Mean-Reversion and Optimization
Journal of Asset Management 16(1) (2015) 14-40
41 Pages Posted: 11 Aug 2014 Last revised: 15 Feb 2016
Date Written: September 22, 2014
The purpose of these notes is to provide a systematic quantitative framework - in what is intended to be a "pedagogical" fashion - for discussing mean-reversion and optimization. We start with pair trading and add complexity by following the sequence "mean-reversion via demeaning → regression → weighted regression → (constrained) optimization → factor models". We discuss in detail how to do mean-reversion based on this approach, including common pitfalls encountered in practical applications, such as the difference between maximizing the Sharpe ratio and minimizing an objective function when trading costs are included. We also discuss explicit algorithms for optimization with linear costs, constraints and bounds.
Keywords: Mean-reversion, optimization, pair trading, regression, Sharpe ratio, objective function, trading costs, constraints, bounds, factor models
JEL Classification: G00
Suggested Citation: Suggested Citation