Pair Trading and Statistical Arbitrage

The strategy of pair trading is a market-neutral trading strategy that allows traders to make profits practically under any dynamics of the market: an uptrend, a downtrend or a lateral movement. The strategy, which appeared in the early 1980s, began to gain popularity among private traders only with the advent of online trading. The fact is that the opportunities for performing paired deals usually appear only for a short period of time, so constant market monitoring and quick response are required, which can only be achieved with a high degree of automation of the trading process.

The first and most important step in pair trading is the search for a pair. The pair are trading instruments (stocks, options, futures, currencies, bonds, etc.), showing a high degree of correlation when the price movement of one of them is accompanied by a similar movement in the strength and direction of the second. In the share market, shares of two companies from the same (or related) industry can act as such a pair. In the futures market, this pair can be futures for a minimal and full-size contract or futures for related (similar) assets. And for Forex it can be currencies of countries that have close trade relations. Traders use various tools of both fundamental and statistical analysis to find a pair suitable for trading. Once the pairs are found, it is not difficult to build a trading strategy for them.

The essence of the pair trading strategy is to find discrepancies in the ratio between the prices of the instruments of the pair. Once significant discrepancies arise, traders open opposite positions on instruments: a long position on an undervalued instrument and a short position on an overvalued one. In most cases, losses for one position are always offset by income from the opposite position. Traders make a profit when the discrepancy between the instruments is adjusted and the assets come to the original (or close to the original) price ratio. Detailed information about the implementation of the pair trading strategy can be found here.

Statistical arbitrage is a generalization of paired trading, where instead of a pair of correlated trading instruments, a couple of related toolbars are considered. The basis of the strategy is the property of returning the ratio of the values of such baskets to the average value. Traders tend to make a couple of baskets in such a way that on a long history their ratio would always return to their average. The logic of trade here is very similar to paired trading: when the cost of baskets diverges by a predetermined amount from its historical average, there is a sale of the overbought basket and the purchase of the resold. When the ratio of values is restored, the positions are closed, and the trader makes a profit.

From the point of view of creating a strategy, statistical arbitration is much more complicated than pair trading. Without specialized software, this can not be avoided, since it is almost impossible to manually sort through different groups of tools and make a couple of baskets with the necessary properties. An interesting solution in this area is SpreadBuilder from Megatrader. This program automatically goes through a lot of trading tools, combining them according to a special algorithm, and gives the user ready sets of the best pairs of baskets for profit.

Currently, trading is increasingly turning into a competition of trading algorithms. Traditional trading systems built on the use of various combinations of technical indicators have long ceased to make a profit. At the forefront now are science-based strategies and technologies for data analysis. Pair trading and statistical arbitrage is an excellent example of such strategies. And if before they scared away with their complexity, now, thanks to the development of online trading and the availability of software, they became available to private traders.

On Megatrader website https://megatrader.org you can find many interesting and useful information about scientifically based, bringing stable income trading strategies, like pair trading or arbitrage.