All About Prediction Markets, How They Work and How to Build One

Prediction markets are quite popular nowadays, and as I was building something over them and researching different ways of building it, I thought to put this blog to share my knowledge and research on how they work

What exactly are prediction markets

Prediction markets are nothing but a general game of predicting outcomes. You might have played something similar in childhood, or maybe you have played games like Mafia, where the goal is to predict or figure out who the real mafia is. At the core, it is all about predicting whether something is going to happen or not, whether someone will become the Prime Minister, or whether an earthquake might occur.

This idea existed even before crypto came into existence. However, decentralisation and putting these markets on the blockchain bring transparency, global accessibility, immutability of settlement mechanisms, and automated execution, which fundamentally change how these systems operate.

Important point to note while building prediction markets

The core idea of a prediction market is what happens when the market resolves. Once the final decision or outcome is known, the winning side should receive money, and the losing side should lose money. The most important part is ensuring that enough collateral or funds are available in the system to pay the winners at the end.

This is why prediction markets always lock money upfront. Every participant deposits funds into the smart contract before voting. These funds act as collateral and guarantee that payouts can be made once the market is resolved. Because the contract already holds all the money, there is no risk of someone refusing to pay after the outcome is decided.

If this collateral logic is weak or missing, the entire market breaks, or you, as a platform need to arrange it(which you would not like to do unless you have a lot of VC money to burn). Even if the prediction is correct, winners will not trust the system unless they are guaranteed to get paid. This settlement guarantee is what makes on-chain prediction markets reliable and trust-minimised.

How to build a prediction market – developers’ view

If you are a developer or a vibecoder planning to build your own prediction market on any topic, you might start by thinking about the different ways this can be built. Questions like why Polymarket chose a liquidity-based model and whether there are other ways to design and write the core logic of such applications naturally come up early in the process. Here we will discuss all such things!

Step 1 : Deciding Outcome Type classification

Binary vs Categorial vs Scalar

If you are building a prediction market, first, you have to think about what the outcome types are for your market.

Binary Markets (Yes/No):

• Simplest format with only two possible outcomes
• Highest liquidity concentration (all capital on two sides)
• Enables precise probability measurement
• Used for straightforward yes/no questions​
• Example: “Will the Federal Reserve cut rates in 2026?”

Categorical Markets (Multiple Outcomes):

• Multiple discrete outcomes competing within one market
• Single market instead of separate binary markets
• Better captures complex real-world scenarios
• Higher analytical complexity
• Example: “Which country will win the 2026 FIFA World Cup?” (32+ outcomes)

Scalar Markets (Numeric Range):

• Users predict values within a specified range
• Used for price predictions or quantitative forecasts
• Example: “What will Bitcoin’s price be on December 31, 2026?” with a range from $50K to $250K

Step 2: Deciding how it will work

1. Parimutuel: Simple yes or no, and putting money in a pot

The simplest way to build a prediction market is to put up a question and let people place money on either yes or no. The smart contract stores all the funds, and once the outcome is finalised, the entire pot goes to the winning side.

Method 1, fixed amount per vote

Assume the voting amount is fixed at $1 per vote.

• Yes side has 1 vote, total $1
• No side has 50 votes, total $50

Total pot = $51

If the final outcome is yes, the yes side wins. Since there is only one voter on the yes side, that person receives the full pot of $51. This includes their original $1 plus the $50 from the losing side.

Method 2, variable amount per vote

Now, let us customise this by allowing users to put any amount of money.

• Person A puts $10 on yes
• Person B puts $5 on yes
• Person C puts $100 on no

Yes side total = $15
No side total = $100

Total pot = $115

If yes wins, the $115 pot is distributed only among the yes voters, based on how much each person contributed.

• Person A share = 10 / 15 = 66.66%
  Payout = 66.66% of $115 = $76.66
• Person B share = 5 / 15 = 33.33%
  Payout = 33.33% of $115 = $38.33

Person C on the no side loses the entire $100.

This logic can be implemented either by issuing vote tokens proportional to the deposited amount or by storing user balances and sides directly inside the smart contract.

Method 3: Commit-Reveal Voting – If you want to hide voting

If you want to hide how people are voting, one of the best approaches is a commit–reveal style mechanism.

In this method, the user first creates a secret or password. They then combine their vote, either yes or no, with this secret and generate a hash from it. Only this hash is submitted to the smart contract during the voting phase. At this stage, no one can see whether the user voted yes or no.

Once the outcome period starts, the user reveals their original vote and secret. The smart contract hashes these revealed values again and checks them against the hash that was previously submitted. If both hashes match, the vote is considered valid.

Example with numbers and flow

1. User wants to vote yes and chooses a secret, for example mySecret123.
2. The user creates a hash of
   yes + mySecret123
   Let us assume the hash is 0xABC123.
3. During the commit phase, the user sends:
   • Vote amount, for example, $10Commit hash 0xABC123
   The smart contract stores only the hash and the amount, not the actual vote.
4. After the market closes and moves to the reveal phase, the user submits:
   • Vote, yes
   • Secret, mySecret123
5. The smart contract recomputes the hash from yes + mySecret123.
   If the result is 0xABC123, the contract accepts the vote and counts the $10 towards the yes side.

If the user provides a wrong secret or changes the vote during reveal, the hash will not match, and the vote will be rejected. This ensures private voting during the market and transparent verification once the outcome is revealed.

Offcourse user doesn’t have to do this, and it will be your platform that needs to take care of secret generation, saving, and revealing, etc.

2. Liquidity-based

In liquidity-based prediction markets, users do not simply click YES or NO and lock money in a pot. Instead, the market creates tradable outcome tokens.

For every market, two tokens exist (You can have more based on no of outcomes, here we will take an example of binary markets):

• YES token
• NO token

These tokens represent claims on the final outcome and are traded like normal assets.

Case 1: Minting YES and NO separately

In this model, the platform mints a fixed number of YES and NO tokens and sells them in the market. The money collected goes into a pool, and after resolution, the winning side takes the pool.

This approach has problems:

• Prices show popularity, not true probability
• Fixed supply limits, late information
• Payout per token is not guaranteed
• Early buyers are unfairly favoured

Because of this, prices from such markets are unreliable.

Case 2: Minting YES and NO in pairs (Polymarket model)

Polymarket mints YES and NO together as a pair, backed by real collateral.

• Deposit 1 USDC
• Mint 1 YES + 1 NO
• At settlement:
  • Winning token = 1 USDC
  • Losing token = 0

This enforces the rule:

YES price + NO price ≈ 1

So token prices directly represent probability.

Why this model works

• Guaranteed payout
• Continuous liquidity
• Accurate price discovery
• Late information always matters

This is why modern prediction markets like Polymarket use pair-minted, collateral-backed tokens traded via order books instead of simple pot-based betting systems.

You might be thinking how price is guaranteed and how yes + no token value remain $1, what if i sell my yes token for 0.8$ and so on. We will discuss this below on how Polymarket works.

Where to trade these tokens, AMM vs CLOB

Now comes the question: where should these tokens trade?

AMM, Automated Market Maker

An AMM uses a mathematical formula to decide prices. Prices change based on liquidity and trading activity. So you basically create a pool contract, set a formula that X*Y=K, or you can limit it between 0 and 1. Set initial liquidity by depositing tokens into the contract that you minted, and then people will trade it and the equation or formula will govern the price.

Pros,

• Always liquid
• Simple UX

Cons,

• Prices can deviate from real probability
• Liquidity providers influence prices heavily

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CLOB, Central Limit Order Book

A CLOB is an order book where users place buy and sell orders at specific prices. It’s like an order book, somebody says I want to sell a yes token for 5, you put it in your database, when the buyer clicks to buy or puts a buy order for 5$, your code will find and match the order and exchange the tokens.

Pros,

• Prices reflect real market belief
• Better probability signal
• Used by Polymarket

Cons,

• More complex infrastructure
• Lower liquidity without active traders, if there is nobody to put buy or sell orders, its a problem, you as a platform have to do it then

Which one should you use

If your goal is to show true probability, use a CLOB.
If your goal is simplicity and guaranteed liquidity, and you don’t want to depend on traders, use an AMM.

Most serious prediction markets choose CLOB because prediction markets are about information, not just trading volume.

How Polymarket Works, Deep Dive for Builders

This section explains who mints tokens, where they are sold, how prices move, how arbitrage works, and why this design exists.

Who creates the market and tokens

A market is created by the platform, not random users.

The platform defines,

• The question
• Outcome set, usually YES and NO
• End time
• Resolution source, called an oracle

Once created, the market contract is deployed or initialised.

Who mints YES and NO tokens

Tokens are not pre-minted in bulk.

YES and NO tokens are minted only when someone deposits collateral, who we call liquidity providers; you can be one.

Flow,

1. User deposits USDC into the market contract
2. Contract mints
   • 1 YES token
   • 1 NO token
3. Both tokens are backed by that same 1 USDC

Important rule,

Tokens can never exist without collateral

This is why the system is always solvent.

Note: Its not important that you put yes + no = 1 USD only, you can set it to 10 USD or 100USD. 1 USD is just easy and a way of normalization, such that the price remains low, and it also shows probability (0 to 1 -> 0% to 100%).

Where do these tokens live

YES and NO are standard ERC-20 tokens.

They live,

• On-chain
• In user wallets
• In smart contracts, when placed in orders

Users fully own their tokens.

Where are tokens bought and sold

Polymarket uses a CLOB, which stands for Central Limit Order Book. In simple terms, this is the same buy and sell system used by normal exchanges, where users place orders at the price they want. One important thing to understand is that order matching happens off-chain, while the actual settlement happens on-chain. On-chain order books are slow and expensive because every small action costs gas. To avoid this, Polymarket runs the order book on its backend servers, matches buy and sell orders off-chain for speed, and then submits the final matched trades to the blockchain. This approach keeps trading fast while still ensuring users retain custody and final settlement remains trustless.

How selling and buying work

Buying YES

If you want to buy YES,

• You place a buy order at a price
• Example, buy YES at 0.60 USDC

If someone sells YES at that price, trade happens.

Selling YES

Users can sell anytime.

Example,

• You own YES tokens
• You place a sell order at 0.75
• If the buyer exists, the trade executes

After selling,

• You get USDC
• You no longer hold YES

You do not need to wait for a resolution.

How prices are actually decided

Prices are not set by Polymarket.
They emerge from, buy, and sell orders. Best bid and best ask determine the current price. Basically, the last traded price.

Why YES + NO price stays near 1

This happens because of arbitrage, not magic. “Arbitrage” means making risk-free profit by exploiting price mismatch.
Example scenario,

• YES price = 0.65
• NO price = 0.40
• Total = 1.05

This should never happen.

Arbitrager does,

1. Deposit 1 USDC
2. Mint 1 YES + 1 NO
3. Sell YES for 0.65
4. Sell NO for 0.40

Total received = 1.05 USDC
Risk-free profit = 0.05

That order gets filled, now the next price is available in the order book, which will be less; if not, the arbitrager will keep filing those orders where it’s greater than 1> and will keep minting and making profit.

This selling pressure pushes prices back to normal.

Opposite case

If,

• YES = 0.45
• NO = 0.45
• Total = 0.90

Arbitrager,

1. Buys YES and NO for 0.90
2. Holds until resolution
3. Redeems for 1 USDC

Again, risk-free profit.

This mechanism forces price correctness.

Who usually does arbitrage

• Bots
• Market makers
• Advanced traders

Polymarket relies on them intentionally.

They keep prices honest.

I am confused about how arbitrage actually moves prices in Polymarket

A common confusion when looking at Polymarket is this: if anyone can place orders at any price in the order book, why does the price ever correct? For example, why do a YES price of 0.65 and a NO price of 0.41, which together add up to 1.06, not stay there forever? Or why can someone not just place an order at 2 USDC and call that the price?

The key thing to understand is that in an order book, prices are not decided by what people ask for, they are decided by what actually trades. Placing an order at any random price does nothing unless someone else agrees to trade at that price(why would somebody buy yes for 2$ when they know the yes token will be worth at max 1$ at the conclusion of the market). Until a trade happens, the market price does not move.

When people say the YES price is 0.65, they usually mean one of these things: the last trade happened near 0.65, or the best buy and sell orders are clustered around that level.

For example, the order book might look like this:

Buy YES at 0.65 → 100 tokens
Buy YES at 0.62 → 200 tokens

Sell YES at 0.66 → 120 tokens
Sell YES at 0.70 → 300 tokens

In this case, the visible market price sits around 0.65 to 0.66. If someone places an order to sell YES at 2 USDC, it simply stays in the book and never executes. Since no trade happens, the price does not change.

Another common misunderstanding is self-trading. In real systems like Polymarket, trading with yourself is blocked. Even if it were allowed, it would not change the real price because no genuine demand or supply is involved. This prevents fake volume and fake price signals.

Now consider a situation where YES trades at 0.65 and NO trades at 0.41. Together, they add up to more than 1 USDC. This creates an arbitrage opportunity, which simply means risk-free profit.

An arbitrageur deposits 1 USDC into the contract and mints:

1 YES token + 1 NO token

They then sell YES into the existing buy orders at 0.65 and sell NO into buy orders at 0.41. In total, they receive 1.06 USDC back, making a profit of 0.06 USDC.

This selling activity is what fixes the price. When the arbitrageur sells YES at 0.65, they consume the buy orders at that price. Once those orders are filled, the next available buy price is lower, for example 0.62. The same thing happens on the NO side. As demand gets consumed and supply increases, prices naturally move back toward balance.

Nothing special or manual is happening here. The arbitrageur is not forcing the market to change. They are simply selling to people who already wanted to buy at those prices. Because Polymarket allows minting YES and NO together for exactly 1 USDC and guarantees redemption at settlement, any situation where prices drift away from this balance becomes free money. Bots and market makers constantly watch for these gaps and act immediately.

This is why prices in Polymarket do not stay wrong for long. You cannot move the market by placing random orders, and you cannot hold prices at incorrect levels because arbitrage will always push them back. The platform itself does not control prices. It only enforces pair minting and guaranteed settlement. Everything else is handled by traders, liquidity, and simple economic incentives.

If you understand that orders do nothing until they trade, that minting creates new supply, and that arbitrage is just selling into overpriced demand, the Polymarket pricing model becomes very clear.

Why not allow users to mint only YES or only NO

Because that would break solvency.

If users could mint YES alone, Unlimited YES could exist, the platform could not pay winners

Pair-minting forces balance.

What happens after the resolution at the contract level

At resolution, Oracle writes the outcome on-chain, and the contract switches state to resolved

Redemption logic: The winning token can be burned for 1 USDC, and the losing token becomes worthless

Collateral is released only through burns.

Why this model

You can see that this model has many benefits. You are not just creating a simple yes or no prediction market; you are also creating a full trading market around it, basically a complete economy built on the idea of predicting outcomes. People can buy early and sell later, hedge risk by holding both sides, trade on volatility, arbitrage mispricing, and, of course, place bets based on their beliefs. All of this activity keeps the market deep and active, and at the same time gives you, as a platform, a strong and sustainable business model.

How would you build this yourself

• MarketFactory contract to create and register new markets with question, end time, and oracle
• Market contract to hold USDC collateral, track market state, and handle resolution
• PairMinting logic that takes USDC and always mints YES and NO tokens together
• OutcomeToken contracts (ERC20) like YES_TOKEN and NO_TOKEN that users can freely trade
• An off-chain order book service to store buy and sell orders without gas cost
• Matching engine to match orders and generate trades at agreed prices
• Settlement contract to settle matched trades on-chain and move tokens and USDC
• Oracle system to publish the final outcome and trigger market resolution
• Redemption logic where winning tokens burn for 1 USDC and losing tokens become zero

Final mental model for developers

• USDC goes into the system
• YES and NO tokens are minted in pairs
• Tokens trade via an off-chain order book
• Trades settle on-chain
• Oracle resolves the market
• Winning tokens redeem for USDC

This is why prediction markets look simple but are actually hard to build correctly

The problem as a developer or founder building this

You also need a solid trading engine. If the engine is slow or unreliable, trades will lag, arbitrage will fail, and the market can easily break, even if your smart contracts are correct.

The biggest problem is finding liquidity providers. If you do not have them, you will have to be the first one to deposit a large amount of money, mint the tokens, and let people trade. The model is safe, but it requires real capital upfront, which is hard for early-stage teams.

Attracting arbitragers is another challenge. In the beginning, there will be no bots and very few people who understand how arbitrage works. To keep prices correct at launch, you usually need to run these bots yourself until the ecosystem matures.

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Prediction markets are awesome, but building them comes with its own set of challenges. I hope this helped in understanding the critical concepts involved and how to build one.