Optimal Pairs Trading Strategies: A Stochastic Mean–Variance Approach

Fenghui Yu, Wai Ki Ching, Chufang Wu*, Jia Wen Gu

*Corresponding author for this work

Research output: Contribution to journalArticleScientificpeer-review

Abstract

In this paper, we consider optimal pairs trading strategies in terms of static optimality and dynamic optimality under mean–variance criterion. The spread of the entity pairs is assumed to be mean-reverting and follows an Ornstein–Uhlenbeck process. A constrained optimal control problem is considered, and the Lagrange multiplier technique is adopted to transform the primal problem into a family of linear-quadratic optimal control problems that can be solved by the classical dynamic programming principle. Both solutions for static and dynamic optimal pairs trading problems are derived and discussed. We show that the “static and dynamic optimality” is a viable approach to the time-inconsistent control problem. Furthermore, numerical experiments are presented to demonstrate the performance of the optimal pairs trading strategies.

Original languageEnglish
Pages (from-to)36-55
Number of pages20
JournalJournal of Optimization Theory and Applications
Volume196
Issue number1
DOIs
Publication statusPublished - 2022

Bibliographical note

Green Open Access added to TU Delft Institutional Repository 'You share, we take care!' - Taverne project https://www.openaccess.nl/en/you-share-we-take-care
Otherwise as indicated in the copyright section: the publisher is the copyright holder of this work and the author uses the Dutch legislation to make this work public.

Keywords

  • Dynamic optimality
  • Mean–variance (MV) analysis
  • Ornstein–Uhlenbeck (OU)
  • Pairs trading
  • Time inconsistency

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