An Improved Pairs Trading Strategy Based on Switching Regime Volatility

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.