Statistical Arbitrage Definition

This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. It is widely used by investment banks, pension funds, mutual funds, and hedge funds that may need to spread out the execution of a larger order or perform trades too fast for human traders to react to.

Also in the 1990’s, Jim Simons and his firm Renaissance Technologies became the foremost practitioner of purely statistical trading techniques, producing returns that were well above market benchmarks. Simons was a mathematician and based his investing approach on machine learning techniques to uncover short-term anomalies in pricing.

Relationship Between The Vix And Sp500 Revisited

The objective is to take advantage of differences between the implied volatility of the option, and a forecast of future realized volatility of the option’s underlying. In volatility arbitrage, volatility rather than price is used as the unit of relative measure, Spread Betting i.e. traders attempt to buy volatility when it is low and sell volatility when it is high. Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume.

statistical arbitrage

Different market condition has a different level of correlation, and this has an important implication for stat-arb trading PnL. In summary, relative pricing based on the principle of no risk-free arbitrage is very different from absolute pricing. It is the foundation of many derivative pricing models and quantitative trading strategies. The explosion of computing power has produced more and more actors in the statistical arbitrage business, and the profitable opportunities have become smaller and harder to find. The $20 bills lying in the grass have, indeed, mostly been picked up. The valuable arbitrage opportunities that underlie its own internal fund are not plentiful enough to expand them to the unwashed public.

6 Overview Of The Process So Far

The existence of the investment based upon model itself may change the underlying relationship, particularly if enough entrants invest with similar principles. The exploitation of arbitrage opportunities themselves increases the efficiency of the market, thereby reducing the scope for arbitrage, so continual updating of models is necessary. In finance, volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlying.

In the second or “risk reduction” phase, the stocks are combined into a portfolio in carefully matched proportions so as to eliminate, or at least greatly reduce, market and factor risk. This phase often uses commercially available risk models like MSCI/Barra, APT, Northfield, Risk Infotech, and Axioma to constrain or eliminate various risk factors.

Statistical Arbitrage In The U S. Equities Market

To define it in simple terms, statistical arbitrage comprises a set of quantitatively driven algorithmic trading strategies. These strategies look to 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 for the trading firms. A point to note here is that Statistical arbitrage is not a high-frequency trading strategy. It can be categorized as a medium-frequency strategy where the trading period occurs over the course of a few hours to a few days.

Relative pricing based on the principle of no risk-free arbitrage underlies most of the derivative pricing models in quantitative finance. That is, a security is valued based on the prices of other securities that are as similar to it as possible. For example an over-the-counter interest-rate swap is valued based on the prices of other traded swaps and not on, for example, some macro-economic factors. A bespoke basket option is valued based on the prices of its components’ vanilla options. statistical arbitrage is also subject to model weakness as well as stock- or security-specific risk. The statistical relationship on which the model is based may be spurious, or may break down due to changes in the distribution of returns on the underlying assets. Factors, which the model may not be aware of having exposure to, could become the significant drivers of price action in the markets, and the inverse applies also.

Projects On Statistical Arbitrage By Epat Alumni

A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans. Market timing is the strategy of making buying or selling decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market rather than for a particular financial asset. StatArb considers not pairs of stocks but a portfolio of a hundred or more stocks—some long, some short—that are carefully matched by sector and region to eliminate exposure to beta and other risk factors.

Statistical arbitrage trading relies on, among other factors, the correlation between stocks. It is important to note, however, that correlation, like volatility, is not static, but time dependent and changing.

Category: Statistical Arbitrage

You can examine the relationship between the true alpha and the Kalman Filter estimates kfalpha is the chart in the upmost left quadrant of the figure. With a level of accuracy this good for our alpha estimates, the pair of simulated stocks would make an ideal candidate for a pairs trading strategy. There are plenty of in-built pair trading indicators on popular platforms to identify and trade in pairs. However, many a time, transaction cost which is a crucial factor in earning profits from a strategy, is usually not taken into account in calculating the projected returns. Therefore, it is recommended that traders make their own statistical arbitrage strategies keeping into account all the factors at the time of backtesting which will affect the final profitability of the trade.

Speed and volume were the key; risk was minimized by keeping holdings short term. Simons shared next to nothing with the public concerning his methods, other than to say that his trades made money only just over 50% of the time. This may have been a colloquial way of saying that individual trades had an expected value just in excess of their cost . Simons hired other mathematicians and computer programmers; he did not value traditional investing professionals with market knowledge. Simons’ co-president, Robert Mercer, attained political notoriety when he became the largest funder of the Trump campaign . As you can see, the Kalman Filter does a very good job of updating its beta estimate to track the underlying, true beta . As the noise ratio Q/R is small, the Kalman Filter estimates of the process alpha, kfalpha, correspond closely to the true alpha, which again are known to us in this experimental setting.