Optimal Switching for Pairs Trading Rule: A Viscosity Solutions Approach

26 Pages Posted: 24 Dec 2014

See all articles by Minh-Man Ngo

Minh-Man Ngo

Independent

Huyên Pham

Université Paris VII Denis Diderot

Date Written: December 23, 2014

Abstract

This paper studies the problem of determining the optimal cut-off for pairs trading rules. We consider two correlated assets whose spread is modeled by a mean-reverting process with stochastic volatility, and the optimal pair trading rule is formulated as an optimal switching problem between three regimes: flat position (no holding stocks), long one short the other and short one long the other. A fixed commission cost is charged with each transaction. We use a viscosity solutions approach to prove the existence and the explicit characterization of cut-off points via the resolution of quasi-algebraic equations. We illustrate our results by numerical simulations.

Keywords: pairs trading, optimal switching, mean-reverting process, viscosity solutions

JEL Classification: C61, G11

Suggested Citation

Ngo, Minh-Man and Pham, Huyen, Optimal Switching for Pairs Trading Rule: A Viscosity Solutions Approach (December 23, 2014). Available at SSRN: https://ssrn.com/abstract=2542186

Minh-Man Ngo

Independent

No Address Available

Huyen Pham (Contact Author)

Université Paris VII Denis Diderot ( email )

Batiment Sophie Germain 5 rue Thomas Mann
Paris, 75205
France

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