An Improved Pairs Trading Strategy Based on Switching Regime Volatility

25 Pages Posted: 27 Jul 2015

See all articles by Marco Bee

Marco Bee

University of Trento - Department of Economics and Management

Giulio Gatti

University of Trento - Department of Economics and Management

Date Written: July 27, 2015

Abstract

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

Suggested Citation

Bee, Marco and Gatti, Giulio, An Improved Pairs Trading Strategy Based on Switching Regime Volatility (July 27, 2015). Available at SSRN: https://ssrn.com/abstract=2636212

Marco Bee (Contact Author)

University of Trento - Department of Economics and Management ( email )

Via Inama 5
I-38122 Trento
Italy
+39-0461-282296 (Phone)
+39-0461-282222 (Fax)

Giulio Gatti

University of Trento - Department of Economics and Management ( email )

Via Inama 5
Trento, I-38100
Italy

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