Statistical Arbitrage in the US

Arbitraged Away?

October 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Statistical arbitrage has attractive strategy characteristics
  • However, the returns are highly dependent on transaction costs
  • Best used as a tactical strategy when volatility is high

INTRODUCTION

Equity markets in 2018 can be characterized by divergence. There is the US, showing strong returns, versus most other developed and emerging markets, which are generating lower or negative returns. A common trade is therefore shorting the US and going long the rest of the world. The supporting thesis is that mean-reversion will set in as the US is fully integrated into the global economy.

However, most investors are likely to be cautious as there is no certainty when the outperformance of the US will cease. Investors can speculate on mean-reversion on index as well as stock level. On the latter, the opportunity set is much larger as there are thousands of individual stocks, which allows the creation of a diversified portfolio of pair trades. Furthermore, the strategy can be enhanced by using statistical measures to improve the pair selection process. In this short research note we will investigate statistical arbitrage in the US stock market.

METHODOLOGY

We focus on all stocks in the US with a market capitalization of larger than $1 billion. The strategy is to create a diversified portfolio of pair trades, which will be dollar-neutral. Each pair consists of a long and a short position of stocks from the same sector. In addition, the two stocks of a pair need to be cointegrated, which is measured with a one-year lookback and a maximum p-value of 0.3. A trade in a pair is entered when the z-score of the stock price ratio breaches +/- 2.0 and exited when the z-score reaches 0 subsequently. The z-score is calculated with a 21-day lookback.

It is worth noting that statistical arbitrage is a sophisticated strategy that comes in all kind of forms and requires many assumptions. Our methodology is in line with academic research and relatively simple.

CASE STUDY: STATISTICAL ARBITRAGE IN THE US REAL ESTATE SECTOR

Considering the nature of mean-reversion, some sectors should offer better opportunities than others. If the stock price of a biotech company jumps due to a drug approval from the US FDA, then it is not necessarily sound to short th