Optimal mean-reverting spread trading: nonlinear integral equation approach

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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 (J Theor Probab 18:499–535, 2005a) and derive the nonlinear integral equations of Volterra-type that uniquely characterize the boundaries associated with the optimal timing decisions in all three problems. These integral equations are used to numerically compute the optimal boundaries.

Original languageBritish English
Pages (from-to)181-203
Number of pages23
JournalAnnals of Finance
Volume13
Issue number2
DOIs
StatePublished - 1 May 2017

Keywords

  • Free-boundary problem
  • Integral equation
  • Local time
  • Optimal stopping
  • Spread trading

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