Optimal Trading with a Trailing Stop

• Published in: Applied mathematics & optimization Vol. 83; no. 2; pp. 669 - 698
• Main Authors: Leung, Tim, Zhang, Hongzhong
• Format: Journal Article
• Language: English
• Published: New York Springer US 01.04.2021; Springer Nature B.V
• Subjects: Calculus of Variations and Optimal Control; Optimization; Control; Differential equations; Mathematical analysis; Mathematical and Computational Physics; Mathematical Methods in Physics; Mathematics; Mathematics and Statistics; Numerical and Computational Physics; Optimization; Portfolio management; Sensitivity analysis; Simulation; Systems Theory; Theoretical; Stop loss; C41; Trailing stop; Optimal stopping; 62L15; 60G40; G11; 91G20; Stochastic floor; 91G80; Drawdown; C61
• ISSN: 0095-4616; 1432-0606
• DOI: 10.1007/s00245-019-09559-0

Trailing stop is a popular stop-loss trading strategy by which the investor will sell the asset once its price experiences a pre-specified percentage drawdown. In this paper, we study the problem of timing to buy and then sell an asset subject to a trailing stop. Under a general linear diffusion framework, we study an optimal double stopping problem with a random path-dependent maturity. Specifically, we first analytically solve the optimal liquidation problem with a trailing stop, and in turn derive the optimal timing to buy the asset. Our method of solution reduces the problem of determining the optimal trading regions to solving the associated differential equations. For illustration, we implement an example and conduct a sensitivity analysis under the exponential Ornstein–Uhlenbeck model.