What is Statistical Arbitrage?
This is one of the strategies employed by Hedge Funds and High Frequency Traders, wherein they profit from mispricings in the market. The core idea being, prices of financial securities revert to their long-term historical average value over time (mean-reversion). To shed more light, let’s quickly walk through the mechanics of a Statistical Arbitrage Strategy.
Think about two imaginary stocks A and B. Now, these two stocks have previously over a long duration of time known to have closely matching performances in the market (i.e their market prices are highly correlated with each other). Every time A goes up, B does too and every time B goes down, A does too. Until, suddenly one day, they deviate from this behaviour and start behaving like they’re not stock-market soul mates. That’s when the Hedge Fund managers and the HFT jump in to exploit this strange behaviour, on the notion that stock A and B will eventually revert back to their average intrinsic values (that’s called mean-reversion) and that their performances will reunite (match made in heaven?). That’s the concept of Statistical Arbitrage (or statarb as the fancy Wall Street traders call it!)
So how does one exploit this market mis-pricing?
Well, when Stock A and B are having trouble in paradise and deviate from correlated price behaviour, you buy the underperforming Stock and sell the outperforming stock, in hope’s that their prices will eventually converge back to their former behaviour. That was simply, right?
The nuances and risks
So keep in mind that Statistical Arbitrage can be expanded to include more than 2 securities, we can base the central idea that 2 baskets of securities which were previously correlated with each other, will revert back to the same behaviour in case of short-term deviations. This is a highly quantitative process and the main risk is that the deviation from their long-term normal price persists for a greater period than expected or worse does not revert back at all, in which case, the investor made the wrong bets on the prices and undergoes compounded amounts of losses!