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Statistical arbitrage

Systematic trading of many small positions selected by a statistical model, relying on the average across hundreds of bets rather than on confidence in any one.

Signals are typically weak, with information ratios per position that look negligible. The strategy works by breadth: hundreds or thousands of positions, held for days, with the book constructed neutral to market, sector and factor exposures.

Turnover is high and capacity is limited, so results depend on transaction cost modelling as much as on signal research. A signal that is profitable on paper frequently disappears once realistic slippage is applied.

The standing risk is that many participants have found the same signals. The August 2007 unwind, when crowded quant books fell sharply together and largely recovered within days, showed that neutrality to factors does not protect against neutrality to other people's leverage. See factor-crowding and pairs-trading.

Related: pairs-trading, factor-crowding, market-neutral, slippage, backtesting, mean-reversion

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Slippage on a market orderA buy order clears four price levels, so the average price paid is worse than the price first quoted.Buy 1,000 shares at marketpricesell orders resting (bar length = size)20.04300 shares20.03200 shares20.01200 shares20.00300 sharesnothing resting at 20.02order sweeps up the bookaverage fill 20.02SLIPPAGE0.02 a share$20.00 in totalintended 20.00Each level fills at its own price; the average is what you really paid.
Slippage on a market order. You click at 20.00, but only 300 shares are resting there, so the rest of the order fills at 20.01, 20.03 and 20.04. The average price paid is 20.02, and that two-cent gap is slippage.

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