Nerds on Wall Street: Math, Machines, and Wired Markets

8.5. Arbitrage and Predictive Strategies

Some quantitative strategies work by pure arbitrage, essentially finding the 4.9-cent nickels in the market before anyone else does. Examples are commodities, such as gold, that trade at the same time on multiple markets around the world. Arbitrageurs move in to equalize the disparities between markets when they arise, buying on the low-priced side and selling on the high-priced side. "Buy low, sell high" is what keeps markets together. Those participants with the lowest transaction costs jump in first, and the physics of supply and demand brings prices back in line.

Being an arbitrageur is nice work if you can get it, but it is largely a game for only the largest players. Another level of quantitative strategy involves making some kind of a prediction. Increasing predictability increases investment return. Improving the consistency and downside error of predictive models reduces risk.