Geeking Out Over the Daily Fantasy Sports Scandal

A look at how a DraftKings employee had an edge in daily fantasy sports (DFS) betting

by Adam Warner

    Published on Oct 7, 2015 at 9:02 AM
    Updated on Jun 24, 2020 at 10:16 AM

    Big news in Daily Fantasy Land. "Scandal Erupts in Unregulated World of Fantasy Sports," reads The New York Times headline:

    "On Monday, the two major fantasy companies were forced to release statements defending their businesses' integrity after what amounted to allegations of insider trading, that employees were placing bets using information not generally available to the public."

    You have a lot going on in merely that one sentence. "Placing Bets"? I thought this whole enterprise was a "game of skill"? I mean, the NFL considers placing bets about the highest crime known to man, yet they can't line up fast enough to get more ads and tie-ins with daily fantasy sports (DFS). 

    Insider trading? That implies buying or selling something on non-public knowledge. That's a bit of a misnomer here. The "insiders" didn't actually trade anything; what they did do (presumably) was use non-public info to derive a modest edge playing the games themselves. More on that later. 

    Just to refresh, in case you have either lived in a cave for the last couple of months or haven't watched a sporting event for at least three minutes: DFS games are perfectly legal (in most states). They allow anyone and everyone to sign up, deposit some money, and play fantasy sports with a different twist to the season-long games. 

    For NFL e.g., you get a virtual salary cap and a roster to fill. Every NFL player has a virtual salary. Your job is to fill out your lineup within the cap and then compete with the other players in your "game" based on the stats the players produce for games that week. 

    There are two basic types of DFS games. One is a 50/50 sort of game, where half of the virtual teams win money and the other half lose. The other is a Grand Prize sort of game, where a small percentage of players win larger payouts. 

    The site operators make a pretty penny on the games themselves. In a $1, 50/50 game, for example, the winners earn $1.80, while the losers fork over the $1. That's 10 cents of every dollar "bet" -- I mean, "game of skill." Revenue is going to grow monstrously this quarter, but all those ads cost money, so profits will presumably wait until the inevitable IPOs. 

    There's one catch for the sites, though: As part of their carve-out to remain legal, they must offer large-prize games with a fixed number of entries. And the game must go on whether they fill out all the slots. 

    Let's say the game has 110,000 slots for $20 each, and the site promises to pay out $2 million. If the game fills, the operator earns $200,000. But every slot that doesn't fill earns the operator less. And if the operator gets fewer than 100,000 players, it loses money, since it still has to pay out the $2 million. The difference between the payout and what it takes in is called the "overlay." And finding these overlays is really the only net edge in playing DFS, as it implies a positive expected gain on your "investment." 

    The other way to win is being "smarter" than your competition. For straight betting, you need to actually win your bet. For DFS, you just need to beat your competition. 

    So, how did these "insiders" do it? Let's assume that the only net winners over time are going to use sophisticated algorithms. You can win in the short term with a combo of basic knowledge and luck, but in the long run, you will lose. 

    So, let's presume they're using algos. The sites themselves use algos to set the player salaries to begin with. That's non-public info that the insiders presumably access. Most actual players will carry "salaries" commensurate with their expected production, and sharper players will produce lineups with similar players. But they won't produce exactly identical lineups, even to themselves, as they pop out multiple permutations. They obviously "buy" more of guys whose values they find favorable. Thus, ownerships rates will vary. 

    And those ownership rates are not public until the actual players' actual games starts. If Bryce Harper's game starts at 7 PM, that's when you know how many virtual teams included Bryce Harper. But if Mike Trout's game doesn't start until 10 PM, you won't know how many teams included him. 

    An algo that doesn't have proprietary info can "infer" Mike Trout's ownership rate with data gleaned from lineups that are revealed at 7 PM. And it can perhaps derive an edge from that calculated info, as it can adjust lineups accordingly (actual players don't lock until their actual games start). And the algo can make the changes much faster than a human can. 

    An insider doesn't need the algo to infer ownership rates. He can presumably see them before they're public and plug that info into optimizing his own lineups before any games have started. He can't play games on his own site, but he can play games on other sites -- at least he could until yesterday.  And given that it's an almost certainty that ownership rates will mirror each other across platforms (think of it as a large sample poll), that info will produce an edge. They also have access to player-specific results, and could spot smarter money quite easily and perhaps mirror those lineups. 

    Why does it matter? Well, the whole goal here is to optimize lineups. And that non-public info will most certainly confer an edge because, remember -- again, you're playing against other players, NOT the game itself. 

    I doubt the "scandal" includes an actual crime. The heart of the story is that a DraftKings employee won $350,000 in a FanDuel football game. DraftKings denies he used inside data to win since he didn't have access to it until after the game started. And if you believe that one… well whatever, let's say it's a valid explanation, even though it appears flimsy. 

    It's clearly a very bad look. The sites are selling their "integrity" in a pretty unregulated realm. And they're trying to convince everyone to plunk down money in order to win money, and any sense that they have no chance doesn't encourage forking over more cash. 

    Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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