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## Introduction to Algorithmic Trading Strategies Lecture 4

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**Introduction to Algorithmic Trading StrategiesLecture 4**Optimal Pairs Trading by Stochastic Control Haksun Li haksun.li@numericalmethod.com www.numericalmethod.com**Outline**• Problem formulation • Ito’s lemma • Dynamic programming • Hamilton-Jacobi-Bellman equation • Riccatiequation • Integrating factor**Reference**• Optimal Pairs Trading: A Stochastic Control Approach. Mudchanatongsuk, S., Primbs, J.A., Wong, W. Dept. of Manage. Sci. & Eng., Stanford Univ., Stanford, CA.**Basket Creation vs. Trading**• In lecture 3, we discussed a few ways to construct a mean-reverting basket. • In this and the next lectures, we discuss how to trade a mean-reverting asset, if such exists.**Stochastic Control**• We model the difference between the log-returns of two assets as an Ornstein-Uhlenbeckprocess. • We compute the optimal position to take as a function of the deviation from the equilibrium. • This is done by solving the corresponding the Hamilton-Jacobi-Bellman equation.**Formulation**• Assume a risk free asset, which satisfies • Assume two assets, and . • Assumefollows a geometric Brownian motion. • is the spread between the two assets.**Ornstein-UhlenbeckProcess**• We assume the spread, the basket that we want to trade, follows a mean-reverting process. • is the long term equilibrium to which the spread reverts. • is the rate of reversion. It must be positive to ensure stability around the equilibrium value.**Instantaneous Correlation**• Let denote the instantaneous correlation coefficient between and .**Univariate Ito’s Lemma**• Assume • is twice differentiable of two real variables • We have**Log example**• For G.B.M., ,**Multivariate Ito’s Lemma**• Assume • is a vector Ito process • is twice differentiable • We have**Notations**• : the value of a self-financing pairs trading portfolio • :the portfolio weight for stock A • :the portfolio weight for stock B**Power Utility**• Investor preference:**Problem Formulation**• , s.t., • , • Note that we simplify GBM to BM of , and remove some constants.**Dynamic Programming**• Consider a stage problem to minimize (or maximize) the accumulated costs over a system path. • Cost = s11 S21 2 5 3 3 s0 s12 s3 S22 4 1 5 5 s23 3 s12 time t = 1 t = 0 t = 2**Dynamic Programming Formulation**• State change: • : time • : state • : control decision selected at time • : a random noise • Cost: • Objective: minimize (maximize) the expected cost. • We need to take expectation to account for the noise, .**Principle of Optimality**• Let be an optimal policy for the basic problem, and assume that when using , a give state occurs at time with positive probability. Consider the sub-problem whereby we are at at time and wish to minimize the “cost-to-go” from time to time . • Then the truncated policy is optimal for this sub-problem.**Dynamic Programming Algorithm**• For every initial state , the optimal cost of the basic problem is equal to , given by the last step of the following algorithm, which proceeds backward in time from period to period**Value function**• Terminal condition: • DP equation: • By Ito’s lemma:**Hamilton-Jacobi-Bellman Equation**• Cancel on both LHS and RHS. • Divide by time discretization, . • Take limit as , hence Ito. • The optimal portfolio position is .**Taking Expectation**• All disapper because of the expectation operator. • Only the deterministic terms remain. • Divide LHR and RHS by .**Dynamic Programming Solution**• Solve for the cost-to-go function, . • Assume that the optimal policy is .**First Order Condition**• Differentiate w.r.t. . • In order to determine the optimal position, , we need to solve for to get , , and .**Dis-equilibrium**• Let . Rewrite: • Multiply by .**Simplification**• Note that • The PDE becomes**Another PDE (1)**• Divide by .**Yet Another PDE (1)**• Divide by .**Riccati Equation**• A Riccati equation is any ordinary differential equation that is quadratic in the unknown function.**Solving a Riccati Equation by Integration**• Suppose a particular solution, , can be found. • is the general solution, subject to some boundary condition.**Particular Solution**• Either or is a particular solution to the ODE. This can be verified by mere substitution.**Substitution**• Suppose . goes to 0 by the definition of**Solving**• 1st order linear ODE