An Improved Pairs Trading Strategy Based on Switching Regime Volatility
25 Pages Posted: 27 Jul 2015
Date Written: July 27, 2015
A pairs trading strategy on energy, agricultural and index futures is developed. The strategy uses different parameters according to a volatility regime detected using a threshold evaluated in two ways, namely by means of a mixture of two Gaussian densities and a Markov switching model. The performance is assessed using different time frames and filters. When associated to cointegration, this investment algorithm gives a larger Sharpe ratio with respect to classical methods; on the other hand, the correlation filter does not work well with the regime switching algorithm.
Keywords: Pairs trading, Gaussian mixture, Hidden Markov Model, Cointegration
JEL Classification: G13, G14
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