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

Abstract

This paper 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. We 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 meanreverting 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, we 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.

Pairs‐trading and spread persistence in the European stock market

“…This is motivated from VECM dynamics as pairs‐trading profitability is directly dependent on cointegration error persistence, which is determined by the speed of mean reversion. This is consistent with the results reported by Kanamura, Rachev, and Fabozzi (), in which an empirical link between profitability and mean reversion is established for spread trading in the gas market. The relationship between the speed of adjustment and the number of participants has been empirically addressed by Brennan, Jegadeesh, and Swaminathan () in a study relating the number of informed traders, proxied by the number of analyst following a firm, with the speed of adjustment to common shocks.…”

“…The threshold is also linked to pairs‐trading profitability as underlined in Equations 10 and 11. The link between mean reversion and profitability has been discussed in the literature by Kanamura et al (), who report an empirical link between them for spread trading in the gas market.…”

Pairs Trading and Spread Persistence in the European Stock Market

“…This is motivated from VECM dynamics as pairs trading profitability is directly dependent on cointegration error persistence which is determined by the speed of mean reversion. This is consistent with the results reported by Kanamura et al (2010) where an empirical link between profitability and mean reversion is established for spread trading in the gas market.…”

Statistical Arbitrage Pairs Trading Strategies: Review and Outlook

“…Kanamura et al . () derive a profit model for spread trading based on a mean‐reverting process. They empirically apply their strategy to the energy futures market.…”

“…use a Markov switching model to develop a pairs trading framework Kanamura et al (2010). derive a profit model for spread trading based on a mean-reverting process.…”