What is Statistical Arbitrage?
Statistical Arbitrage comprises a set of quantitatively driven trading strategies which exploit the relative price movements across thousands of financial instruments by analyzing the price patterns and the price differences between financial instruments. The end objective of such strategies is to generate alpha (higher than normal profits) for the trading firms.
Statistical Arbitrage is quite popular among High Frequency Trading and quant traders. Any arbitrage opportunity arising due to misquoting in prices can be very advantageous to a technology-driven trading strategy. Such opportunities may exist only for a few seconds in the market before the prices get re-adjusted, but those few moments are enough for a speed trading strategy to make money from.
However, there are many misconceptions about the statistical arbitrage strategies in the industry. We point out a few here.
Statistical Arbitrage Is (NOT) Risk-Free
Arbitrage strategies are considered risk free opportunities where you buy in one market and sell in another market as long as the price difference exists. For instance, if say gold is cheaper in Dubai than in London and you buy it in Dubai and sell it in London to make a profit from the difference; you had an arbitrage. Arbitrage can be explained with the help of this example is presented below:
However, in case of statistical arbitrage, it is not so simple. Statistical arbitrage uses mathematical models to identify statistical mispricing in the prices of highly correlated stocks. The arbitrage opportunity depends on the ability of the market prices to return to the predicted means. In periods of financial crisis, such strategies would be quite risky.
Pair Trading And Statistical Arbitrage Are (NOT) Different
Both have overlapping meanings which involve finding highly correlated pairs of stocks which are mispriced due to market inefficiencies and can be leveraged to make profits until the prices revert back to the historical or predicted values. A simple pair trading strategy is explained here along with data and a model in excel. You can download the files and run a simple pair strategy to understand what is meant by market inefficiencies.
Correlation And Co-integration Are (NOT) The Same
High correlation does not necessarily imply high co-integration.
Correlation reflects the relationship between two stocks in terms of price returns. However, it is not a robust indicator that measures long-term movements because it is sensitive to small-time deviations.
Co-integration measures the relationship between price movements of two stocks over long time periods and can serve as an additional parameter to find the pairs.
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