In a Down Crypto Market, Does Investing in Prediction Markets Make Sense?

With crypto in a bear market, some crypto investors are looking for alternatives. Prediction markets are one option. On Kalshi, it's possible to buy contracts that pay out if a specific outcome occurs, including those tied to a given cryptocurrency's price on a given date.

Kalshi also lists perpetual futures for Ethereum (CRYPTO: ETH), XRP (CRYPTO: XRP), and a dozen other coins, and to many investors, getting paid for a correct prediction sounds like a cheaper way to earn a return than buying and holding. But does that actually make sense, or is there a flaw in the logic?

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This is a bad idea if you aren't a hedge fund

Outcome markets are simple on the surface, but they're actually very complex (thus, risky and often frustrating for individual investors) to trade.

Every event contract is priced somewhere between $0.01 and $0.99. The price asked per contract is determined by the crowd's estimate of the event's odds of occurring. Buying a contract at $0.25 means risking $0.25 to make $0.75; with a contract price of $0.70, $0.70 is at risk to make just $0.30. Higher probabilities make for lower returns.

That ceiling is the trouble with replacing crypto-market investments with prediction-market bets.

If, for instance, Ethereum triples in value during the next three years, whoever owns the coin directly will capture the threefold return in their account. On the other hand, whoever bought a prediction market contract for Ethereum to be "above $2,500 by December" will collect $1 per contract they bought for a bit less than $1.

The implication is that being wrong is usually worse with a prediction market contract than with a spot investment, regardless of the market in which the investment is made.

Ethereum bought at $1,900 and held through a decline until its price reaches $1,500 is guaranteed to be frustrating, but the investor still holds an asset worth about 80% of its original value, and its price could credibly recover. A contract that misses its strike price will expire worthless, even if the miss is only by a penny or two -- and if it ever becomes obvious that the contract will expire worthless, people will dump it well in advance of that actually happening, so there's a limited window of time to exit before total disaster.

Perpetuals are another potential pitfall

Aside from prediction markets, Kalshi's other crypto product, perpetual futures, is also quite risky for those accustomed to investing in cryptocurrencies.

In June, Kalshi launched the first perpetual futures cleared for U.S. investors by the Commodity Futures Trading Commission (CFTC), adding Ethereum and XRP within a week. Nothing like it was available on a regulated U.S. venue before that.

Perpetuals never expire, and they follow the price of the underlying asset without ever settling or expiring. They also add the ability to use leverage, which requires an automated mechanism to close (liquidate) positions when the user's collateral runs out.

What happened in June is an instructive period on the risks of trading perpetuals. Ethereum's price fell to less than $1,900 on June 3, and as a result, about $1.8 billion of leveraged positions were liquidated by exchanges within 24 hours. The coin's price is back near $1,908 today, so everyone who lost 100% of their funds to liquidations would still have the value in their accounts if they had just bought the coin on spot markets and held on rather than using leverage. Being right on the direction of price and wrong on the timing of price is almost always survivable when you own the asset and often fatal when you rent it using leverage.

So investors should not think about pivoting to prediction markets simply because crypto is in a bear market. There's no such thing as simply pivoting into a different type of market and immediately succeeding, especially not in unforgiving arenas like prediction markets and perpetual futures.

Alex Carchidi has positions in Ethereum. The Motley Fool has positions in and recommends Ethereum and XRP. The Motley Fool has a disclosure policy.