25 Pages Posted: 20 Jul 2011
Date Written: July 19, 2011
We develop an optimal trend following trading rule in a bull-bear switching market, where the drift of the stock price switches between two parameters corresponding to an uptrend (bull market) and a downtrend (bear market) according to an unobservable Markov chain. We consider a finite horizon investment problem and aim to maximize the expected return of the terminal wealth. We start by restricting to allowing flat and long positions only and describe the trading decisions using a sequence of stopping times indicating the time of entering and exiting long positions. Assuming trading all available funds, we show that the optimal trading strategy is a trend following system characterized by the conditional probability in the uptrend crossing two threshold curves. The thresholds can be obtained by solving the associated HJB equations. In addition, we examine trading strategies with short selling in terms of an approximation. Simulations and empirical experiments are conducted and reported.
Keywords: trend following trading rule, bull-bear switching model, partial information, HJB equations
JEL Classification: G1
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