Dynamic modeling of mean‐reverting spreads for statistical arbitrage

Statistical arbitrage strategies, such as pairs trading and its generalizations rely on the construction of mean‐reverting spreads enjoying a certain degree of predictability. Gaussian linear state‐space processes have recently been proposed as a model for such spreads under the assumption that the observed process is a noisy realization of some hidden states. Real‐time estimation of the unobserved spread process can reveal temporary market inefficiencies which can then be exploited to generate excess returns. We embrace the state‐space framework for modeling spread processes and extend this methodology along three different directions. First, we introduce time‐dependency in the model parameters, which allows for quick adaptation to changes in the data generating process. Second, we provide an on‐line estimation algorithm that can be constantly run in real‐time. Being computationally fast, the algorithm is particularly suitable for building aggressive trading strategies based on high‐frequency data and may be used as a monitoring device for mean‐ reversion. Finally, our framework naturally provides informative uncertainty measures of all the estimated parameters. Experimental results based on Monte Carlo simulations and historical equity data are discussed, including a co‐integration relationship involving two exchange‐traded funds.