4 Risks of Statistical Arbitrage

Statistical arbitrage is a type of investment strategy that uses statistical analysis in order to try to take advantage of securities that are not priced correctly. This strategy utilizes computer models and advanced mathematics to try to make profits in the market. While the word arbitrage implies that there is no risk to this type of strategy, there are indeed risks that you need to be aware of.

1. Individual Stock Risk

Statistical arbitrage generally includes correlated stocks or securities. A model is developed based on the tendencies of these correlated securities. When a deviation occurs between the two securities, the one that goes above the statistical mean will be sold. The investment tool that goes below the line will be bought. When they return to the mean, you will realize a profit in both directions.

This strategy can get you into trouble if one of the stocks does not behave like it should. For example, if you bought the stock that was moving down and you later found out that the company was going out of business, you would lose a substantial amount of money. In order for statistical arbitrage to work, you need the securities to behave like they have been behaving in the past.

2. Execution

If you want statistical arbitrage to work, you have to rely on your broker to execute your orders. Many times, you have to have split-second execution in order to profit from this type of trading strategy. In some cases, the broker will not be able to fill your trade and they will simply cancel the order. When this happens, you might be stuck with a short position on one security, but you did not get your long order filled. This could put you in a bad situation that could result in losing money because you need two orders to find success.

3. Model Affecting the Market

When a prominent statistical arbitrage model is created, it can sometimes affect the market. In many cases, just the existence of the model will have an impact on the market. If enough people execute the same strategy, it can impact the securities that are being traded. For example, if enough people know that two stocks are correlated, they will alternately purchase orders at the same time, when the model recommends it. This can increase or decrease the prices of the securities and affect the profitability.

4. Changes in the Market

Even if a statistical model has been successful in the past, there is a chance that the market could change and render it useless in the future. Financial markets are always changing and evolving into different situations. This is why every trading expert says that "past results are no indication of future performance." The market has to behave similar to how it has behaved in the past in order for a strategy like this to work. You always have to be aware of this risk if you are going to use statistical arbitrage.