A Market Neutral Statistical Arbitrage Trading Model

Abstract

The momentum effect is a systematic inefficiency in the market that can be exploited by a trading strategy. This conclusion is supported by theoretical and empirical evidence. But the academic research that tries to quantify the performance of this kind of strategy often relies on a methodology that is too simplistic. The question arises what performance a trader realistically could achieve in relation to the results presented in academic journals. To answer this, we have written a computer program to run simulations with the added realism of transaction costs and more advanced trading rules based on a wider array of data than classic methodology allows. This has been done on Swedish stocks between 1995 and 2001. We then compare the simulation based on our own advanced model with a simulation that emulates a simplistic methodology. It is found that the negative impact on return of including transaction costs is outweighed by the lower risk attributed to our more advanced trading rules, as indicated by e.g. Sharpe and standard measures of risk. We can thus conclude that the momentum effect might be even more attractive as a basis for a trading strategy than have been suggested in prior academic research. As an academic paper, we think that the methodology (our simulation platform) used to obtain the conclusion in our thesis is more important than the conclusion itself. It is evident that a good evaluation of any trading strategy requires more realistic simulations than is commonplace in academia today.