Topic · Systematic Strategies & Alpha
← All topicsStatistical Arbitrage
26 articles · 4 checkpoints · 15 deeper reads · 7 reference notes
Every article, in reading order
plant a flag as you finish eachRead these first
Instead of hedging a stock against an index someone else picked, build the hedge from the data itself: the dominant modes of covariation across thousands of stocks, extracted by PCA, are tradeable baskets in their own right, and what's left over after subtracting them is what you trade.
The whole trading rule is three numbers, where you get in, where you get out, where you give up. Simulating a known mean-reverting spread shows the folklore entry at two standard deviations is far too wide, and explains why desks use it anyway.
The working model behind almost every spread trade, a quantity pulled back toward a level, with the pull proportional to how far it has strayed. Three parameters fall out of a single regression, and they tell you your holding period, your position size and whether the trade survives costs.
Before you can trade a spread you have to build one, and the hedge ratio you pick decides what the residual actually contains. Regressing A on B and regressing B on A give answers 18% apart on the same data, and the gap between them is bigger than any sampling error you will ever quote.
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