Arbitrage Factors

This chapter reviews various aspects of arbitrage factors in a stock market. Arbitrage seeks to exploit an inefficiency in the market by buying a security and simultaneously selling it for a profit. Comprehending statistical arbitrage is important to understanding pairs trading because they are in essential ways the same—or such that statistical arbitrage should be considered a form of pairs trading, as there are also some differences. It is shown that pairs trading has elements of both relative value and statistical arbitrage. The pairs trading strategy tries to take advantage of related securities whose prices have diverged from their historical norms. It is explained that an arbitrage position is built on convergence expectations and relies on the comparison between traded market prices and the relationship that the trader believes should exist based on historical analysis.