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Optimal Trend Following Trading Rules

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Optimal Trend Following Trading Rules

Abstract

This paper is concerned with the optimality of a trend following trading rule. The underlying market is modeled as a bull-bear switching market in which the drift of the stock price switches between two states: the uptrend (bull market) and the downtrend (bear market). Such switching process is modelled as a hidden Markov chain. This is a continuation of our earlier study reported in Dai et al. [5] where a trend following rule is obtained in terms of a sequence of stopping times. Nevertheless, a severe restriction imposed in [5] is that only a single share can be traded over time. As a result, the corresponding wealth process is not self-financing. In this paper, we relax this restriction. Our objective is to maximize the expected log-utility of the terminal wealth. We show, via a thorough theoretical analysis, that the optimal trading strategy is trend-following. Numerical simulations and backtesting, in support of our theoretical findings, are also reported.

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