Trading Strategy with stochastic volatility in a limit order book market

Abstract

In this paper, we employ the Heston stochastic volatility model to describe the stock’s volatility and apply the model to derive and analyze trading strategies for dealers in a security market with price discovery. The problem is formulated as a stochastic optimal control problem, and the controlled state process is the dealer’s mark-to-market wealth. Dealers in the security market can optimally determine their ask and bid quotes on the underlying stocks continuously over time. Their objective is to maximize an expected profit from transactions with a penalty proportional to the variance of cumulative inventory cost. We provide an approximate, analytically tractable solution to the stochastic control problem. Numerical experiments are given to illustrate the effects of various parameters on the performances of trading strategies.