Definition
Statistical arbitrage (stat arb) identifies pairs or baskets of related securities that have temporarily diverged from their historical pricing relationship. When the spread exceeds a statistical threshold, the strategy goes long the relatively cheap security and short the expensive one, profiting when the relationship reverts. Modern stat arb uses factor models, machine learning, and high-frequency data.
lightbulb Example
Two oil companies historically trade with a 0.95 correlation. Company A drops 5% on no news while B is flat—the spread widens to 2.5 standard deviations. The strategy buys A and shorts B, profiting when the spread reverts to normal within days.
verified_user Key Points
- Exploits temporary statistical mispricing
- Mean-reversion based—buys cheap, shorts expensive
- Requires large position sizing for small per-trade profits
- Model risk and regime changes are key risks