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Pairs trading is a very popular species of stat arb, and works like this. You look for various correlated stocks, like Dell and IBM, Coke and Pepsi, or Exxon and BP. When one goes up while the other goes down, or vice versa, you bet on a reversal. So lets say Dell is up 4% over the past 2 weeks, while IBM is up only 1%, you buy IBM and short Dell. Stat arb in general looks at mean reversion on the sub one month horizon.

I've heard many stat arb players are having a bad month. I think the problem is, when volatilities and correlations change, its difficult to adjust one's models appropriately, so you either under-adjust over over-adjust. I was on a pairs desk for a while, and must say it's a tough way to make money. I think the only way to make money is A) not use too much, so you are focusing on only 20-40 pairs or B) use the strategy in concert with an insanely fast electronic Direct Market Access system. I suppose the latter, a really fast off-the-floor marked making system, combined with a simple stat arb algorithm, is a big part of how Renaissance prints money.

This incredibly simple strategy made lots of money for traders until 2003, when it started to get crowded. I think its a great example of an arbitrage: they exist, with hindsight they are insanely simple, and they are ephemeral. Other strategies I know of that have vanished are equally simple--not go long calendar spreads simple, but simple enough--so I'm generally skeptical of really complicated strategies, and make no apologies for the simplicity of my best ideas. Good ideas are generally simple once you know them, so anything extra fancy that's meant to be practical tends to reflect deliberate obfuscation of an idea whose simplicity belies its stupidity.

Strangely, there was an academic paper on this in 1998 by Goetzmann, Rouwenhorst, and Gatev that never made it into an academic Journal. You could have read this paper and made money for 4 years on this idea. I wonder why it was never published?

Anyway, I hear many Risk Arb players at big shops are getting creamed. It seemed like you make money for 3 years, then give it all back in a couple weeks. Classic mode-mean trade: mode is positive, mean is zero.
Paul N (guest) meinte am 10. Aug, 03:31:
I don't get it, how do simple strategies possibly yield results? Is it true that no one else thinks of them? Are most people delusional?

"Mode is positive, mean is zero" seems like an appropriate motto for all hedge funds (relative to e.g. equal-risk stocks). 
Eric Falkenstein antwortete am 10. Aug, 03:55:
Well, look at pairs. It's simple. It worked for a long time. In Risk arb, going long the target and short the aquirer made a boatload in many years. In convertible bond arbitrage, going long the convert, shorting the equity with the appropriate ratio, gave you a sharpe>2 for many decades. The list is long, but many strategies generate Sharpes well above the S&P500. The trick is to see them before they become too well known. 
Bernard Guerrero (guest) antwortete am 10. Aug, 22:31:
Is this really arbitrage, Eric?
There isn't any underlying theory or locked-in relationship that demands that the pairs remain equally correlated even over short horizons, so I'm wondering if this qualifies as an arb in the true sense of taking immediate advantage of a pricing discrepancy as per the Law of One Price. That isn't to say that the correlations aren't real, but the magnitude varies and you're clearly taking on risk. 
Paul N (guest) antwortete am 11. Aug, 03:25:
I was thinking about this today, if stat arbs are losing big, someone has to be winning big at their expense - presumably the more complicated models designed to take advantage of stat arb programs in times of high volatility? 
j (guest) antwortete am 11. Aug, 09:11:
Yes, value has not evaporated, just changed hands. How? I suspect technology: better programs, run on faster machines in concert with Direct Market Access. 
j (guest) antwortete am 13. Aug, 19:55:
The Street.com reports that Goldman has put in $2bn of the funds itself to GES, which was valued at $3.6bn at the end of last week. What happened to the $3.6bn? In whose hands it ended? Could it be that somebody figured out how to exploit GES and other fund's algorithms? They were (are?) all using the same ideas & systems. 
OneEyedMan (guest) antwortete am 16. Aug, 21:16:
Marginal trades vs. aggregates
Value certainly can evaporate due to the nature of bubbles.

Let's say the price of asset x is jointly assumed to be p(x) = A + d where A is the intrinsic value we agree on and d is the known discounted value of future dividends. As long as we share a common valuation of A and d the price is stable. If we all wake up one morning and decide the new value of A is 1/2 the old A then the total wealth of the society will fall.


Closing prices are the prices at which trades occur, but as the M&A business shows, the price for all or a big chunk of shares is often very different.

I expect we'll find that this market turmoil had many winners and losers but that the dollars lost by the losers is far greater than the amount won by the winners, and transaction costs will be too small to explain the difference 
j (guest) antwortete am 17. Aug, 19:57:
Say on August 1st., 2007, total stock market capitalization was A, and on August 13th., 2007 it was A again. We have heard that some hedge funds are big losers. Excluding those living off transaction costs, who are the winners? And if losers lost because of their stat arb sys went wrong, how did the winners win? 
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