Algorithmic Trading with Learning
28 Pages Posted: 1 Jan 2014 Last revised: 13 Oct 2015
Date Written: October 12, 2015
We propose a model where an algorithmic trader takes a view on the distribution of prices at a future date and then decides how to trade in the direction of her predictions using the optimal mix of market and limit orders. As time goes by, the trader learns from changes in prices and updates her predictions to tweak her strategy. Compared to a trader who cannot learn from market dynamics or form a view of the market, the algorithmic trader's profits are higher and more certain. Even though the trader executes a strategy based on a directional view, the sources of profits are both from making the spread as well as capital appreciation of inventories. Higher volatility of prices considerably impairs the trader's ability to learn from price innovations, but this adverse effect can be circumvented by learning from a collection of assets that co-move. Finally, we provide a proof of convergence of the numerical scheme to the viscosity solution of the dynamic programming equations which uses new results for systems of PDEs.
Keywords: Algorithmic Trading, High Frequency Trading, Nonlinear Filtering, Brownian Bridge, Stochastic Optimal Control, Adverse Selection
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