A Profit Model for Spread Trading with an Application to Energy Futures

Abstract

This article proposes a profit model for spread trading by focusing on the stochastic movement of the price spread and its first hitting time probability density. The model is general in that it can be used for any financial instrument. The advantage of the model is that the profit from the trades can be easily calculated if the first hitting time probability density of the stochastic process is given. The authors then modify the profit model for a particular market—the energy futures market. It is shown that energy futures spreads are modeled by using a mean-reverting process. Since the first hitting time probability density of a mean-reverting process is approximately known, the profit model for energy futures price spreads is given in a computable way by using the parameters of the process. Finally, the authors provide empirical evidence for spread trades of energy futures by employing historical prices of energy futures (WTI crude oil, heating oil, and natural gas futures) traded on the New York Mercantile Exchange. The results suggest that natural gas futures trading may be more profitable than WTI crude oil and heating oil due to its high volatility in addition to its long term mean reversion, which offers supportive evidence of the model prediction.