Avellaneda statistical arbitrage forex

We analyse HJB equations for an unconstrained portfolio and for another portfolio constrained for market neutrality. Market neutrality is important when doing statistical arbitrage with a factor model, as it immunises the portfolio against market fluctuations. Basic pairs trading strategies where the spreads are directly tradeable have this immunisation built in, see Angoshtari [ 9 ]. However in our case, because the factors are not tradeable, the optimisation should be constrained in order to have a market-neutral portfolio.

We implement various optimal portfolios in backtests on historical stock prices data. These studies give us a practical sense for profitability of the optimal strategies that are given by the proposed models. From these studies, we arrive at three main conclusions about statistical arbitrage strategies: first, the proposed co-integrated model with eigenportfolios being factors can generate a large number of co-integrated stocks over a long time horizon, second, these strategies are sensitive to parameter estimation, and third, these strategies have greater potential to out-perform the benchmark during periods of higher overall market volatilities.

Sensitivity to parameter estimation is in line with the backtesting studies in Yeo and Papanicolaou [ 2 ], where they demonstrate the variation in Sharpe ratios relative to estimation windows and stock selections. Literature of Related Research A formal definition for statistical arbitrage is given in Hogan et al.

A test for co-integration of financial time series is constructed in Engle and Granger [ 3 ], namely, the Engle-Granger co-integration test. An application of Engle and Granger [ 3 ] for co-integration-based trading strategies are shown in Vidyamurthy [ 11 ], trading of co-integrated pairs with implementation of methods for filtering and parameter estimation to handle latency is studied in Elliott et al.

Principal component analysis of large number of stocks co-integrated through common factors is the topic in Avellaneda and Lee [ 1 ], and is the basis for the model in this article. Empirical testing of pairs trading, including out-of-sample experiments with changing parameters, is completed in Galenko et al. Analysis showing significance of short-term reversal and momentum factors on returns of pairs trading is presented in Chen et al. Stochastic control and optimisation for pairs trading with OU spreads is studied in Mudchanatongsuk et al.

A stochastic control approach for optimal trading of co-integrated pairs is proposed and solved in Tourin and Yan [ 17 ] and Angoshtari [ 9 ], and stochastic control for pairs trading with a local-volatility model is analysed by Li and Tourin [ 8 ].

A multi-variate version of the stochastic control problem with power utility is the topic in Chiu and Wong [ 5 ] and Ma and Zhu [ 6 ], with analyses of the matrix Riccati equation being presented. Additionally, there is the long-term stability analysis for matrix Riccati equations of multiple-asset models completed in Davis and Lleo [ 18 ], and the matrix Riccati equations analysis for a single co-integrated pair with partial information is studied in Lee and Papanicolaou [ 19 ].

Related work also includes the optimal trading of spreads with transaction costs and stop-loss criterion, which are analysed in Lei and Xu [ 21 ] and Leung and Li [ 22 ]. Structure of This Article In this article, we propose and solve stochastic control and optimisation problems for optimal statistical arbitrage portfolios, and then analyse the solutions for the unconstrained portfolio and the market-neutral constrained case.

We explore the implementation of these portfolios by performing some empirical studies on historical stock data. The organisation of the article is as follows: Sect. Model Constructions and Optimisations This section introduces the models and the stochastic control and optimisation problems for multiple co-integrated stocks with factors.

We first build the stochastic system for stock prices, factors, and spreads in Sect. Then in Sect. In Sect. Utilising Eqs. The factor loadings in Eq. Remark 2. This will be relevant in Sect. Risk aversion measures the risk preferences of traders.

By utilising the exponential ansatz 2. Proposition 2. We call the time-constant part of Eq. Utilising the solution of the HJB Eq. The form of the model for this unconstrained control problem fits into the framework set forth in Davis and Lleo [ 25 ] and Davis and Lleo [ 18 ], and hence, the same argument for verification of these references applies here. We extend the time domain for the ODEs 2. Our analysis for the matrix Riccati Eq. Let us rewrite the matrix Riccati ODE 2. Proof From formula 2.

In order to do so, it is useful to define the following properties. Definition 2. With these definitions that are given above, we have the following proposition for the matrix Riccati equation 2. Proof We first perform a change of variable. If there were an arbitrage, then it would always be optimal to take additional positions in the arbitrage portfolio, hence causing the value function to have a singularity in finite time, thus reaching a Nirvana, see Lee and Papanicolaou [ 19 ].

Stability of the matrix Riccati Eq. After analysing the stability of the matrix Riccati Eq. We start the analysis by introducing the following lemma, which is a theorem from Wielandt [ 27 ] in regard to the eigenvalues of matrices. Comprehensive mathematical knowledge for this lemma can be found in chapter one of Horn and Johnson [ 28 ].

Lemma 2. Proof By observing ODE 2. Consequently, the long term certainty equivalent rate of the unconstrained control problem that is described by Eq. From the analyses of Propositions 2. Hence, as t tends toward negative infinity, Eq. Market neutrality generally means that the returns of a portfolio are impacted only by the idiosyncratic returns of the stocks contained in the portfolio, and are uncorrelated with the returns of a benchmark or market factors, see Angoshtari [ 9 ] and Avellaneda and Lee [ 1 ].

Hence, under the condition of market neutrality, if we can diversify with a large number of co-integrated stocks, then there is a very high probability that the portfolio can maintain steady growth and low volatility. We now reformulate the optimal portfolio that is studied in Sects. This will be shown in the proof of Proposition 2. Analogous to the unconstrained control problem of Sects.

Proof Proposition 2. By utilising the formulae of Eq. As shown in the proof of Proposition 2. It is indeed correct for the model that is proposed here in Sect. Only those who can recognize and take advantage of arbitrage opportunities first can benefit, turning it into a winner-takes-all situation. This has made it difficult to make consistent profit from price discrepancies, as one needs to recognize them quickly and be the first to leverage them.

Yet, arbitrage is a necessary tool in the marketplace as it quickly eliminates market inefficiencies and keeps prices uniform across markets [ 2 , 5 , 11 , 6 , 3 , 17 ]. One type of arbitrage is taking advantage of the difference of the cost of an ETF against the summation of the prices of the stocks in the underlying basket.

If the cost of an ETF exceeds the cost of the underlying basket of stocks, then one can buy the individual stocks for the prices on the market, and sell the ETF in order to make a profit. Another type of arbitrage is through taking advantage of discrepancies within currency conversions, such as in a currency triangle.

For example, if one converts a certain currency to another, and then again to another, and then back to the original currency, then the resulting balance does not necessarily equal the initial balance if there exists a discrepancy. Taking advantage of such a discrepancy results in arbitrage.

Another key type of arbitrage is known as statistical arbitrage. Statistical arbitrage relies on historical data and statistics to determine relatively risk-free strategies, although of course this may not always be exactly the case. One simple example of statistical arbitrage is pairs trading. Pairs trading consists of identifying correlations between two or more stocks.

When stocks have historically appeared to be strongly correlated, then we can assume that they ultimately will converge when they currently seem to diverge. For example, if stock A and stock B are correlated they may even be in the same field, such as Coca Cola and Pepsi , and the price of stock A increases while that of stock B remains the same, then we can expect that the two will converge again.

In this case, the optimal decision to make is to sell stock A and buy stock B. This paper deals with algorithms for statistical arbitrage. We present novel techniques for this problem based on online learning. In section 2 , we discuss a new formulation of the problem of statistical arbitrage. We present online learning algorithms for statistical arbitrage in Section 3.

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The indicator provides the statistical analysis component. V2 Arb products calculate the spread of the pairs by dividing one by the other, they then calculate the moving average of the spread then plot trader defined standard deviations either side of this moving average. The trade entry and exit thresholds are determined by the STD Multiple in the indicator this can be adjusted by the trader The trade entry thresholds STDs are set by eyeballing the typical departure from the mean before the spread recouples.

Obviously timeframe and system parameters are critically important. Short term arbing is very difficult and it's easy to get caught when the pairs decouple. This is often seen towards the end of the Asian session and near the Frankfurt open. As liquidity flows into the market spread can become directional over short timeframes. In terms of suitable arb pair selection you can use the FX AlgoTrader real time correlation indicator to select highly correlated arbitrage pairs on any timeframe.

The V3 system uses a log spread algorithm which allows the trader to see the reversion potential in dollar terms. This allows traders to see the power of the longer term arb compared to short term arb trading. What knowledge do I need to know in order to use your Stab Arb product? You would need to understand that there are is no guarantee mean reversion will take place when you expect it to.

What's the minimum account size for arb trading forex? Both V2 and V3 arb products can be run on micro, mini and standard MT4 accounts. Which timeframes have you found to be the best to trade arbs? It depends on you and what you want to achieve — if you like short term overnight arbs based on the Asian thin liquidity market then 5 minutes might be good for you. Alternatively — if you like to make decent money without having to give the broker lots in spread costs - Daily charts would provide fewer trades with much larger profits for arbs which reverted to the mean.

Generally the longer the timeframe the higher the profit. The guy is an x-commercial trader so bear that in mind! The tool is only as good as the trader in terms of picking the right pairs to trade and setting the right parameters. So, in summary, arb traders will need to experiment to find the best system settings which match their trading style, risk and general expectations.

In general is this EA quite profitable? What's the approximate ROI? The potential profit is displayed by the EA under the "Reversion Potential" data label on the main chart. This figure is calculated on the difference between the current spread and it's moving average. In terms of timeframe you can make a lot more money on longer term charts in comparison to short term high frequency arb trades. We dont produce ROI or equity curve data any more as the results will vary hugely from trader to trader.

The tools only reflect the ability of the trader to select the optimum assets, timeframes and parameters to trade. It all goes back to how fast can you run : The V3 seems to be closing some trades at a loss - how can this happen? There are a number of reasons this could happen which are:- The arb trades have breached the maximum risk parameters and the system has auto closed both positions The system is being run in Aggregation mode and the daily profit target has already been achieved - once the profit target is hit the system will close out all open arbs - this could result in loss making arbs being closed automatically to protect your achieved aggregated target.

Can you help me understand why the EA has not closed a trade even though reversion has already occured? This could happen due to the following reasons:- 1 V3 can only close arb trades which are in profit. If your current arb is not in profit possibly as it was opened on another timeframe the system will not close the arb trades. What's going on?

The 'Disable Gen Starb' global variable has been set by the system. If you delete the variable the system will reactivate. Does the system perform dynamic rebalancing? At the moment there is no dynamic rebalancing. An alternative approach is to trade the opposite side of the arb on a lower timeframe which would create a dynamic hedge to a degree Additional Comment: Some V3 customers have been experimenting with a alternative approach to dynamic rebalancing in cases where an open arb trade is decoupling from it's MA and creating a drawdown.

Rather than rebalancing the lot sizing of the existing arb a new arb is set up which is the exact opposite of the current arb. This creates a perfect hedge and also allows reduces the drawdown as the shorter term arb will gradually eat into the drawdown created by the longer term decoupled arb.

The principle is simply based on trading short term spread volatility seen on the shorter timeframe. This approach is not a guaranteed "Get of jail free card" but it can substantially de-risk positions where significant decoupling has taken place and in tandem reduce the magnitude of a potential loss.

I use the FX AlgoTrader correlation indicator and I would like a system to trade when two conditions are met. They are: 1 Daily correlation is more than 75 2 5min correlation is less than These condition are only met only a limited number of times per a day. Its very hard to wait all day in front of my PC. My question for you is If so, what is the product?

The V2 or V3 arbitrage engine will do this if you set them up accordingly. The correlation indicator was designed to be used for arb traders to aid in their pair selection. You could do this visually and look to only trade the largest divergences each day. Pole for example writes that SA uses mathematical models to generate returns from systematic movements in securities prices.

According to Avellaneda and Lee , the term statistical arbitrage encompasses a variety of strategies characterized by systematic trading signals, market neutral trades and statistical methods. Montana defines SA as an investment strategy that exploits patterns detected in financial data streams. Burgess defines statistical arbitrage as a framework for identifying, modelling and exploiting small but consistent regularities in asset price dynamics.

However, there is no guarantee of when the two prices will re-converge; therefore, investors should always consider using stop-loss orders when employing this strategy. The pairs trading strategy mentioned above is a market-neutral strategy.

As you can see there is considerable variance of returns in any given bin that the mean summary metric obscures. All strategies aim to exploit relative value opportunities through the implementation of long-short positions. Term structure arbitrage is a common SA strategy which typically involves taking market-neutral long-short positions at different points of a term structure as suggested by a relative value analysis.

Cross Asset Arbitrage Thomaidis and Kondakis define SA as an attempt to profit from pricing discrepancies that appear in a group of assets. Do, Faff and Hamza claim that SA is an equity trading strategy that employs time series methods to identify relative mispricings between stocks.

Burgess also describes statistical arbitrage as a generalization of a traditional arbitrage where mispricing is statistically determined through replicating strategies. In the formation period we selected historical price data in a specifically selected period of time. Now suppose in a more general case, that these two time series are both integrated of order one I and so are from the get go non-stationary.

While a CADF test works for pairs trading, it does not work for triplet and multiple-asset arbitrage. Projects On Statistical Arbitrage By Epat Alumni Specifically the excess return of Berkshire A is the as the dependent variable and the factors on the right-hand-side of Eq and Eq are the independent variables.

The estimated coefficients are then used as the portfolio weights for the construction of the replicating asset. The returns of the replicating portfolio will, in the long run, match the returns of the Berkshire A stock, since the replicating portfolio is constructed from theoretically correct asset pricing model specifications. Stat Arb V4. This definition cannot be operational unless we define how to measure a positive expected excess return and an acceptably small potential loss.

However, the complex and dynamic landscape of financial markets suggests that no definitive theoretical or operational definition of SA is likely to be agreed. Because of this we propose to use the definition in conjunction with a classification scheme. What Is Statistical Arbitrage? A typical market-neutral approach is to go long bin 10 and short bin 1, or simply drop all the forecasts into an optimizer since you have a nice monotonic pattern.

An investment practice that attempts to profit from inefficiencies in price by making transactions that offset each other. For example, one may buy a security at a low price and, within a few seconds, re-sell it to a willing buyer at a higher price. These are excellent arb opportunities for traders who are patient and are able to trade on the longer timeframes. Nonetheless, there are also numerous opportunities to trade shorter timeframes and align the traders in the direction of the longer term trend.

Why Statistical Arbitrage Breaks Down Key in the definition is the introduction of the augmented information set, which, in addition to the market information at time t, also includes the knowledge of the final price. Hogan et al. What is event arbitrage? The events may be economic or industry-specific occurrences that consistently affect the securities of interest time and time again. The high level of forecasting accuracy using price-based factor models has important theoretical and practical implications.

You profited using a market-neutral pairs trading strategy more often used by hedge funds than retail traders. You decide for the next pairs trade to use traditional technical analysis techniques and leverage to juice your returns even further while remembering that models can break at any time. There are plenty of in-built pair trading indicators on popular platforms to identify and trade in pairs.