As I have written before, there are thousands of strategies that you can use as a trader to maximize your profits. Some of the strategies I have talked about before include: hedging, algorithmic trading, scalping, and value investing among others. In addition, there are traders who focus on technical analysis while others focus purely on fundamental analysis. The secret to maximize your profits is to focus on one or two strategies. The more strategies you use, the more mistakes you are likely to do. In this article, I will focus on statistical arbitrage.
Statistical arbitrage is a jargon. Everyone who hears the word gets the wrong impression. They think it’s a tough strategy involving tough mathematical models and calculations. It’s not. In fact, statistical arbitrage is one of the easiest strategies that one can use out there. However, the profits made using the strategy are not as much. However, it is one way you are certain that you could make huge amounts of money.
Statistical arbitrage (SA) is a complex word used to refer to pairs trading. It is a simple way of using hedging as a strategy. In SA, you take two assets and trade them in the opposite direction. For instance, in a normal silent day (one without major news coming in), two similar assets will trade in the same direction. For instance, two companies in the same sector will trade in the same direction. For instance, oil companies such as Exxon Mobil and Chevron will ‘always’ trade in the same direction. This is because their fundamentals are almost certain. For instance, if the price of crude oil goes down by 4%, then chances are high that the two companies mentioned above will be impacted through spill over effects. In the same way, retail companies such as Target and Walmart will follow one another.
The same is the same in the commodities market. For instance, the West Texas Intermediary (WTI) and ICE Brent crude will move in the same direction. Their correlation is almost perfect.
In statistical arbitrage therefore, the goal is to identify companies or asset classes that have a unique level of correlation and then open two trades simultaneously. In case of a perfect correlation situation, you will open opposing trades. For instance, in the case of Brent and WTI crude, you will open long and short trades. Your goal is that WTI (which you bought) will go up and Brent (which you short) will go down. Then, your profit will be the differential. Assume that Brent makes you $200 in profit while WTI makes you a $100 loss, your profit will be $100. Therefore, you will mitigate the negative loss.
However, pairs trading will not always work. When trading equities, it will not always work out that way in the short term. For instance, assuming that Walmart and Target have been trading perfectly for the last week and there is no financial release coming up. Then, on this day, a ratings agency downgrades Target. Chances are that the cycle will be broken and you will likely make a loss.
In the case of equities, how do you determine the company to long or short? One, the companies need to be related. For instance, in case of the energy sector, you can use oil companies such as Exxon and Chevron. Alternatively, you can use an oil company such as Exxon and an oil servicing company such as Halliburton. Second, you need to conduct a thorough analysis of the two companies. A correlation is a good way to start. Yahoo Finance is a good way to get the data for analysis. The same is true for other asset classes.