Pairs trading: The performance of a stochastic spread model with regime switching-evidence from the S&P 500

Abstract

There remains a lack of literature on a pairs-trading model that is able to capture the mean reversion and two different states of spreads. The purpose of this study is to combine the Markov regime-switching model and the Vasicek model to implement a pairs-trading strategy that utilizes the S&P 500 stock components from January 1, 2006, through September 28, 2012. We compare our model's performance with the performance of previous methods based on a variety of portfolios and trading periods. The empirical results show that the trading rule of the Markov regime-switching model with mean reversion has the best performance with a simple portfolio. Furthermore, the results show that shorter trading periods produce better performance than longer trading periods and that the trading rule performs strongly during the global financial crisis of 2008 to 2009.