In one of my previous articles I focused on the concept of Market Quality created with the help of Market Internals. In today’s article I will get back to the original topic of Market Internals. I would like to present another interesting concept of their application.
So, what is it about?
One of the generally popular styles of trading is called Statistical Arbitrage (or StatArb). The principle of this trading style is very simple:
1. We take two highly correlated shares; often from the same industry – e.g. PEP and KO.
2. These kinds of shares correlate very closely. Thanks to that, they are occasionally converging and sometimes diverging. These are great opportunities for trading. How?
3. First of all, we calculate the difference between either the prices of both shares, or their ratio.
4. Afterwards, we calculate the “usual” difference or ratio – the so-called MEAN. To do this, we use a simple moving average of the price difference or ratio.