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

26 Pages Posted: 23 Feb 2013 Last revised: 27 Apr 2015

See all articles by Tim Leung

Tim Leung

University of Washington - Department of Applied Math

Xin Li

Columbia University

Date Written: April 26, 2015

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 cost and stop-loss level.

Keywords: optimal double stopping, mean reversion trading, Ornstein-Uhlenbeck process, stop-loss

JEL Classification: C41, G11, G12

Suggested Citation

Leung, Tim and Li, Xin, Optimal Mean Reversion Trading with Transaction Costs and Stop-Loss Exit (April 26, 2015). International Journal of Theoretical and Applied Finance, Vol. 18, No. 3, 2015. Available at SSRN: https://ssrn.com/abstract=2222196 or http://dx.doi.org/10.2139/ssrn.2222196

Tim Leung (Contact Author)

University of Washington - Department of Applied Math ( email )

Lewis Hall 217
Department of Applied Math
Seattle, WA 98195
United States

HOME PAGE: http://faculty.washington.edu/timleung/

Xin Li

Columbia University ( email )

345 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

HOME PAGE: http://www.columbia.edu/~xl2206/

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