SSRN Id1762118
SSRN Id1762118
SSRN Id1762118
Abstract
We develop an optimal trend following trading rule in a bull-bear switching market, where the
drift of the stock price switches between two parameters corresponding to an uptrend (bull mar-
ket) and a downtrend (bear market) according to an unobservable Markov chain. We consider
a finite horizon investment problem and aim to maximize the expected return of the terminal
wealth. We start by restricting to allowing flat and long positions only and describe the trading
decisions using a sequence of stopping times indicating the time of entering and exiting long
positions. Assuming trading all available funds, we show that the optimal trading strategy is
a trend following system characterized by the conditional probability in the uptrend crossing
two threshold curves. The thresholds can be obtained by solving the associated HJB equations.
In addition, we examine trading strategies with short selling in terms of an approximation.
Simulations and empirical experiments are conducted and reported.
Keywords: Trend following trading rule, bull-bear switching model, partial information, HJB
equations
AMS subject classifications: 91G80, 93E11, 93E20
∗
Dai is from Department of Mathematics, National University of Singapore (NUS) 10, Lower Kent Ridge Road,
Singapore 119076, [email protected], Tel. (65) 6516-2754, Fax (65) 6779-5452, and he is also affiliated with Risk
Management Institute and Institute of Real Estate Studies, NUS. Zhang is from Department of Mathematics, The
University of Georgia, Athens, GA 30602, USA, [email protected], Tel. (706) 542-2616, Fax (706) 542-2573. Zhu
is from Department of Mathematics, Western Michigan University, Kalamazoo, MI 49008, USA, [email protected], Tel.
(269) 387-4535, Fax (269) 387-4530. Dai is supported by the Singapore MOE AcRF grant (No. R-146-000-138-112)
and the NUS RMI grant (No.R-146-000-124-720/646). We thank seminar participants at Carnegie Mellon University,
Wayne State University, University of Illinois at Chicago, and 2010 Mathematical Finance and PDE conference for
helpful comments.
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1762118
http://ssrn.com/abstract=1762118
1 Introduction
Roughly speaking, trading strategies can be classified as i) the buy and hold strategy, ii) the contra-
trend strategy, and iii) the trend following strategy. The buy and hold strategy can be justified
because the average return of stocks is higher than the bank rate1 . An investor that performs
the contra-trending strategy purchases shares when prices fall to some low level and sells when
they go up to a certain high level (known as buy-low-sell-high). As the name suggests, the trend
following strategy tries to enter the market in the uptrend and signal investors to exit when the
trend reverses. In contrast to the contra-trend investors, a trend following believer often purchases
shares when prices go up to a certain level and sells when they fall to a higher level (known as
buy-high-sell-higher).
There is an extensive literature devoted to the contra-trend strategy. For instance, Merton [14]
pioneered the continuous-time portfolio selection with utility maximization, which was subsequently
extended to incorporate transaction costs by Magil and Constantinidies [13] (see also Davis and
Norman [5], Shreve and Soner [19], Liu and Loeweinstein [12], Dai and Yi [3], and references
therein). The resulting strategies turn out to be contra-trend because the investor is risk averse
and the stock market is assumed to follow a geometric Brownian motion with constant drift and
volatility. Recently Zhang and Zhang [24] showed that the optimal trading strategy in a mean
reverting market is also contra-trend. Other work relevant to the contra-trend strategy includes
Dai et al. [1], Song et al. [20], Zervors et al. [23], among others.
The present paper is concerned with a trend following trading rule. Traders who adopt this
trading rule often use moving averages to determine the general direction of the market and to
generate trade signals [21]. However, to the best of our knowledge, there is not yet any solid
theoretical framework supporting the use of moving average2 . Recently, Dai et al. [4] provided a
theoretical justification of the trend following strategy in a bull-bear switching market and employed
the conditional probability in the bull market to generate the trade signals. However, the work
imposed a less realistic assumption3 : Only one share of stock is allowed to be traded. In the present
paper, we will remove this restriction and develop an optimal trend following rule. We also carry
1
Recently Shiryaev et al. [18] provided a theoretical justification of the buy and hold strategy from another angle.
2
There does exist research on statistical analysis for trading strategies with moving averages. See, for example,
[6].
3
The same assumption was imposed in [24], [20], and [23].
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1762118
http://ssrn.com/abstract=1762118
out extensive simulations and empirical analysis to examine the efficiency of our strategy.
Following [4], we model the trends in the markets using a geometric Brownian motion with
regime switching and partial information. More precisely, two regimes are considered: the uptrend
(bull market) and downtrend (bear market), and the switching process is modeled as a two-state
Markov chain which is not directly observable4 . We consider a finite horizon investment problem,
and our target is to maximize the expected return of the terminal wealth. We begin by considering
the case that only long and flat positions are allowed. We use a sequence of stopping times to
indicate the time of entering and exiting long positions. Assuming trading all available funds, we
show that the optimal trading strategy is a trend following system characterized by the conditional
probability in the uptrend crossing two time-dependent threshold curves. The thresholds can be
obtained through solving a system of HJB equations satisfied by two value functions that are
associated with long and flat positions, respectively. Simulation and market tests are conducted to
demonstrate the efficiency of our strategy.
The next logical question to ask is whether adding short will improve the return. Due to
asymmetry between long and short as well as solvency constraint, the exact formulation with short
selling still eludes us. Hence, we instead utilize the following approximation. First, we consider
trading with the short and flat positions only. Using reverse exchange traded funds to approximate
the short selling we are able to convert it to the case of long and flat. Then, assuming there are
two traders A and B. Trader A trades long and flat only and trader B trades short and flat only.
Combination of the actions of both A and B yields a trading strategy that involves long, short
and flat positions. Simulation and market tests are provided to investigate the performance of the
strategy.
The rest of the paper is arranged as follows. We present the problem formulation in the next
section. Section 3 is devoted to a theoretical characterization of the resulting optimal trading
strategy. We report our simulation results and market tests in Section 4. In Section 5, we examine
the trading strategy when short selling is allowed. We conclude in Section 6. All proofs, some
technical results and details on market tests are given in Appendix.
4
Most existing literature in trading strategies assumes that the switching process is directly observable, e.g. Jang
et al. [9] and Dai et al. [2].
where αr ∈ {1, 2} is a two-state Markov chain, µ(i) ≡ µi is the expected return rate5 in regime
i = 1, 2, σ > 0 is the constant volatility, Br is a standard Brownian motion, and t and T are the
initial and terminal times, respectively.
The process αr represents the market mode at each time r: αr = 1 indicates a bull market
(uptrend) and αr = 2 a bear market (downtrend). Naturally, we assume µ1 > 0 and µ2 < 0.
µ ¶
−λ1 λ1
Let Q = , (λ1 > 0, λ2 > 0), denote the generator of αr . So, λ1 (λ2 ) stands for
λ2 −λ2
the switching intensity from bull to bear (from bear to bull). We assume that {αr } and {Br } are
independent.
Let
t ≤ τ10 ≤ v10 ≤ τ20 ≤ v20 · · · ≤ τn0 ≤ vn0 ≤ · · · , a.s.,
Ji (S,
α, t, Λi )
( " #I{τn <T } )
Y∞
Sv 1 − Ks
Et log eρ(τ1 −t) eρ(τn+1 −vn ) n , if i = 0,
Sτn 1 + Kb
n=1
( " # ∞ " #I{τn <T } )
= Y
Sv1 ρ(τ2 −v1 ) Sv 1 − Ks
Et log e (1 − Ks ) eρ(τn+1 −vn ) n ,
S Sτn 1 + Kb
n=2
if i = 1.
Ji (S,
α, t,
(Λi ) " #)
X∞ µ ¶
S v 1 − K s
Et ρ(τ1 − t) + log n
+ ρ(τn+1 − vn ) + log I{τn <T } , if i = 0,
Sτn 1 + Kb
(" n=1 #
Sv 1
= Et log + log(1 − Ks ) + ρ(τ2 − v1 )
S
" µ ¶ #)
∞
X S 1 − K
v n s
+
log
Sτn
+ ρ(τn+1 − vn ) + log
1 + Kb
I{τn <T } , if i = 1,
n=2
∞
X PN
where the term E ξn for random variables ξn is interpreted as lim supN →∞ E n=1 ξn . Our goal
n=1
is to maximize the reward function6 .
Remark 1 Note that the indicator function I{τn <T } is used in the definition of the reward functions
Ji . This is to ensure that if the last buy order is entered at t = τn < T , then the position will
be sold at vn ≤ T . The indicator function I confines the effective part of the sum to a finite time
horizon so that the reward functions are bounded above.
σ2 σ2
µ2 − < ρ < µ1 − . (2)
2 2
Note that only the stock price Sr is observable at time r in marketplace. The market trend αr
is not directly observable. Thus, it is necessary to convert the problem into a completely observable
one. One way to accomplish this is to use the Wonham filter [22].
6
It is easy to see that the problem is equivalent to maximizing the expected logarithm utility of the terminal
wealth over allowable trading strategies that incur proportional transaction costs.
7 2 2
Intuitively, one should never buy stock if ρ ≥ µ1 − σ2 and never sell stock if ρ ≤ µ2 − σ2 .
(µ1 − µ2 )pr (1 − pr ) b
dpr = [− (λ1 + λ2 ) pr + λ2 ] dr + dBr , (3)
σ
br is the innovation process (a standard Brownian motion; see e.g., Øksendal [15]) given by
where B
br .
dSr = Sr [(µ1 − µ2 ) pr + µ2 ] dr + Sr σdB (5)
Ji (S, p, t, Λi ) ≡ Ji (S, α, t, Λi ),
subject to (3) and (5). We emphasize that this new problem is completely observable because the
conditional probability pr can be obtained using the stock price up to time r.
Note that, for a given Λ0 , we have
Z vn Z vn
Sv n br ,
log = f (pr )dr + σdB (6)
Sτn τn τn
where
σ2
f (pr ) = (µ1 − µ2 )pr + µ2 − . (7)
2
The following lemma gives the bounds of the values functions. Its proof is given in Appendix.
and
µ ¶
σ2
Vi (p, t) ≤ µ1 − (T − t), for i = 0, 1.
2
Next, we consider the associated Hamilton-Jacobi-Bellman equations. It is easy to see that, for
t < T and stopping times τ1 and v1 ,
and
½Z v1 ¾
V1 (p, t) = sup Et f (ps )ds + log(1 − Ks ) + V0 (pv1 , v1 ) ,
v1 t
Remark 2 In this paper, we restrict the state space of p to (0, 1) because both p = 0 and p = 1 are
entrance boundaries (see Karlin and Taylor [10] and Dai et al. [4] for definition and discussions).
Now we define the buying region (BR), the selling region (SR), and the no-trading region (N T )
as follows:
Theorem 2 There exist two monotonically increasing boundaries p∗s (t), p∗b (t) ∈ C ∞ (0, T ) such
that
Moreover,
ρ − µ2 + σ 2 /2
i) p∗b (t) ≥ ≥ p∗s (t) for all t ∈ [0, T );
µ1 − µ2
ρ − µ2 + σ 2 /2
ii) lim p∗s (t) = ;
t→T − µ1 − µ2
1 1 + Kb
iii) there is a δ > 2
log such that p∗b (t) = 1 for t ∈ (T − δ, T ).
µ1 − ρ − σ /2 1 − Ks
The proof is placed in Appendix. The theoretical results enable us to examine the validity of
the program codes for numerically solving the system of HJB equations.
We call p∗s (t) (p∗b (t)) the optimal sell (buy) boundary. To better understand Theorem 2, we
provide a numerical result for illustration8 . In Figure 1, we plot the optimal sell and buy boundaries
against time. It can be seen that both the buy boundary and the sell boundary are increasing with
time, between the two boundaries is the no trading region (NT), the buy region (BR) is above the
buy boundary, and the sell region (SR) is below the sell boundary. Moreover, the sell boundary p∗s (t)
ρ − µ2 + σ 2 /2 0.0679 + 0.77 + 0.1842 /2
approaches the theoretical value = = 0.9, as t → T = 1.
µ1 − µ2 0.18 + 0.77
Also, we observe that there is a δ such that p∗b (t) = 1 for t ∈ [T − δ, T ], which indicates that it is
never optimal to buy stock when t is very close to T . Using Theorem 2, the lower bound of δ is
estimated as
1 1 + Kb 1 1.001
2
log = 2
log = 0.021,
µ1 − ρ − σ /2 1 − Ks 0.18 − 0.0657 − 0.184 /2 0.999
0.9
NT
0.85
p
0.8
p*(t)
s
0.75
SR
0.7
0 0.2 0.4 0.6 0.8 1
t
approaches T . The behavior of the thresholds when t approaches to T is due to our technical require-
ment of liquidating all the positions at T . Because we are interested in long-term investment, we
will approximate these thresholds, as in [4], by constants p∗s = lim p∗s (t) and p∗b = lim p∗b (t).9
T −t→∞ T −t→∞
Assume the initial position is flat and the initial conditional probability p(0) ∈ (p∗s , p∗b ). Then our
trading strategy can be described as follows. As pt goes up to hit p∗b , we take a long position, that
is, investing all wealth in stock. We will not close out the position unless pt goes down to hit p∗s .
According to (3)-(4), we have
(µ1 − µ2 )pr (1 − pr )
dpr = g(pr )dr + d log Sr , (13)
σ2
where ¡ ¢
(µ1 − µ2 )pt (1 − pt ) (µ1 − µ2 )p + µ2 − σ 2 /2
g(p) = − (λ1 + λ2 ) p + λ2 − .
σ2
(13) implies that the conditional probability pt in the bull market increases (decreases) as the stock
price goes up (down). Hence, our strategy suggests that we buy only when stock price is going up
and sell only when stock price is going down. This is a typical trend following strategy!
We conclude this section by a verification theorem, showing that the solutions V0 and V1 of
problem (9)-(10) are equal to the value functions and sequences of optimal stopping times can be
9
The constant thresholds are essentially associated with the infinity horizon investment problem:
1
lim max E(WT ), where WT be the terminal wealth.
T →∞ T
Theorem 3 (Verification Theorem) Let (w0 (p, t), w1 (p, t)) be the unique bounded strong solution
to problem (9)-(10) with w0 (p, t) ≥ 0 and p∗b (t) and p∗s (t) be the associated free boundaries. Then,
w0 (p, t) and w1 (p, t) are equal to the value functions V0 (p, t) and V1 (p, t), respectively.
Moreover, let
Λ∗0 = (τ1∗ , v1∗ , τ2∗ , v2∗ , · · ·),
where the stopping times τ1∗ = T ∧ inf{r ≥ t : pr ≥ p∗b (r)}, vn∗ = T ∧ inf{r ≥ τn∗ : pr ≤ p∗s (r)}, and
∗
τn+1 = T ∧ inf{r > vn∗ : pr ≥ p∗b (r)} for n ≥ 1, and let
where the stopping times v1∗ = T ∧ inf{r ≥ t : p∗r ≤ p∗s (r)}, τn∗ = T ∧ inf{r > vn−1
∗ : pr ≥ p∗b (r)},
and vn∗ = T ∧ inf{r ≥ τn∗ : pr ≤ p∗s (r)} for n ≥ 2. If vn∗ → T , a.s., as n → ∞, then Λ∗0 and Λ∗1 are
optimal.
We use both simulations and tests on historical market data to examine the effectiveness of the
theoretical characterization of the trading strategy. To estimate pt , the conditional probability in a
bull market, we use a discrete version of the stochastic differential equation (13), for t = 0, 1, . . . , N
with dt = 1/252,
µ µ ¶ ¶
(µ1 − µ2 )pt (1 − pt )
pt+1 = min max pt + g(pt )dt + log(St+1 /St ), 0 , 1 , (14)
σ2
where the price process St is determined by the simulated paths or the historical market data. The
min and max are added to ensure the discrete approximation pt of the conditional probability in
the bull market stays in the interval [0, 1]. Note that the equation for pt is the same as that in [4]
because it is irrelevant to objective functions.
4.1 Simulations
For simulation we use the parameters summarized in Table 1 and a 40 year time horizon. They are
the same as those used in [4] so that it is easy to compare the results.
10
11
We now turn to test the trend following trading strategy in real markets. Here we conduct the ex-
ante tests.10 The parameters are determined using only information available at the decision time
and updated periodically. More concretely, let us use the test of SP500 as an example to explain
the process. We have SP500 historical closing data since 1962. We use the first 10 years data to
derive statistics for bull (rally at least 20%) and bear (decline at least 20%) markets to serve as
the initial parameters for determining the buy-sell thresholds. We then update the parameters and
thresholds at the beginning of every year if new up or down trends are confirmed ending before the
beginning of the year. We update the parameters using the so called exponential average method
in which the update of the parameters is determined by the old parameters and new parameters
with formula
update = (1 − 2/N )old + (2/N )new,
where we chose N = 6 based on the number of bull and bear markets between 1962–1972. The
exponential average allows to overweight the new parameters while avoiding unwanted abrupt
changes due to dropping old parameters. Then we use the yearly updated parameters to calculate
the corresponding thresholds. Finally, we use these parameters and thresholds to test the SP500
index from 1972-2011. The equity curve of the trend following strategy is compared to the buy
and hold strategy in the same period of time in Figure 2. The upper, middle and the lower curves
represents the equity curves of the trend following strategy, the buy and hold strategy including
dividend and the SP500 index without dividend adjustment, respectively.
As we can see, the trend following strategy not only outperforms the buy and hold strategy
in total return, but also has a smoother equity curve, which means a higher Sharpe ratio. A
similar ex-ante test is done for the Shanghai Stocks Exchange index (SSE). Since we have only
10 year data (2001–2011) for the SSE, we have to estimate the initial parameters. We summarize
the tests on SP500 and SSE in Table 4 showing annualized return along with quarterly Sharpe
ratio in parenthesis, where the estimate for the SSE initial parameters are µ1 = 1, µ2 = −1, and
λ1 = λ2 = 1.11 The equity curves for the SSE test are shown in Figure 3. The SSE index closing
10
Ex-post tests of a trend following strategy were conducted in [4]. In the present paper we carry out the ex-ante
tests which are more convincing.
11
We have also tried other initial parameter values, e.g. µ1 = 0.4, µ2 = −0.4, λ1 = 1, λ2 = 0.5, which yield similar
results as we present here. These results are available upon request.
12
2
10
Figure 2: Trend following trading of SP500 1972–2011 compared with buy and hold
4
10
3
10
2002 2004 2006 2008 2010 2012
Figure 3: Trend following trading of SSE 2001–2011 compared with buy and hold
13
5 Allowing shorts
Can we benefit by adding shorts? In practice there are differences between short and long. Notably,
the short risks may lose more than the initial capital, so the no-bankruptcy constraint would have
to be imposed, which makes the problem intractable under our theoretical framework. One way to
circumvent this difficulty is to use the reverse Exchange Traded Funds (ETFs) of the corresponding
indices to determine threshold values for short selling. In such an approximation to short sell Sr
we long a reverse ETF which is equivalent to longing an asset Sˆr = 1/Sr . First we consider the
case when only short and flat positions are allowed. Use qr = 1 − pr to represent the conditional
probability of Sˆr in an uptrend (equivalently Sr is in a downtrend) and denote
It is easy to verify that the process Sˆr and qr satisfy the system of stochastic differential equations
14
where
Since the form of the system of stochastic equations (16) and (17) is the same as (3) and (5),
we conclude that the optimal trading strategy when allowing only short and flat has the same form
as that of the long and flat only case. Moreover, the thresholds for qr determined by (17) and (18)
can be calculated using the same numerical procedure described in Section 4 with the parameter
(15).
The next logical step is to allow both long and short along with flat positions in trading.
Following the method we have used so far, to analyze trading with long, short and flat positions we
would need to add a new value function V−1 corresponding to start with a short position which will
considerably complicate the analysis. An alternative is to consider the following approximation.
First assume there are two traders A and B. Trader A trades long and flat only and trader B
trades short and flat only. As discussed before, trader A can use the method in Section 3 to find
two thresholds p∗b and p∗s and to make buying and selling decisions when pr cross those thresholds.
Trader B can similarly determine two thresholds qb∗ and qs∗ for buying the inverse ETF and going
flat when qr cross those thresholds. Furthermore, we can use the relationship q = 1 − p to translate
the thresholds for qr to that of pr . Namely, when pr crosses 1 − qb∗ from above trader B should
short the index and when pr crosses 1 − qs∗ from below trader B should go flat. Finally, we combine
the action of A and B. Let us use the parameters in Table 1 as an illustration. In this case the four
thresholds have the following order:
1 − qb∗ = 0.589 < p∗s = 0.774 < 1 − qs∗ = 0.849 < p∗b = 0.947. (19)
Now we consider the net combined position of trader A and B. If we start with a long position one
will sell to flat first when pr crosses p∗s from above. If market deteriorates further then one will sell
short when pr crosses 1 − qb∗ eventually. Symmetrically, if the starting position is short one will
cover the short first as market improves and pr crosses 1 − qs∗ , and a long position will be initiated
when the uptrend further strengthes such that pr crosses p∗b .
15
Ss + Ss (1 − K) − Sc (1 + K)
(see Appendix 7.3) (20)
Ss
rather than simulate inverse ETF with a gain Ss /Sc . This is because the inverse ETF works well
as an approximation of sell only in short term while our trend following trading strategy tends to
have relative long holding period for a position.
Again, we run the 5000 round simulation for 10 times and summarize the mean and standard
deviation in Table 5.
Comparing Table 5 and Table 2 we see that adding shorts does improve the performance consid-
erably. However, it seems that the gain from short selling is less than that from long. This is not
surprising given that the market is biased to the up side in the long run.
We now turn to market tests. Ex-ante test of SSE from 2001 to 2011 with long, short and
flat positions yields an annualized return of 18.48% with a quarterly Sharpe ratio 0.306. This
represents a significant improvement over the trend following strategy using only long and flat
positions. However, a similar test for SP500 using the trend following strategy with long, short
and flat positions from 1972 to 2011 only gives an annualized return of 2.57% which is worse than
the annualized return of 8.57% using the buy and hold strategy. Thus, using the trend following
strategy to sell index short may lose money. This is not entirely surprising. It is well known for
practitioners that shorting a market is treacherous (see e.g. [16]).
6 Conclusion
We consider a finite horizon investment problem in a bull-bear switching market, where the drift
of the stock price switches between two parameters corresponding to an uptrend (bull market) and
a downtrend (bear market) according to an unobservable Markov chain. Our target is to maximize
16
7 Appendix
7.1 Proofs of Results
Proof of Lemma 1. It is clear that the lower bounds for Vi follow from their definition. It remains
17
where the last equality is due to (2). We then obtain the desired result. Similarly, we can show the
inequality for V1 . 2
Proof of Theorem 2. Denote Z(p, t) ≡ V1 (p, t) − V0 (p, t). It is not hard to verify Z (p, t) is the
unique strong solution to the following double obstacle problem:
in (0, 1) × [0, T ), with the terminal condition Z(p, T ) = log (1 − Ks ) . Apparently ∂t Z|t=T ≤ 0,
which implies by the maximum principle
∂t Z ≤ 0. (21)
∂p Z ≥ 0. (22)
By (22), we immediately infer the existence of p∗s (t) and p∗b (t) as given in (9) and (10). Their
monotonicity can be deduced from (21).
Now let us prove part i. If (p, t) ∈ SR, i.e. Z(p, t) = log (1 − K) , then
namely,
ρ − µ2 + σ 2 /2
p≤ ,
µ1 − µ2
18
we have
w0 (pvk , vk )
≥ E[ρ(τk+1 − vk ) + ¡w0 (pτk+1 , τk+1 )] ¢
≥ E[ρ(τk+1 − vk ) + µw1 (pτk+1 , τk+1 ) − log(1 + Kb ) I{τk+1 <T } ] ¶
Sv
≥ E[ρ(τk+1 − vk ) + log k+1 + w1 (pvk+1 , vk+1 ) − log(1 + Kb ) I{τk+1 <T } ]
µ Sτk+1 ¶
Svk+1
≥ E[ρ(τk+1 − vk ) + log + w0 (pvk+1 , vk+1 ) + log(1 − Ks ) − log(1 + Kb ) I{τk+1 <T } ]
Sτk+1
Sv
= E[ρ(τk+1 − vk ) + log k+1 + w0 (pvk+1 , vk+1 ) + (log(1 − Ks ) − log(1 + Kb )) I{τk+1 <T } ].
Sτk+1
Note that the above inequalities also work when starting at t in lieu of vk , i.e.,
· ¸
Sv1
Ew0 (pt , t) ≥ E ρ(τ1 − t) + log + w0 (pv1 , v1 ) + (log(1 − Ks ) − log(1 + Kb ))I{τ1 <T } .
Sτ1
Use this inequality and iterate (25) with k = 1, 2, . . ., and note w0 ≥ 0 to obtain
19
Finally, it is easy to check that the equalities hold when τk = τk∗ and vk = vk∗ . This completes
the proof. 2
20
21
22
Assuming that the signals from the trend following strategy indicate short selling at r = s and then
cover at r = c and that the margin requirement for short selling is α, we calculate the return on
the above trade when trading full margin. Let w be the wealth at r = s. Suppose we can short sell
k shares on full margin. Then kSs = α(w + kSs ) or w = kSs 1−α
α . When we cover at r = c the net
gain is kSs (1 − K) − kSc (1 + K) taking into account of the trading cost. Thus, the return is
23
[1] M. Dai, H. Jin, Y. Zhong and X. Y. Zhou, Buy low and sell high, Contemporary Quantita-
tive Finance: Essays in Honour of Eckhard Platen, edited by Chiarella, Carl and Novikov,
Alexander, Springer, pp. 317-334, (2010).
[2] M. Dai, H.F. Wang, and Z. Yang, Leverage management in a bull-bear switching market,
SSRN, http://ssrn.com/abstract=1571613, (2010)
[3] M. Dai and F. Yi, Finite horizontal optimal investment with transaction costs: a parabolic
double obstacle problem, Journal of Diff. Equ., 246, pp. 1445-1469, (2009).
[4] M. Dai, Q. Zhang, and Q. Zhu, Trend following trading under a regime switching model, SIAM
Journal on Financial Mathematics, 1, pp. 780-810, (2010).
[5] M.H.A. Davis and A.R. Norman, Portfolio selection with transaction costs, Mathematics of
Operations Research, 15, 676-713, (1990).
[6] M.T. Faber, A quantitative approach to tactical asset allocationno access, 9, pp. 69C79, (2007).
[8] A. Friedman, Variational Principles and Free-Boundary Problems, Wiley, New York, (1982).
[9] B.G. Jang, H.K. Koo, H. Liu, and M. Loewenstein, Liquidity Premia and transaction costs,
Journal of Finance, 62, pp. 2329-2366, (2007).
[10] S. Karlin and H.M. Taylor, A Second Course in Stochastic Processes, Academic Press, New
York, 1981.
[11] R.S. Liptser and A.N. Shiryayev, Statistics of Random Processes I. General Theory, Springer-
Verlag, Berlin, New York, 1977.
[12] H. Liu and M. Loeweinstein, Optimal portfolio selection with transaction costs and finite
horizons, Review of Financial Studies, 15, pp. 805-835, (2002).
24
[14] R.C. Merton, Optimal consumption and portfolio rules in a continuous time model, Journal
of Economic Theory, 3, pp. 373-413, (1971).
[15] B. Øksendal, Stochastic Differential Equations 6th ed. Springer-Verlag, Berlin, New York,
2003.
[16] W. J. O’Neal, How to Make Money in Stocks: A Winning System in Good Times or Bad, 2nd
edition, McGraw-Hill, New York, 1995.
[17] R. Rishel and K. Helmes, A variational inequality sufficient condition for optimal stopping
with application to an optimal stock selling problem, SIAM J. Control and Optim., Vol. 45,
pp. 580-598, (2006).
[18] A. Shiryaev, Z. Xu and X. Y. Zhou, Thou shalt buy and hold, Quantitative Finance, 8, pp.
765-776, (2008).
[19] S.E. Shreve and H.M. Soner, Optimal investment and consumption with transaction costs,
Annals of Applied Probability, 4, 609-692, (1994).
[20] Q.S. Song, G. Yin and Q. Zhang, Stochastic optimization methods for buyinglow- and-selling-
high strategies, Stochastic Analysis and Applications, 27, pp. 52-542, (2009).
[22] W.M. Wonham, Some applications of stochastic differential equations to optimal nonlinear
filtering, SIAM J. Control, 2, pp. 347-369, (1965).
[23] M. Zervos, T.C. Johnsony and F. Alazemi, Buy-low and sell-high investment strategies, Work-
ing paper, (2011).
[24] H. Zhang and Q. Zhang, Trading a mean-reverting asset: Buy low and sell high, Automatica,
44, pp. 1511-1518, (2008).
25