Statistical Arbitrage in Indian Stock Market — Introduction

Statistical arbitrage, more commonly called Stat Arb, is based on the statistical mispricing of one or more assets compared to the expected future value of these assets.

Deterministic arbitrage, on the other hand, ensures a risk-free profit from being long in some securities and short in others.

It's a computational and quantitative approach to trading.

The Birth of Stat Arb can be dated back to the mid-1980s when a small group of researchers working under Nunzio Tartaglia at Morgan Stanley created a program to buy and sell stocks in pair combinations.

The program quickly earned a reputation along with great profits but the strategy was kept hidden for a while soon the idea behind the strategy was revealed and was named Pairs Trading.

A pair of stocks is identified based on fundamental or market similarities. Pair trade earns profits based on mean reversion, So it’s mostly the mean-reverting stocks. Commodities stocks will work great in this case.

In the pair of chosen stocks that generally behaves or is perceived to behave similarly in the market changes, one is priced over the mean and the other below the mean.

When the spread between two stocks is high, we short the outperforming stock and long the underperforming stock. It hedges the risk from the whole market movements.