Ornstein–Uhlenbeck Drawdowns and Trailing-Stop Trading

Summary

The document develops a trading strategy with trailing stops under the assumption that currency exchange rates behave in a mean-reverting way similar to Ornstein–Uhlenbeck processes. It derives an explicit expression for the running maximum of an Ornstein–Uhlenbeck process when the process is stopped after reaching a specified maximum drawdown. That result is used to describe projected strategy returns.

The authors compare theoretical characteristics from the derivation with observed ones and discuss hypothetical applications to currency-pair trading. The proposed approach therefore links a stochastic-process model, a drawdown-based stopping rule, and expected trading outcomes. The excerpt offers no numerical performance results, transaction-cost analysis, or detailed evidence that exchange rates satisfy the assumed process behavior. Its profitability rationale is theoretical and depends on the fit of the mean-reversion assumption and the trailing-stop setup.

Key ideas

• The strategy assumes currency exchange rates have mean-reverting behavior resembling an Ornstein–Uhlenbeck process.
• A trailing stop closes exposure after the process reaches a specified maximum drawdown.
• The analysis derives the running maximum of the process under that stopping rule.
• Derived return characteristics are compared with observed characteristics in a hypothetical currency-pair application.
• The excerpt does not provide numerical results or establish that the process assumption holds in live markets.

Tags

# 1507.01610


# Analysis of Ornstein-Uhlenbeck process stopped at maximum drawdown and application to trading strategies with trailing stops









We propose a strategy for automated trading, outline theoretical justification of the profitability of this strategy and overview the hypothetical results in application to currency pairs trading. The proposed methodology relies on the assumption that processes reflecting the dynamics of currency exchange rates are in a certain sense similar to the class of Ornstein-Uhlenbeck processes and exhibits the mean reverting property. In order to describe the quantitative characteristics of the projected return of the strategy, we derive the explicit expression for the running maximum of the Ornstein-Uhlenbeck process stopped at maximum drawdown and look at the correspondence between derived characteristics and the observed ones.

Shown in full with attribution under the source's licence. Licence: abstract CC0

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