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Optimal Pairs Trading Strategies: A Stochastic Mean–Variance Approach

Author

Listed:
  • Fenghui Yu

    (TU Delft)

  • Wai-Ki Ching

    (The University of Hong Kong
    Hughes Hall)

  • Chufang Wu

    (The University of Hong Kong
    Southern University of Science and Technology)

  • Jia-Wen Gu

    (Southern University of Science and Technology)

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.

Suggested Citation

  • Fenghui Yu & Wai-Ki Ching & Chufang Wu & Jia-Wen Gu, 2023. "Optimal Pairs Trading Strategies: A Stochastic Mean–Variance Approach," Journal of Optimization Theory and Applications, Springer, vol. 196(1), pages 36-55, January.
    • Handle: RePEc:spr:joptap:v:196:y:2023:i:1:d:10.1007_s10957-022-02131-x
    DOI: 10.1007/s10957-022-02131-x
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    References listed on IDEAS

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