Optimal pairs trading: A stochastic control approach

Abstract

In this paper, we propose a stochastic control approach to the problem of pairs trading. We model the log-relationship between a pair of stock prices as an Ornstein-Uhlenbeck process and use this to formulate a portfolio optimization based stochastic control problem. We are able to obtain the optimal solution to this control problem in closed form via the corresponding Hamilton-Jacobi- Bellman equation. We also provide closed form maximum-likelihood estimation values for the parameters in the model. The approach is illustrated with a numerical example involving simulated data for a pair of stocks. ©2008 AACC.