Statistical Arbitrage: the most profitable trade you've never heard of

Statistical Arbitrage: the most profitable trade you’ve never heard of

13 mins read

Statistical arbitrage (also known as statistical arbing) uses computer algorithms to compare prices on trading platforms, in order to exploit price differences and profit from them.

Although the concept of statistical arbitrage has been around since the 1980s, it wasn’t until 2009 that it became truly viable as an investment strategy due to advances in technology and reductions in transaction costs.

Statistical arbitrage hedge fund In this article we will take a look at how statistical arbitrage works, why it’s so profitable, and how you can get started with this exciting trading strategy.

Statistical arbitrage sounds like something only high frequency traders would be into, but it’s actually pretty simple to execute and extremely profitable. In fact, if you’re in any sort of buy-and-hold investing strategy where you hold your positions for at least three months, you should consider using statistical arbitrage as part of your investment strategy. Here’s how it works…

An overview of what it is

Statistical trading strategies that attempts to take advantage of pricing discrepancies between different markets.

For example, if shares of Company A are trading at $10 on the New York Stock Exchange and $11 on the London Stock Exchange, a statistical arbitrageur would buy shares of Company A on the NYSE and sell them on the LSE, profiting from the price difference.

The main risk in this type of trading is being arbitraged or outsmarted by someone else who sees what’s happening and starts buying on one market while selling on the other. To avoid this risk, many quantitative traders employ computers programmed with sophisticated algorithms to look for small discrepancies and immediately execute trades when they find them.

Types of Statistical Arbitrage 

Statistical arbitrage is a trading strategy that takes advantage of statistical disparities in asset prices. This type of arbitrage is usually carried out by computer algorithms, but can also be done by humans. The most common type of statistical arbitrage is pairs trading, which involves taking long and short positions in two similar assets.

Other types of statistical arbitrage include event-driven arbitrage and intra-market arbitrage. Event-driven arbitrage entails profiting from differences in securities’ price reactions to different types of events such as mergers or bankruptcies.

Intra-market arbitrage profits from price discrepancies within a single market or exchange without involving securities of differing issuers or sectors.

  • Volatality Arbitrage
  • Risk Arbitrage
  • HFT

How Statistical Arbitrage Affects the Market?

Statistical arbitrage is a type of trading that seeks to profit from statistical anomalies in the market. This strategy is often used by hedge funds and other sophisticated investors. The trader will look for discrepancies between different stock prices in different markets, often caused by information lags or computer-based trading errors. 

The trader might notice, for example, that Stock A was selling at $10 on one exchange while it was selling at $11 on another exchange. The trader could then buy the cheaper stock and sell it on the more expensive exchange to make a quick profit. It can also work the other way around.

Say one exchange had an inflated price for some reason. If traders wanted to bet against this inflated price, they would need to be able to quickly convert their money into shares of the company before it reached its peak.

The same principle applies if they wanted to invest in something else. In these cases, traders use an intermediary like Goldman Sachs which helps them quickly convert money into any stocks they want without having to go through the hassle of using a foreign currency.

Statistical arbitrage in pairs trading using Python

The first step is to choose the stocks for pairing. We have taken the two stocks Blink Charging Co

(ticker symbol: BLNK) and NIO (ticker symbol: NIO).

Let us first fetch the closing prices for both stocks.

# Import the libraries
import pandas as pd
import yfinance as yf
import numpy as np
import statsmodels.api as sm
import matplotlib.pyplot as plt

# Define list of tickers
tickers_list = ['BLNK', 'NIO’]

# Define data with Dataframe
data = pd.DataFrame(columns=tickers_list)

# Fetch the data
for ticker in tickers_list:
data[ticker] = yf.download(ticker,'2018-12-01','2022-03-31')['Adj Close']

# Show first five rows of the data
%matplotlib inline

# Customise the size of the plot
plt.figure(figsize=(15, 7))
plt.plot(data['BLNK'], lw=1.5, label='Close Price of BLNK',color='red')
plt.plot(data['NIO'], lw=1.5, label='Close Price of NIO',color='#6CA6CD')
plt.grid(True)
plt.legend(loc=0)

# This helps us tighten the figure margins
plt.axis('tight')
plt.xlabel('Dates')
plt.ylabel('Price ($)')
plt.title('Close prices for BLNK and NIO')
plt.grid(True);
plt.show()

What are some risks?

Statistical arbitrage, or stat arb for short, is a trading strategy that seeks to profit from price discrepancies between similar assets. The risks associated with this strategy are two-fold: first, the trades are heavily reliant on accurate data and modeling; and second, the strategy can be adversely affected by changes in market conditions.

Statarb traders need their models to accurately account for all potential sources of risk. When markets are less liquid (e.g., low volume), models may fail to capture how these differences affect prices, leading to inaccurate predictions about where prices will converge.

These inaccuracies will cause trades to misfire, resulting in higher losses than if liquidity was more consistent, However, these risks can also lead to outsized returns: historical evidence suggests that when markets become less liquid (e.g., during flash crashes), statarb strategies often outperform traditional long-only strategies.

How to apply statistical arbitrage for pairs trading?

Image Credits: Investopedia.com

For applying quantitative arbitrage work inside a pairs trading strategy:

  1. First, you have to pick the stocks for matching.
  2. After you have picked the stocks, secondly you will find out the closing values of both equities and visualise them.
  3. Now, you will compute and visualise the pair’s spread and the z-score of the spread
  4. Then, you will verify the stationarity of the spread by performing the Augmented Dickey-Fuller.
  5. Lastly, the trading signals can be created if the pair is stationary according to the ADF test. After a period, the paired stocks invariably return to their mean.

Financial Crisis hit StatArb

It is a significant point of contention that the typical decline in portfolio value might also be attributable to a causative process. The financial crisis of 2007-2008 also happened at this period. Many, if not the great majority, of investors of whatever type, incurred losses during this one year time span.

The correlation of observed loss at fund managers utilising statistical arbitrage isn’t always indicative of reliance. As new rivals enter the market, and funds spread their trades over more platforms than StatArb, a claim may be made that there should be no reason to anticipate the platform model to behave anything like one another. Their statistical models might be fully independent.

Which websites are appropriate for the strategy?

There are a few different websites that statistical arbitrage can be used on. The most popular website for this strategy is the Forex market. Other websites include the stock market, commodities market, and even the cryptocurrency market.

In order to profit from this strategy it is important to have access to several markets. It is also important to note that while there are many successful investors who use statistical arbitrage as their primary investment strategy, it should not be attempted without having a strong understanding of how it works or without any other backup strategies in place. It is not a beginner-friendly strategy and has a very high level of risk associated with it.

Capital Market Analogy

Likewise, if we buy a stock on the market. We are buying the future cashflows of the specific company. The only way, we make money is when our belief about the firm cash flow is bigger than what the market believes it to be. There are also statistical arbitrage trading software.

Similarly, it’s the reverse when we are short of stock. Our conviction is smaller than the chance the market is attributing it to the company’s cash flow.

The sole restriction is transactions or positions when the danger of an event going against us has a significant cost such as death. Here, while on an anticipated basis, it does not make sense to purchase insurance, it works from a risk point of view.

The chance of disaster is relatively low but the cost of not defending against it is quite expensive. These are additional bets, we should take when the absolute loss due of the downside is quite significant.

Verdict

Image Credits: Pankaj Balani Tweet

If you’re looking for a high-profit, low-risk trading strategy, statistical arbitrage is a great option. Also known as statarb, this strategy involves taking advantage of small price discrepancies between two different markets.

For example, if stock A is trading for $10 on one exchange and $10.05 on another, a stat arb trader would buy stock A on the first exchange and sell it on the second, pocketing a quick 5 cents per share. Because the cost of buying or selling a single share is typically only pennies, these tiny margins can translate into substantial profits over time.

Statarb traders have also been known to bet against themselves, setting up what’s called a synthetic short position in which they make an opposing bet that limits their risk while still generating steady returns.

The downside? Well, like any other type of investment, there are no guarantees in the market; if you don’t get out before something unexpected happens (like an economic collapse), your money could be at risk.

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