Lead-lag in StatArb

Another important consideration is that this strategy implicitly expects the portfolio to lead and the trading instrument is lagging in terms of reaction by market participants. When this is not true, for example, when the trading instrument we are trying to trade is actually the one leading price moves across the portfolio, then this strategy doesn't perform well, because instead of the trading instrument price catching up to the portfolio, now the portfolio prices catch up to the trading instrument. This is the concept of lead-lag in StatArb; to be profitable, we need to find trading instruments that are mostly lagging and build a portfolio of instruments that are mostly leading.

A lot of the time, the way this manifests itself is that during some market hours, some instruments lead others and during other market hours, that relationship is reversed. For example, intuitively one can understand that during Asia market hours, trading instruments traded in Asian electronic exchanges such as Singapore, India, Hong Kong, and Japan lead price moves in global assets. During European market hours, trading instruments traded in Germany, London, and other European countries lead most price moves across global assets. Finally, during American market hours, trading instruments in America lead price moves. So the ideal approach is to construct portfolios and establish relationships between lead and lag instruments differently in different trading sessions.

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