Statistical arbitrage with cointegration

Statistical arbitrage refers to strategies that employ some statistical model or method to take advantage of what appears to be relative mispricing of assets, while maintaining a level of market neutrality.

Pairs trading is a conceptually straightforward strategy that has been employed by algorithmic traders since at least the mid-eighties (Gatev, Goetzmann, and Rouwenhorst 2006). The goal is to find two assets whose prices have historically moved together, track the spread (the difference between their prices), and, once the spread widens, buy the loser that has dropped below the common trend and short the winner. If the relationship persists, the long and/or the short leg will deliver profits as prices converge and the positions are closed.

This approach extends to a multivariate context by forming baskets from multiple securities and trading one asset against a basket of two baskets against each other.

In practice, the strategy...