If you watch prediction markets closely, you’ll notice that spreads tend to widen during periods of volatility. This happens across markets like Kalshi and Polymarket. At first glance it may look like markets are simply “becoming inefficient,” but the explanation is much simpler. The root cause is thin liquidity and the behavior of the participants providing that liquidity.
The Root Cause: Thin Liquidity
Most prediction markets operate with relatively shallow order books. There are fewer professional participants continuously quoting both sides of the market compared with traditional financial markets.
Because of this, when uncertainty increases, the amount of liquidity sitting near the current price tends to disappear quickly. Orders are pulled, sizes shrink, and the gap between buyers and sellers grows.
This is why spreads widen.
Volatility doesn’t directly cause wider spreads. Instead, volatility causes participants to reduce their willingness to trade, which leaves less liquidity in the book.
The Role of Market Makers
Market makers play a large role in this process.
In any market, a market maker’s job is to quote both a bid and an ask while managing risk. They profit by capturing the spread, but they also carry inventory risk if the market moves against them.
When markets become more volatile or information becomes less clear, market makers face a problem: they are less certain about the fair value of the contract.
To manage this risk, they typically do two things:
- Reduce exposure – quote smaller sizes or step away from the market.
- Increase the spread – widen the difference between the bid and ask.
Both actions lower their risk if the price suddenly moves.
This behavior is standard across financial markets, not just prediction markets.
The Key Difference From Traditional Markets
The important difference is who provides liquidity.
In traditional markets: equities, futures, and options, there is a large pool of professional liquidity providers. Firms invest lots into infrastructure and models to quote markets continuously.
Prediction markets are different.
Professional market-making participation is still limited, and much of the liquidity comes from individual traders placing limit orders rather than large firms running automated quoting systems.
This means prediction markets often have:
- thinner books
- larger spread changes during uncertainty
- liquidity that disappears quickly when information changes
At first glance this might seem like a weakness.
How Thin Liquidity Can Create Inefficiencies
Thin liquidity and volatility can also create temporary pricing inefficiencies.
When new information enters the market, prices have to move to reflect a new probability. In a deep market, this adjustment usually happens quickly because there is enough liquidity on both sides to absorb trades.
In thinner markets, the process is less smooth.
If a large order hits the book, it can consume several price levels at once. The price may move beyond what traders ultimately believe is the fair probability. After the initial move, liquidity returns and the price often drifts back toward a more balanced level.
This is sometimes called an overshooting effect.
In simple terms, the price moves too far in one direction because there wasn’t enough liquidity to absorb the initial demand or supply. As more participants enter the market and provide liquidity, the price stabilizes.
These inefficiencies are usually short-lived, but they occur more often in markets with thinner books.
Why This Can Actually Be an Advantage
Those same structural features that create wider spreads, also make market microstructure easier to observe.
Because liquidity is thinner and less dominated by professional firms, certain signals stand out more clearly:
Order book imbalances
Large differences between buy and sell liquidity can persist longer before being arbitraged away.
Liquidity walls
Large limit orders are more visible and can influence short-term price movement.
Probability drift
Prices can move gradually toward new consensus probabilities rather than instantly adjusting.
In highly efficient traditional markets, these patterns are often extremely short-lived because professional market makers and arbitrage systems remove them quickly. Prediction markets, by contrast, can leave these signals visible for longer periods of time.
Final Thoughts
Spreads widen during volatility because liquidity becomes scarce. Market makers and liquidity providers reduce exposure and widen spreads when they are less certain about fair value.
Prediction markets experience this more dramatically than traditional markets due to thinner professional liquidity.
But that same structure also creates an opportunity: order flow, liquidity positioning, and probability changes are easier to observe.
For traders who pay attention to market structure, that visibility can be a real edge.