A few people have asked me what I think of Brexit, specifically with respect to the Predictit market: Will the UK vote to leave the EU by year-end 2016. Rather than answer all of those questions individually I decided to write a quick brief on strategy for this market.
First let me address my personal bias: I am pro Brexit. I think the EU is a terrible political organization and the UK is a terrible fit for membership in that organization even under the best conditions, which is far from what we are seeing in Europe at present. I would not have bothered to point out my bias, a good argument should stand on its own merit, except that in this case it actually provides a tangible differentiated benefit towards understanding the present conditions of the market. Openness to Brexit as a real possibility, something that actually could happen, changes how this market looks, and reveals a relationship pattern that should yield a productive return.
To start we should review the polling data. Polling has been back and forth for the last several months, with neither side able to string together more than a couple of consecutive ‘wins’. As far as polling methodology goes, different polling types have produced different results, and the inclusion or exclusion of undecided voters has favored both “Remain” or “Leave” depending on the week and poll source. Still, if you were to take the poll data at face value, the market prices should be “Leave” @ 51 cents and “Remain” @ 49 cents as of April 19th.
Obviously, we have yet to see anything near that number reflected in the trading price.
90 day market price of Brexit as of April 19th
So, now we have to consider what is being priced in. Predictit is defining the market resolution as “The Government of the United Kingdom shall hold a referendum on that country’s membership in the European Union, in which a qualifying majority expresses opposition to remaining a member.” I would interpret that as the most favorable “Leave” resolution conditions possible. Not requiring the actual execution of Brexit or the possibility of a double-referendum, minimizes the risk that might otherwise be attached to this contract by the political and legalistic chicanery of europhilic government officials.
So, again, why the low price? It is my belief that, in spite of polling data evidence, many people consider it impossible that the UK would actually leave the EU. Importantly, this belief is more strongly represented in “Remain” voters, who are demographically speaking higher income, have higher levels of post-secondary schooling, and are located more frequently in major metropolitan centers than “Leave” supporters. Considering the composition of “Remain”, is it any wonder that most British (and by extension international) media institutions, which are staffed almost entirely by this genteel demographic, would be unable to comprehend the actual likelihood of Brexit?
Is there truth to the notion that Brexit presents such a massive uncertainty that it would fail even with very strong polling suggesting the opposite? Sure. That idea seems well supported by the failed Scottish Independence Referendum. Brexit would present a real challenge to the UK in terms of realignment, and that could be reflected in some negative impacts. But, and this is the significant thing for trading on this, how close did the Scottish Referendum come to success relative to the polling data, and in what time frame?
Looking at the data, the “Remain” side was nearly always ahead in the long range forecasts, but was cut to within single digits in the month leading up to the actual vote. In fact, the risk was so under-appreciated by the government and the media that a last minute, widely mocked, campaign to encourage the Scottish not to leave the UK was clumsily rolled out of No.10 mere weeks before the referendum was scheduled to take place. “Remain” ultimately won by 10%, which represented an outperform of 5% above the average opinion polling of the week leading up to the referendum.
Now consider the time factor. Even though polling had been conducted weekly for over two years prior to the referendum, public interest in the event, as best as can be assumed from Google search trend data, was relatively small until the month before the actual referendum. The acceleration of search interest, in relative terms, during the one month period of time beginning August 18th at 4% and ending with the referendum on September 18th at 100% coincided with a narrowing of the opinion polling margin and a subsequent move towards more conservative betting lines from bookies, all of which is an excellent demonstration of the tremendous velocity at which apathy is demolished by proximity.
Good Trends for Scottish Independence Referendum, Full Year 2014
There are three really significant strategic takeaways from this:
- “Remain”, which has disproportionate control over the media and so called ‘thought leadership’ did not take “Leave” seriously until dangerously late in the game.
- The impact of incumbency was only worth a +5% bonus over polling for “Remain”
- Public interest was as much as 25 times less one month prior to the referendum as it was the day of the referendum.
Subjectively, I would say that Brexit represents a less significant a change in the status quo than does the prospect of an independent Scotland, and my conclusion seems consistent with the strong polling for Brexit “Leave” relative to Scotland “Leave” over the same periods of time when measured against their respective referendums.
Now, with all that in mind, we can finally talk about the strategic case for investing in this market.
My high level take on this is Brexit “Leave” shares are structurally undervalued until they reach 45 cents, and should then be priced according to a -3% on weekly polling averages. The market should be considered in terms of time left before June 23rd, (hereafter: T). If my logic holds, share prices for “Leave” should be generally inversely correlated with T until we hit the 45 cent structural price. After that, we should see “Leave” under priced by more than 3% of polling data. Once we hit T=1 week, assuming the same relative polling, we will hit the lowest discount rate, which should get us to the -3% discount. The only way that trading discount will be diminished is if “Leave” polling starts showing a consistent gap over “Remain” that credits 75% of undecided voters to “Remain”.
In application, my advice for a conservative strategy, assuming you are buying “Leave” (invert these numbers if you want to run the other side of this market), selling shares for a profit with a greater than 99% chance of success, would be to buy anything below 38 while T=30+ days, then setting sale price for 45 cents immediately. Moderate risk would involve purchasing below 40 and holding until the market gets within T=2 weeks and pricing according to conditions. Higher risk would be buying anything under 42 cents and holding for T=below 2 days when the conditions will be volatile, assuming the polling hasn’t shifted the dynamic. If you want to buy and hold for resolution, considering all of the other data, I would price according to the previous week average polling data -5% at the absolute minimum.
Can you hedge this market? Actually, yes, there is a likely prospect for hedging in the Boris Johnson Prime Minister in 2016 market. If Brexit does happen, David Cameron’s leadership of the conservative party might be at an end. There is little doubt that his most probable replacement would be Boris, who has already declared he is in favor of Brexit, and polls well with conservative voters, besides being one of the few UK politicians that qualifies as a household name. Obviously there are a lot of “if” cascades involved in this hedge, but the market is trading at 19 cents for “Yes” as of April 19th, which seems a reasonable price considering the market should be pricing in Brexit “Leave” and the evacuation of Cameron’s leadership for any other reason including a scandal driven non-confidence vote (IE a worsening of the panama papers scandal “Dodgy Dave”), his removal to prevent a fracture of the conservative party even if the referendum fails, or even a health issue that might render him unable to preform the job. I would suggest buying this at anything below 22 cent until Brexit “Leave” hits 45 cents and anything under 50% of the current market price after that if you are interested in pursing this strategy. Following the Brexit referendum resolution I might take another look at this market considering how the circumstances have changed (a close loss for Brexit “Leave” may threaten to destroy the conservative party).
PS: THIS IS ENTIRELY MY OWN LOGIC. YOU APPLY IT AT YOUR OWN RISK.