Statistical arbitrage pairs trading strategies: Review and outlook

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Modern stock market trading computers have become so fast that the speed of light is now their key limiting factor. A new paper by a physicist and a mathematician explains how traders can take advantage of this ultimate speed limit. Computers were originally introduced in trading because they are faster than us in responding to market signals. To solve this problem, traders over the last few years have been building automated high-frequency trading HFT systems that compete by making thousands of trades a minute to maximize profit.

But delays in communication over a network can throw a monkey wrench in this scheme. These delays can be caused by many factors, such as slow routing computers, excessive traffic, routes that go through many different computers, and so on. On ordinary networks, like the Internet, these factors add so many delays that the time it takes for a signal to physically traverse fiber-optic cables is only a small fraction of the total latency delay.

So currently, there are many projects to build faster fiber-optic cables, including one between Chicago and New York, to achieve faster HFT trades. The Chicago-New York cable will shave about 3 milliseconds off the communication time. A number of these cables are actually underwaterbecause going across the ocean is faster than making detours on land. See a larger version here. Because of how HFT operates — generally, the profit from an HFT trading opportunity goes to statistical arbitrage pairs trading strategies review and outlook first firm to act on it, while other firms get nothing, to beat other traders to the punch, this has led to a race between trading firms to have the fastest hardware and the fastest signal cables.

Recently, the time it takes to execute these trades has statistical arbitrage pairs trading strategies review and outlook from milliseconds thousandths of a second to microseconds millionths of a second. Typically, the latency for HFT trades is now below microseconds. Traders in the same city can achieve that by optimizing their computers, network hardware, and software for speed.

But when it comes to trading between cities — or worse, between continents — the speed of light, not routing or traffic delays, actually becomes the limiting factor. It takes at least As trading times go down, this light-speed delay can become important, even between closer pairs of cities, such as London and Paris, where the minimum delay is about 1 millisecond. They advise market traders to locate their computers at certain points in between the two markets, with the locations of these points determined by how fast each market can send pricing information to the trading computers.

Optimal trading points blue between different markets red. Freer and Wissner-Gross examined which locations would maximize trading profit, taking these light-speed delays into account. In the simplest version of their analysis, they found that if the pricing information at the two exchanges incorporates new data equally statistical arbitrage pairs trading strategies review and outlook, the best place for a trading computer is at the midpoint between the two exchanges, along a geodesic great circle.

However, the locations directly in between major markets are frequently in remote places, such as the Arctic, in the middle of oceans, or hundreds of miles from major cities. The map above shows the locations of major international markets, in red, and places where trading computers should be positioned to trade between these markets with maximum profitability, in blue. For instance, a trader wanting to exploit price differences between the New York Stock Exchange and the London Stock Exchange might want to place a computer in the middle of the Atlantic, because it could execute trades based on information from both of the two exchanges more quickly than ones based in either America or England.

Space-time diagram of a geographically separated trade. Initially, these firms will probably want to just switch some of their trading systems to computers that have already been set up in better locations, to take advantage of this new research as statistical arbitrage pairs trading strategies review and outlook as possible, he notes. But, the importance of being able to execute trades on millisecond timescales now makes such a project increasingly commercially viable.

Alex Wissner-Gross website Dr. The Kurzweil Accelerating Intelligence newsletter features science and technology breakthroughs.

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High-frequency trading To solve this problem, traders over the last few years have been building automated high-frequency trading HFT systems that compete by making thousands of trades a minute to maximize profit.

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