When to cross the spread: Curve following with singular control

Felix Naujokat and Ulrich Horst

No 2011-053, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk

Abstract: In this article the problem of curve following in an illiquid market is addressed. Using techniques of singular stochastic control, we extend the results of [NW11] to a twosided limit order market with temporary market impact and resilience, where the bid ask spread is now also controlled. We first show existence and uniqueness of an optimal control. In a second step, a suitable version of the stochastic maximum principle is derived which yields a characterisation of the optimal trading strategy in terms of a nonstandard coupled FBSDE. We show that the optimal control can be characterised via buy, sell and no-trade regions. The new feature is that we now get a nondegenerate no-trade region, which implies that market orders are only used when the spread is small. This allows to describe precisely when it is optimal to cross the bid ask spread, which is a fundamental problem of algorithmic trading. We also show that the controlled system can be described in terms of a reflected BSDE. As an application, we solve the portfolio liquidation problem with passive orders.

Keywords: stochastic maximum principle; convex analysis; fully coupled forward backward stochastic differential equations; trading in illiquid markets (search for similar items in EconPapers)
JEL-codes: C61 G11 (search for similar items in EconPapers)
Date: 2011
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