjust for Market Type

Binary Markets: Use standard Kelly sizing (clear win/loss) Scalar Markets: Use 50-75% of binary Kelly (precision risk—two boundaries to miss) Index Markets: Use 75-100% of binary Kelly (diversified components = lower single-point risk)

Rule 4: Scale Down for Uncertainty

If your probability estimate has wide error bars (you think 60-80%, midpoint 70%), use lower confidence:

Liquidity: Understanding Market Depth

What Is Liquidity?

Liquidity measures how easily you can buy or sell without moving the price significantly.

High Liquidity:

Low Liquidity:

Assessing Liquidity Before Trading

Step 1: Check Order Book Depth

Example Order Book:

| Price | Shares Available (Ask) | Price | Shares Available (Bid) | |-------|------------------------|-------|------------------------| | $0.66 | 200 shares | $0.64 | 150 shares | | $0.67 | 300 shares | $0.63 | 400 shares | | $0.68 | 150 shares | $0.62 | 300 shares | | $0.70 | 500 shares | $0.60 | 600 shares |

Midpoint: ($0.66 + $0.64) / 2 = $0.65

Liquidity Analysis:

Verdict: Moderate liquidity. Can trade up to $400-500 (600-750 shares) without severe slippage. For trades over $500, split into multiple orders.

Step 2: Calculate Potential Slippage

You want to buy $1,000 worth of YES shares. Current best ask (sell price): $0.66

Execution:

  1. Buy 200 shares at $0.66 = $132
  2. Buy 300 shares at $0.67 = $201
  3. Buy 150 shares at $0.68 = $102
  4. Buy 500 shares at $0.70 = $350
  5. Remaining $215 / $0.70+ = ~307 shares at higher prices

Weighted Average Price Paid: ($132 + $201 + $102 + $350) / (200 + 300 + 150 + 500) = $785 / 1,150 shares = $0.683 per share

Slippage: $0.683 - $0.66 (initial quote) = $0.023 (3.5% slippage)

Impact: You paid 3.5% more than expected. If your edge was 5%, slippage consumed 70% of expected profit.

Minimizing Slippage

Tactic 1: Use Limit Orders

Set maximum price you're willing to pay. Order only executes if price is available.

Example: Place limit order to buy 1,000 shares at $0.67 or better. If price never reaches $0.67, order doesn't fill (you avoid overpaying).

Tactic 2: Split Large Orders

Instead of buying $1,000 at once, buy $200-250 every 15-30 minutes. Allows order book to replenish.

Tactic 3: Trade During High-Activity Periods

Liquidity is highest when many traders are active (during U.S. trading hours, after major news). Avoid trading in off-hours when spreads widen.

Bid-Ask Spreads: The Hidden Cost

Understanding the Spread

Bid Price: Highest price buyers will pay (what you receive if selling) Ask Price: Lowest price sellers will accept (what you pay if buying)

Spread = Ask - Bid

Example:

Market: YES contract

Spread as Transaction Cost

Round-Trip Cost = 2 × Spread (buy, then sell later)

Calculation:

Implication: Your forecast must have over 4.7% edge just to break even after spread costs.

When Spreads Are Too Wide to Trade

Rule of Thumb: Only trade if edge exceeds 2x the spread percentage.

Example:

Spread: $0.05 on $0.50 midpoint = 10% spread Minimum Required Edge: 20 percentage points (e.g., market at 50%, your estimate over 70%)

If your edge is 15 points (50% vs 65%), spread eats over half your expected profit—skip the trade.

Spread Variations by Market

Narrow Spreads (1-3%):

Wide Spreads (5-15%):

Trade Accordingly: Focus on high-liquidity markets with narrow spreads unless you have exceptional edge on low-liquidity markets.

Worked Example: Complete Position Sizing & Liquidity Analysis

Scenario: You're trading Panama Canal transits for January 2025.

Market: "Will Panama Canal exceed 950 transits in January 2025?"

Your Analysis:

Step 1: Kelly Calculation

Simplified Kelly (for buying NO):

Fractional Kelly (1/4 Kelly):

Step 2: Position Size

Capital: $1,000 Position: 13.9% = $139

Step 3: Check Liquidity

Order Book (NO side, which equals selling YES):

| Price (YES Bid) | Shares Available | Equivalent NO Ask | |-----------------|------------------|-------------------| | $0.41 | 500 shares | $0.59 | | $0.40 | 300 shares | $0.60 | | $0.39 | 200 shares | $0.61 |

Buying NO at $0.55 (selling YES at $0.45):

Not shown in order book—need to place limit order and wait for taker.

Alternative: Buy NO directly from AMM (automated market maker) at $0.55.

Liquidity Verdict: $139 / $0.55 = 253 shares. Order book has 500 shares at $0.59, 300 at $0.60—adequate liquidity. Slippage risk is low for this size.

Step 4: Spread Analysis

Spread: $0.04 (8.9% of midpoint) Edge: 25 percentage points Ratio: 25 / 8.9 = 2.8x (edge exceeds spread by 2.8x)

Verdict: Trade is acceptable (edge over 2x spread).

Step 5: Execute

Place limit order: Buy 253 NO shares at $0.55 or better.

Outcome (if correct):

Outcome (if wrong):

Expected Value: (0.80 × $253) - $139.15 = $202.40 - $139.15 = +$63.25 (45.4% expected return)

Advanced: Portfolio-Level Risk Management

Correlation and Diversification

Problem: You have five 10% positions ($100 each) on:

  1. LA Port December throughput (bullish)
  2. Long Beach December throughput (bullish)
  3. Oakland December throughput (bullish)
  4. Seattle December throughput (bullish)
  5. Trans-Pacific index (bullish)

Issue: All five are highly correlated (correlation over 0.8). If Trans-Pacific trade weakens, all five lose simultaneously.

Effective Exposure: 5 × 10% × 0.8 correlation = 40% concentrated risk in single theme.

Solution: Diversify across uncorrelated themes:

  1. Trans-Pacific (bullish LA Port)
  2. Trans-Atlantic (bullish NY/NJ Port)
  3. Geopolitical (bearish Suez Canal transits)
  4. Policy (bullish U.S.-India tariff stability)
  5. Seasonal contrarian (bearish Q1 Asian exports post-Chinese New Year)

Correlation Matrix: Average correlation under 0.3 → true diversification.

Maximum Drawdown Limits

Rule: Set portfolio-level stop-loss at 20-25% drawdown from peak equity.

Example:

Why: Protects against catastrophic losses from overconfidence or systematic model errors (e.g., all your forecasts assume stable geopolitics, but war breaks out).

Rebalancing Position Sizes

As winning trades grow and losing trades shrink, position sizes drift from targets.

Monthly Rebalancing:

  1. Calculate current capital
  2. Recalculate Kelly sizing for open positions
  3. Trim oversized winners (over 15% of portfolio), add to undersized positions

Example: Position started at $100 (10% of $1,000 capital). After market moves, position is now worth $200 but capital is $1,100 (other positions lost money). Position is now 18% of portfolio (over target). Sell $80 to bring back to $120 (11% of $1,100).

Common Mistakes

Mistake 1: Ignoring Spreads on Small Edges

Problem: You find 5% edge (market 50%, you think 55%) but spread is 8%. You trade anyway.

Why It Fails: 8% spread on round-trip wipes out 5% edge. Expected value is negative.

Solution: Only trade edges over 2x spread.

Mistake 2: Betting Too Large on High-Confidence Trades

Problem: You're "95% sure" and bet 50% of capital. Outcome surprises, you lose 50%.

Why It Fails: Overconfidence. Even 95% confidence means 1 in 20 wrong. Large bets on rare losses destroy capital.

Solution: Cap single positions at 10-15%, even with 95% confidence.

Mistake 3: Chasing Illiquid Markets

Problem: You see 30% edge on obscure market but liquidity is 100 shares total. You try to buy $500 (moves price 50%).

Why It Fails: Slippage eliminates edge.

Solution: Only trade if position size is under 10% of available liquidity at acceptable prices.

Ready to Apply What You've Learned?

Turn knowledge into action.

Start Trading on Ballast Markets →

Apply systematic position sizing and liquidity analysis to real prediction markets. Start with small positions (1-2% of capital) and scale up as you validate your process.

Next Steps

Continue Learning:

Practice Exercises:

  1. Calculate Kelly % for a market: YES at $0.70, your estimate 80% probability
  2. Given order book, calculate slippage for $500 purchase
  3. Determine if 12% edge with 6% spread is tradeable (2x rule)

Advanced Topics:

Disclaimer

This content is for educational purposes only and does not constitute financial advice. Position sizing models like Kelly Criterion assume accurate probability estimates—errors compound quickly. Prediction markets involve risk of total capital loss. Start with fractional Kelly and small positions until you've validated forecasting accuracy over 20+ trades.