Selling a stock at the ultimate maximum

Details Selling a stock at the ultimate maximum Selling a stock at the ultimate maximum

2009-08-07

arxiv.org/abs/0908.1014v1

Annals of Applied Probability 2009, Vol. 19, No. 3, 983-1014

Economy

Quantitative Finance

Portfolio Management

Published in at http://dx.doi.org/10.1214/08-AAP566 the Annals of Applied Probability (http://www.imstat.org/aap/) by the Inst

Scientific paper

10.1214/08-AAP566

Assuming that the stock price $Z=(Z_t)_{0\leq t\leq T}$ follows a geometric Brownian motion with drift $\mu\in\mathbb{R}$ and volatility $\sigma>0$, and letting $M_t=\max_{0\leq s\leq t}Z_s$ for $t\in[0,T]$, we consider the optimal prediction problems \[V_1=\inf_{0\leq\tau\leq T}\mathsf{E}\biggl(\frac{M_T}{Z_{\tau}}\biggr)\quadand\quad V_2=\sup_{0\leq\tau\leq T}\mathsf{E}\biggl(\frac{Z_{\tau}}{M_T}\biggr),\] where the infimum and supremum are taken over all stopping times $\tau$ of $Z$. We show that the following strategy is optimal in the first problem: if $\mu\leq0$ stop immediately; if $\mu\in (0,\sigma^2)$ stop as soon as $M_t/Z_t$ hits a specified function of time; and if $\mu\geq\sigma^2$ wait until the final time $T$. By contrast we show that the following strategy is optimal in the second problem: if $\mu\leq\sigma^2/2$ stop immediately, and if $\mu>\sigma^2/2$ wait until the final time $T$. Both solutions support and reinforce the widely held financial view that ``one should sell bad stocks and keep good ones.'' The method of proof makes use of parabolic free-boundary problems and local time--space calculus techniques. The resulting inequalities are unusual and interesting in their own right as they involve the future and as such have a predictive element.

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