A pairs trading strategy based on switching-regime volatility for commodity futures

A pairs trading strategy on energy, agricultural and index futures uses different parameters according to a volatility regime that is detected using a threshold evaluated in two ways, namely by means of a mixture of two Gaussian densities and a Markov-switching model. When associated to cointegration, this investment algorithm gives a larger Sharpe ratio with respect to classical methods

Relative value trading was developed during the mid-1980s by a team led by Nunzio Tartaglia (Gatev et al, 2006). The idea prescribes to short the overpriced asset and buy the undervalued one when they diverge, counting on a long-run equilibrium and a future convergence of the two assets.

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