IDEAS home Printed from https://ideas.repec.org/p/arx/papers/1602.05858.html
   My bibliography  Save this paper

On the Profitability of Optimal Mean Reversion Trading Strategies

Author

Listed:
  • Peng Huang
  • Tianxiang Wang

Abstract

We study the profitability of optimal mean reversion trading strategies in the US equity market. Different from regular pair trading practice, we apply maximum likelihood method to construct the optimal static pairs trading portfolio that best fits the Ornstein-Uhlenbeck process, and rigorously estimate the parameters. Therefore, we ensure that our portfolios match the mean-reverting process before trading. We then generate contrarian trading signals using the model parameters. We also optimize the thresholds and the length of in-sample period by multiple tests. In nine good pair examples, we can see that our pairs exhibit high Sharpe ratio (above 1.9) over the in-sample period and out-of-sample period. In particular, Crown Castle International Corp. (CCI) and HCP, Inc. (HCP) achieve a Sharpe ratio of 2.326 during in-sample period and a Sharpe ratio of 2.425 in out-of-sample test. Crown Castle International Corp. (CCI) and Realty Income Corporation (O) achieve a Sharpe ratio of 2.405 and 2.903 respectively during in-sample period and out-of-sample period.

Suggested Citation

  • Peng Huang & Tianxiang Wang, 2016. "On the Profitability of Optimal Mean Reversion Trading Strategies," Papers 1602.05858, arXiv.org.
    • Handle: RePEc:arx:papers:1602.05858
    as

    Download full text from publisher

    File URL: http://arxiv.org/pdf/1602.05858
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Tim Leung & Xin Li, 2016. "Optimal Mean Reversion Trading:Mathematical Analysis and Practical Applications," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 9839, December.
    2. Tim Leung & Xin Li & Zheng Wang, 2015. "Optimal Multiple Trading Times Under the Exponential OU Model with Transaction Costs," Papers 1504.04682, arXiv.org.
    3. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
    4. Tim Leung & Xin Li, 2015. "Optimal Mean Reversion Trading With Transaction Costs And Stop-Loss Exit," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-31.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Ivan Letteri & Giuseppe Della Penna & Giovanni De Gasperis & Abeer Dyoub, 2022. "DNN-ForwardTesting: A New Trading Strategy Validation using Statistical Timeseries Analysis and Deep Neural Networks," Papers 2210.11532, arXiv.org.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Yerkin Kitapbayev & Tim Leung, 2018. "Mean Reversion Trading With Sequential Deadlines And Transaction Costs," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(01), pages 1-22, February.
    2. Yerkin Kitapbayev & Tim Leung, 2017. "Optimal mean-reverting spread trading: nonlinear integral equation approach," Annals of Finance, Springer, vol. 13(2), pages 181-203, May.
    3. Guo, Kevin & Leung, Tim, 2017. "Understanding the non-convergence of agricultural futures via stochastic storage costs and timing options," Journal of Commodity Markets, Elsevier, vol. 6(C), pages 32-49.
    4. Jiao Li, 2016. "Trading VIX Futures under Mean Reversion with Regime Switching," Papers 1605.07945, arXiv.org, revised Jun 2016.
    5. Jiao Li, 2016. "Trading VIX futures under mean reversion with regime switching," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 1-20, September.
    6. Tim Leung & Raphael Yan, 2018. "Optimal dynamic pairs trading of futures under a two-factor mean-reverting model," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 5(03), pages 1-23, September.
    7. Endres, Sylvia & Stübinger, Johannes, 2017. "Optimal trading strategies for Lévy-driven Ornstein-Uhlenbeck processes," FAU Discussion Papers in Economics 17/2017, Friedrich-Alexander University Erlangen-Nuremberg, Institute for Economics.
    8. Hongzhong Zhang, 2018. "Stochastic Drawdowns," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 10078, December.
    9. Tim Leung & Zheng Wang, 2019. "Optimal risk-averse timing of an asset sale: trending versus mean-reverting price dynamics," Annals of Finance, Springer, vol. 15(1), pages 1-28, March.
    10. Boming Ning & Kiseop Lee, 2024. "Advanced Statistical Arbitrage with Reinforcement Learning," Papers 2403.12180, arXiv.org.
    11. Alex S. L. Tse & Harry Zheng, 2023. "Speculative trading, prospect theory and transaction costs," Finance and Stochastics, Springer, vol. 27(1), pages 49-96, January.
    12. Haipeng Xing, 2019. "A singular stochastic control approach for optimal pairs trading with proportional transaction costs," Papers 1911.10450, arXiv.org.
    13. Stübinger, Johannes & Endres, Sylvia, 2017. "Pairs trading with a mean-reverting jump-diffusion model on high-frequency data," FAU Discussion Papers in Economics 10/2017, Friedrich-Alexander University Erlangen-Nuremberg, Institute for Economics.
    14. Boming Ning & Prakash Chakraborty & Kiseop Lee, 2023. "Optimal Entry and Exit with Signature in Statistical Arbitrage," Papers 2309.16008, arXiv.org, revised Mar 2024.
    15. Tim Leung & Hongzhong Zhang, 2017. "Optimal Trading with a Trailing Stop," Papers 1701.03960, arXiv.org, revised Mar 2019.
    16. Azze, A. & D’Auria, B. & García-Portugués, E., 2024. "Optimal stopping of an Ornstein–Uhlenbeck bridge," Stochastic Processes and their Applications, Elsevier, vol. 172(C).
    17. Baviera, Roberto & Santagostino Baldi, Tommaso, 2019. "Stop-loss and leverage in optimal statistical arbitrage with an application to energy market," Energy Economics, Elsevier, vol. 79(C), pages 130-143.
    18. Tim Leung & Jiao Li & Xin Li & Zheng Wang, 2016. "Speculative Futures Trading under Mean Reversion," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 23(4), pages 281-304, December.
    19. Jize Zhang & Tim Leung & Aleksandr Y. Aravkin, 2018. "Mean Reverting Portfolios via Penalized OU-Likelihood Estimation," Papers 1803.06460, arXiv.org.
    20. Alexander Lipton & Marcos Lopez de Prado, 2020. "A closed-form solution for optimal mean-reverting trading strategies," Papers 2003.10502, arXiv.org.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:1602.05858. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: http://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.