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How to Construct Market Neutral Statistical Arbitrage Strategies

Updated on 2013-05-14 by Guest

Market neutral statistical arbitrage trading strategies can be very profitable low-risk ways to trade no matter which direction the markets are moving. Start with searching the internet to obtain correlation information of financial instruments by analyzing and comparing price data along with fundamental and technical data in the markets you want to trade, and review the data to find highly correlated financial instruments.

Pairs Trading to be Market Neutral and Potentially Profitable

Your focus to profit is to match two financial instruments which are highly correlated long-term or short-term, by trading one long and the other short when the pairís priceís deviates from each other for a certain amount of time from their historical price valuation, and or technical, and or fundamental valuation correlations.

The most common correlation metric is the price ratio. Price ratio deviation can vary but 2.0 to 3.0 standard deviations are recommended to profit from if and when the pair goes back to its normal standard deviation correlation. 1.0 standard deviation is possible to profit from but with increased risk, and the idea of market neutral trading is to lessen risk. Of course to measure deviations youíll need charting software to view it.

Correlation Time Frames

You can apply correlation to short or intermediate or long-term time frames just as you would in normal investing and trading. Start with analyzing the longest correlation timeframe you can get then moving down to shorter correlation timeframes to help determine which is best for your style of investing and trading.

Stocks Pairs Trading

You can use the most common price ratio correlation comparison, along with also using technical, fundamental correlation analysis or all of them together to build your stock pairís trading strategies. Start with reviewing stocks in the same industry sector. Leading industry sector company competitors would be a perfect example to start comparing correlations with. You could also use stock indexís if you like.

Divergence Means Possible Profit Opportunity

Potential profit opportunities in stock pairs can be identified when the stock pair price deviation ratio starts hitting 1.0 plus and preferably 2.0 to 3.0 standard deviations. With back-testing and optimizing of the pairs youíre focused on youíll be able to find the best deviation to use on your pairs market neutral trading.

Taking the Positions in Stock Pairs Trading

When a highly correlated stock pair diverge, take a buy-long position in the underperforming stock, and a sell-short position in the over performing stock. The position sizes should be matched by the value of each position. Example: $1M Long $1M Short. The same matching buy-long value and sell-short value applies to other financial instruments youíll be trading.

Keeping Risk to a Minimum

As with all trading strategies there is risk that divergences can last longer than normal, and longer than your prepared to stay in the position while waiting for the divergence to end and the stock pair prices to move back to their long-term price correlation to profit. So again, review correlation timeframes to determine the best trading and correlation timeframes thatís best for you.

Stop-Loss to Live and Trade Another Day

Market neutral statistical arbitrage trading is designed to be low-risk high-reward trading, but in that market neutral trading involves at least some risk, you should have a stop-loss prices in mind with each of the stock pairs youíre trading to be ready to implement if and when the stock pairs prices do hit your stop-loss price as a total of the pairís trade.

Recommended stop-loss as a general rule is 8% of your position capital or your total portfolio capital or less if possible to a maximum of 15% to 20% but this amount is entirely based on your risk appetite and overall asset allocation of your investment portfolio, and other risk management factors.

More Stock Pairs Trading Examples

Another market neutral stock trading example would be buying ABC Tablet Computer Company and selling short XYZ Desktop Laptop Computer Company because tablet computing is now currently growing exponentially compared to desktop laptop computing. Yet again another example would be buying ABC Beef and matching that with a short sell on XYZ Chicken because thereís news of salmonella poisoning in chicken.

Forex Futures Commodities Eminiís and Options Pairs Trading

Market neutral statistical arbitrage trading strategies also work with these financial instruments also as long as you can determine that the pairs you choose are highly correlated and then wait for them to diverge to take a position and wait for them to go back to being correlated to close the positions and make a profit. A good example of currently highly correlated forex pairs are the USDJPY and the EURJPY. Again if you take a forex pairs trade, be sure to match value for value of each of the pairs. Youíll want to first calculate lot size, so youíll need to match each lots value on your account to make them equal.

Futures Pairs Trade Example

A futures pairís trade example could be an arbitrage between an index cash position and a futures contract. If and when the futures contract price becomes more than the cash position, you could attempt to profit from them by selling short the future and buying long the index. Many times the price moves between a commodity or index and the futures contract are so small that profits are only available to very fast traders. This is where high-speed computer generated algorithmic trading or what is called algo-trading is needed to profit from as these very fast price changes happen which a trader manually trading can easily miss.

Options Pairs Trade Example

An options pairís trade could be you buying a call option in a out-performing stock and buying a put in an under-performing stock which again the underlying stock securities are highly correlated in price and if you choose other fundamental and or technical valuation metrics. If and when the stock pair prices move back to their long-term price correlation again, the options become worthless providing you to profit from the proceeds of one or both of the option positions.


With the swings in the markets even the smartest pro-traders can lose money and small and weak players can easily get squeezed out of the market all together. Market neutral statistical arbitrage trading strategies help small traders as well as the large institutions to make money in the markets with very low risk.
Pairís trading is very simple and great for range bound whipsaw choppy markets. Look for the high correlations in financial instrument pairs and when the divergences happen take the long and short positions and wait for the correlation in those pairs to come back to normal again to take profits. In case it doesn't take stop-loss and move on to another market neutral trading opportunity.

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Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.