Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/45632 
Year of Publication: 
2011
Series/Report no.: 
KIT Working Paper Series in Economics No. 27
Publisher: 
Karlsruher Institut für Technologie (KIT), Institut für Volkswirtschaftslehre (ECON), Karlsruhe
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.
Subjects: 
futures spread trading
energy futures markets
mean-reverting process
first hitting
time probability density
profit model
WTI crude oil
heating oil
natural gas
JEL: 
C51
G29
Q40
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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