Statistical arbitrage

As we saw in the previous section, arbitrage is based on the idea of mispricing: a situation in which an asset is priced incorrectly. But to say whether something is priced incorrectly or correctly, we need a reference that is known to be priced correctly, don’t we?

In classical arbitrage, such a reference is the asset price itself, and we take advantage of mispricing across different trading venues trading the same asset. Statistical arbitrage (stat arb) uses the concept of fair value to determine whether the asset is mispriced. In simple terms, with classical arbitrage, we compare the price of the asset versus another price of the asset that exists at the same moment in time. With stat arb, we compare the price of the asset to a theoretical fair value to which we expect the price to revert in the future.

In a certain sense, stat arb is a modification or extension of the concept of mean reversion. Indeed, a successful mean reversion strategy is based...