Investors, financiers and hedge funds, among other industry experts, use statistical strategies and quantitative analysis of a series of data to identify viable trading of securities. While this is squarely based on buy/sell decisions over computer algorithms, the primary aim is to lock in profits. One such alternative strategy applied is statistical arbitrage, a technique that heavily relies on reversing prices from the historical to their normal.
Originating from 1980s and championed by Morgan Stanley, this approach enjoys maximum use in financial markets. It is a classic yet fundamental technical analysis that employs a combination of quantitative algorithm trading strategies to exploit relative price fluctuations across financial instruments.
This implies that the financial industry's key players can utilize invaluable information collected to assess price patterns and differences between financial instruments and enhance chances for profitability. Statistical arbitrage represents not a high, medium strategy but a medium frequency that allows trading to take place over a specified period.
How Statistical Arbitrage works
Statistical arbitrage is designed using corporate activity, lag or lead effects including short-term momentum among other factors to exploit mathematical models in evaluating arithmetical configurations. It emerges as an alternative to the traditional price data analysis tool. Since securities like stocks tend to experience an upward and declining trend, the strategy makes the most out of this fluctuation by use of software programs to track and monitor such behavior. The assessment is anchored on security pricing, frequency and volume for optimized trading.
In some instances, pairs can be identified using advanced time series, statistical tests and analysis to help specify entry and exit points for strategic leverage. Diverse in-built pair indicators are widely acceptable on market platforms to locate trading pairs except for transactional costs only essential in computing projected returns.
To such a degree, this is why the financial industry encourages critical players to establish their independent statistical arbitrage strategies to keep track of all factors during back-testing to enhance final profitability. Although this technique earns quantitative trading entities lots of profit, it can be ineffective if prices tend to continue drifting away from the archived normal. Into the bargain, benefits generated based on statistical arbitrage models might not consistently be 100 percent guaranteed.
Benefits of statistical arbitrage
Statistical arbitrage remains helpful when there is unpredictability to project better stable incomes with minimal risks in any market situation. Conceivably, it is the reason why such market-neutral strategies are gaining popularity, thanks to the ability to diversify risks to the lowest possible level.
Moreover, when compared to market volatility and investing in government bonds, statistical arbitrage is one of the safest globally. It can assume a modest correlation in respect to existing market conditions and available risk-return ratios for analysis to increase viability. It provides a window of opportunity for investors and analysts to perform transactions via a pair of securities, especially when both the extended and contracted positions are applied concurrently.
Statistical arbitrage will continue to gain market relevance because security pairing pricing is more statistical than market centered. Lastly, it helps evaluate investments for the increased rate of returns at low risk based on available news, political events, and social-economic trends among other factors.