By Liz Benston

Wed, Jan 16, 2008 (2 a.m.)

With pundits and pollsters failing to pick the winners in the first two Democratic presidential contests, maybe online “prediction markets” -- far more sophisticated than your daddy’s bookie -- have found the secret.

They rely on political junkies who believe so firmly in their own research on who will win, they’re willing to bet on it.

Prediction markets behave much like stock markets. Online participants wager money on the probability of various outcomes, from political races to economic conditions and entertainment contests. There are no bookies setting lines on these sites, which merely create a market for bettors to trade “contracts” on outcomes.

For the record, two of the best-known markets -- the Iowa Electronic Markets and Intrade.com -- have Democratic Sen. Hillary Clinton in a slight lead for the Oval Office.

Here’s how it works: If you think Clinton will win, you buy a contract on that victory. Among the traders in the Iowa market Tuesday, 56 percent thought Clinton will win the Democratic nomination, thus setting the price of a Clinton contract at 56 cents. If Clinton wins, the trader gets $1 -- a profit of 44 cents. If she loses, the gambler gets nothing. If more people think Clinton will win, her contract will rise in value -- and her contract buyers will profit less if she wins.

As in a stock market, traders are rewarded for buying low and selling high and punished for buying high and selling low. The price, therefore, represents people’s expectations at any given moment.

Prediction market operators say their exchanges make for better predictors of events than casino bookmakers, let alone pollsters. Significantly, the Iowa Electronic Markets and Intrade.com correctly predicted George Bush’s narrow-margin win in 2004 over Democratic challenger John Kerry, while exit polls showed Kerry ahead.

“The bookie’s odds will be influenced by his appetite for risk, the action he’s got on his side and his own bias,” said John Delaney, chief executive officer of Dublin-based Intrade.com, the world’s largest prediction market. “If I were to ask you where you would find the expected value of IBM, would you ask a broker or go to the stock exchange? The aggregation of information that happens on an exchange typically provides better information than if you had several buyers and just one seller.”

The Iowa Electronic Markets, the oldest prediction market and the only major prediction exchange based in the United States, has an impressive track record: Compared with 964 polls conducted over five presidential elections since 1988, the exchange has been closer to the real outcome 74 percent of the time.

The exchange is administered by college faculty and was established for research purposes, though it’s open to real-money traders everywhere as well as students of politics and finance and their professors.

Offshore prediction markets such as Intrade operate beyond the reach of U.S. regulators, and the Iowa markets have a promise from the government that regulators won’t prosecute the exchange, a nonprofit that doesn’t charge for trades.

The most popular contract on Intrade.com, just ahead of the presidential front-runners, is whether the U.S. economy will enter a recession. (About 69 percent of traders think so.)

Each subsequent presidential primary has attracted more traders since Intrade launched its first political futures in 2001, Delaney said.

“The contest between Clinton and Obama, and the wide-open, volatile GOP race and the Lazarus-type of resurrection of John McCain ... is fascinating to people all over the globe.”