Every profession has its buzzwords to create the illusion that things are more complex than they really are. Everything from the Latin terms used by medical doctors to the chatter of gearheads talking about the latest car engine, simple concepts are often clothed in complicated-sounding terms.
Investing professionals are no different in their use of complicated nomenclature to describe simple things and ideas.
I know I was intimidated when I first heard the termstatistical arbitrage. To me, it sounded like I would need a math Ph.D. or at least an advanced understanding of statistical theory to figure out what it meant. Not being an advanced math person, I was fortunate to have had a trading mentor who patiently explained to me what statistical arbitrage is and how to use it profitably.
Ever since I was made aware of this unique and profitable trading technique, I have used it in a variety of market conditions to capture profits that would otherwise be unavailable. This method’s not for everyone, but if you’re an active investor who is looking for additional tricks of the trade, statistical arbitrage may be just the ticket.
What Is Statistical Arbitrage?
Simply put, statistical arbitrage is a fancy term for pair trading, which is the buying or selling of a pair ofstocks based on their relationship with each other.
Often, the stock price of companies in the same sector or type of business follows one another very closely. A pair trader observes the relationship between two stocks and buys or sells whenever the relationship gets out of sync, acting on the assumption that the historical correlation is likely to continue.
Is it a foolproof method? No, but it does provide another tactic in your investing toolbox.
It is easier to understand this concept with an illustration. The following chart shows the relationship between The Coca-Cola Company (NYSE:KO) and PepsiCo, Inc. (NYSE:PEP), perhaps the most popular stock pair for statistical arbitrage.
Notice how closely the two stocks follow each other until near the end of May. At this time, PepsiCo, Inc. (NYSE:PEP) falls out of sync with The Coca-Cola Company (NYSE:KO), dropping as Coca-Cola stays steady and starts to climb. Statistical arbitrage traders would purchase PepsiCo, Inc. (NYSE:PEP) stock as soon as the divergence is recognized.
As you can see, the pair quickly moved back into sync, providing a profit opportunity for statistical arbitrage traders. There are multiple ways this can be approached.
For example, let’s say The Coca-Cola Company (NYSE:KO) started rapidly climbing higher than PepsiCo, Inc. (NYSE:PEP). Savvy statistical arbitrage traders would short The Coca-Cola Company (NYSE:KO) shares in anticipation of its price falling back into the historic correlation.
In addition, the idea is not just limited to two stocks. The same idea can be applied to groups of three or more correlated names. However, special software is often employed to manage multiple-issue statistical arbitrage.