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Optimal Closing of a Momentum Trade

Part of: Mathematical finance Stochastic processes

Published online by Cambridge University Press:  30 January 2018

Erik Ekström  and
Carl Lindberg
Erik Ekström*
Affiliation:
Uppsala University
Carl Lindberg*
Affiliation:
Chalmers University of Technology
*
∗ Postal address: Uppsala University, Box 480, SE-75106 Uppsala, Sweden. Email address: ekstrom@math.uu.se
∗∗ Postal address: Second Swedish National Pension Fund - AP2, SE 40424 Göteborg, Sweden.
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Abstract

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There is an extensive academic literature that documents that stocks which have performed well in the past often continue to perform well over some holding period - so-called momentum. We study the optimal timing for an asset sale for an agent with a long position in a momentum trade. The asset price is modelled as a geometric Brownian motion with a drift that initially exceeds the discount rate, but with the opposite relation after an unobservable and exponentially distributed time. The problem of optimal selling of the asset is then formulated as an optimal stopping problem under incomplete information. Based on the observations of the asset, the agent wants to detect the unobservable change point as accurately as possible. Using filtering techniques and stochastic analysis, we reduce the problem to a one-dimensional optimal stopping problem, which we solve explicitly. We also show that the optimal boundary at which the investor should liquidate the trade depends monotonically on the model parameters.

Keywords

Optimal stoppingmomentumtradingquickest detection problem for Brownian motion

MSC classification

Primary: 91G10: Portfolio theory
Secondary: 60G40: Stopping times; optimal stopping problems; gambling theory
Type
Research Article
Information
Journal of Applied Probability , Volume 50 , Issue 2 , June 2013 , pp. 374 - 387
Copyright
© Applied Probability Trust 

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