Pairs Trading: An Optimal Selling Rule with Constraints

TL;DR

This paper develops an optimal selling rule for pairs trading under trading constraints, modeling stock prices with geometric Brownian motion and trading permissions with a Markov chain, solved via HJB equations.

Contribution

It introduces a novel threshold-based optimal selling strategy for pairs trading with trading constraints, providing a closed-form solution and verification theorem.

Findings

Optimal threshold curve determines selling points

Closed-form solution for the optimal policy

Numerical experiments validate the strategy

Abstract

The focus of this paper is on identifying the most effective selling strategy for pairs trading of stocks. In pairs trading, a long position is held in one stock while a short position is held in another. The goal is to determine the optimal time to sell the long position and repurchase the short position in order to close the pairs position. The paper presents an optimal pairs-trading selling rule with trading constraints. In particular, the underlying stock prices evolve according to a two dimensional geometric Brownian motion and the trading permission process is given in terms of a two-state {trading allowed, trading not allowed} Markov chain. It is shown that the optimal policy can be determined by a threshold curve which is obtained by solving the associated HJB equations (quasi-variational inequalities). A closed form solution is obtained. A verification theorem is provided. Numerical experiments are also reported to demonstrate the optimal policies and value functions.