OPTIMAL MEAN REVERSION TRADING WITH TRANSACTION COSTS AND STOP-LOSS EXIT

Tim Leung and Xin Li ()
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Xin Li: IEOR Department, Columbia University, New York, NY 10027, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2015, vol. 18, issue 03, 1-31

Abstract: Motivated by the industry practice of pairs trading, we study the optimal timing strategies for trading a mean-reverting price spread. An optimal double stopping problem is formulated to analyze the timing to start and subsequently liquidate the position subject to transaction costs. Modeling the price spread by an Ornstein–Uhlenbeck process, we apply a probabilistic methodology and rigorously derive the optimal price intervals for market entry and exit. As an extension, we incorporate a stop-loss constraint to limit the maximum loss. We show that the entry region is characterized by a bounded price interval that lies strictly above the stop-loss level. As for the exit timing, a higher stop-loss level always implies a lower optimal take-profit level. Both analytical and numerical results are provided to illustrate the dependence of timing strategies on model parameters such as transaction costs and stop-loss level.

Keywords: Optimal double stopping; mean reversion trading; Ornstein–Uhlenbeck process; stop-loss (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (48)

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Working Paper: Optimal Mean Reversion Trading with Transaction Costs and Stop-Loss Exit (2015)
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DOI: 10.1142/S021902491550020X

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