Optimal Mean-Reverting Spread Trading: Nonlinear Integral Equation Approach

Tim Leung and Yerkin Kitapbayev

Abstract: We study several optimal stopping problems that arise from trading a mean-reverting price spread over a finite horizon. Modeling the spread by the Ornstein-Uhlenbeck process, we analyze three different trading strategies: (i) the long-short strategy; (ii) the short-long strategy, and (iii) the chooser strategy, i.e. the trader can enter into the spread by taking either long or short position. In each of these cases, we solve an optimal double stopping problem to determine the optimal timing for starting and subsequently closing the position. We utilize the local time-space calculus of Peskir (2005a) and derive the nonlinear integral equations of Volterra-type that uniquely char- acterize the boundaries associated with the optimal timing decisions in all three problems. These integral equations are used to numerically compute the optimal boundaries.

Date: 2017-01, Revised 2017-01
New Economics Papers: this item is included in nep-mst
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Journal Article: Optimal mean-reverting spread trading: nonlinear integral equation approach (2017)
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