Optimal Mean Reversion Trading with Transaction Costs and Stop-Loss Exit

By Tim Leung, Xin Li. 2014

86 citations recorded by the source corpus.

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 cost and stop-loss level.

Subfields: Finance, Management Science and Operations Research

View Paper: https://www.semanticscholar.org/paper/f6f4714b5028d7466621bde3d3ebd3317fe8ad20

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In Management Science and Operations Research

Citations in the corpus

Stochastic Gradient Descent in Continuous Time (2016, background): “The ﬁrst is the well-known Ornstein-Uhlenbeck (OU) process (for examples in ﬁnance, see [19], [20], [29], and [18]).”
Model-based pairs trading in the bitcoin markets (2017, background): “The first one by Leung and Li (2015) also incorporates transaction costs.”