Optimal Trading Stops and Algorithmic Trading
20 Pages Posted: 21 Jan 2014
Date Written: January 19, 2014
Trading stops are often used by traders to risk manage their positions. In this note, we show how to derive optimal trading stops for generic algorithmic trading strategies when the P&L of the position is modelled by a Markov modulated diffusion. Optimal stop levels are derived by maximising the expected discounted utility of the P&L. The approach is independent of the signal used to enter the position. We analyse in details the case of trading signals with a limited (random) life. We show how to calibrate the model to market data and present a series of numerical examples to illustrate the main features of the approach.
Keywords: Trading stops, Algorithmic trading, Stop loss, Target profit, Utility functions, Markov chain, Calibration
JEL Classification: C51, G12, G13
Suggested Citation: Suggested Citation