Introduction

Statistical arbitrage is the practice of using a mathematical model to identify a mispricing in the market and take advantage of it to make a profit. As a trading strategy, it has been around for decades and has become more popular in recent years due to the growth of algorithmic trading. In this article, we’ll look at what statistical arbitrage is, how it works and how you can use it to make money.

What is Statistical Arbitrage?

Statistical arbitrage (also known as “stat arb”) is a type of trading strategy that uses mathematical models to identify mispricings in the market. It involves taking a position on a mispriced instrument or asset with the belief that the market will correct itself and the position will be profitable.

The strategy is based on the premise that the price of a given asset will eventually move towards its fair value, and that any deviation from that fair value is an opportunity for profit. To realize this opportunity, traders use statistical models to identify and exploit mispricings in the market.

Statistical arbitrage relies on quantitative analysis and complex algorithms to identify mispriced assets and take advantage of them. The strategy is typically executed by computer algorithms, but can also be done manually.

How Does Statistical Arbitrage Work?

Statistical arbitrage works by taking a position on an asset or instrument where the price deviates significantly from the fundamental value. This can be done by buying or selling the asset, or by taking a long or short position in derivatives such as options or futures.

In order to identify mispriced assets, a trader must first construct a model that will determine the fundamental value of the asset. This model should take into account various factors such as supply and demand, economic conditions, political environment and so on. Once the model has been constructed, the trader can then use it to identify assets that are mispriced.

When an asset is identified as being mispriced, the trader can then decide whether to buy or sell it, or if they should take a long or short position in a derivative. Once the position is taken, the trader will wait for the market to correct itself and the position to become profitable.

Types of Statistical Arbitrage

Statistical arbitrage can be divided into two types:

1. Pair Trading - Pair trading involves taking a long position on one security and a short position on a related security. The idea is that if one security moves up, the other will move down, and vice versa. This allows the trader to benefit from the relative mispricing between the two securities.

2. Index Arbitrage - Index arbitrage involves taking a long or short position on an index or group of securities, such as a stock index or currency index. The idea is that if an index moves up or down, the individual securities in the index will move in the same direction, allowing the trader to benefit from the mispricing.

Risks of Statistical Arbitrage

While statistical arbitrage can be a profitable trading strategy, it is not without its risks. One risk is that the model used to determine the fundamental value of the asset may be incorrect or incomplete, resulting in a mispricing that cannot be corrected. Additionally, the strategy is subject to market volatility and can be adversely affected by sudden changes in market conditions. Lastly, the strategy requires significant capital investments and is often difficult for small traders to execute effectively.

Conclusion

Statistical arbitrage is a powerful trading strategy that can be used to identify and exploit mispriced assets in the market. The strategy involves using mathematical models to determine the fundamental value of an asset and taking a position on it when it is mispriced. There are two main types of statistical arbitrage: pair trading and index arbitrage. However, the strategy carries significant risks that must be taken into consideration before attempting it.