Trading strategy with stochastic volatility in a limit order book market

Qing-Qing Yang (), Wai-Ki Ching (), Jiawen Gu () and Tak Kuen Siu
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Qing-Qing Yang: The University of Hong Kong
Wai-Ki Ching: The University of Hong Kong
Jiawen Gu: Southern University of Science and Technology

Decisions in Economics and Finance, 2020, vol. 43, issue 1, No 15, 277-301

Abstract: Abstract In this paper, we employ the Heston stochastic volatility model to describe the stock’s volatility and apply the model to derive and analyze trading strategies for dealers in a security market with price discovery. The problem is formulated as a stochastic optimal control problem, and the controlled state process is the dealer’s mark-to-market wealth. Dealers in the security market can optimally determine their ask and bid quotes on the underlying stocks continuously over time. Their objective is to maximize an expected profit from transactions with a penalty proportional to the variance of cumulative inventory cost. We provide an approximate, analytically tractable solution to the stochastic control problem. Numerical experiments are given to illustrate the effects of various parameters on the performances of trading strategies.

Keywords: Limit order book (LOB); Dynamic programming (DP); Hamilton–Jacobi–Bellman (HJB) equation; Market impact; Stochastic volatility (SV) model (search for similar items in EconPapers)
JEL-codes: C5 C6 D8 D9 G4 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (1)

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Working Paper: Trading Strategy with Stochastic Volatility in a Limit Order Book Market (2016)
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DOI: 10.1007/s10203-020-00278-8

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