Online trading exchanges (TradeSports, Betfair) differ from more traditional sports betting websites (Sportsbook.com, Bodog) in that there is no "house." That is, the exchanges are clearinghouses for buyers and sellers to trade with each other at prices set by each other, whereas the traditional betting websites are owned by casinos that are in business to rip off their customers.
While casinos attempt to post odds at a market clearing price, the exchanges offer "live" pricing. For example, Bodog might offer me static, pre-game odds of Jacksonville over Indianopolis at 3-to-1 on Sunday (implying JAX has a 25% chance of winning); TradeSports shows me the price throughout the game. So, the JAX contract starts the game at $0.25, with the price moving up or down depending on how the game is going. If JAX scores an early touchdown to go up 7-0, the contract might rise in value to $0.50, at which point I can sell for a profit of $0.25 ($0.50 market value less $0.25 cost) or hold it in the hopes that JAX wins and I collect a profit of $0.75 ($1.00 less $0.25).
The price of the contracts on these exchanges are determined not by casinos, but rather by users. By offering better pricing, more liquid markets, and a superior customer experience through user involvement, online trading exchanges are a good example of how Web 2.0 capabilities compare to the old Web (in this case, online casinos).
The potential for online exchanges is limitless, and one wonders if and when established exchange companies (NYSE, Nasdaq) will react or intervene. The most active online trading exchange markets are sporting events, but contracts in financial markets and other events ("When will Brangelina get divorced?") are also quite liquid. TradeSports has even applied to the Commodity Futures Trading Commission (CFTC) to open a regulated futures exchange in the US.
Wikipedia does a better job of summarizing than I can...
WARNING: This blog does not contemplate the legality of transacting on these sites, and I certainly do not wish to suggest any activity that will get readers fined or thrown in jail.
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