STOCHASTIC LINEARIZATION FOR OIL PRODUCTS

Abstract

In the report, I try to find a better way to remove multiple factors that affect the oil price by using the ratio mean-reverting relation, and to linearize the ratio so that a trader can trade using such approach. We use the current price of the oil product, the current price of the crude, and the information regarding the parameters to find a ˜fair value™ for the crack. Such a fair value is calculated in a probabilistic manner: within certain range, we need to sell or clear our positions; outside of the certain range, we need to buy the crack immediately. Such a trading strategy is very different from the existing ˜crack™ trading: in the existing crack trading, once we buy one share of the product, we need to sell exactly one share of the crude. Because of such configuration, it will not capture the ˜ratio™ relationship among different between the crude and the product. In our linearization trading strategy, the ratio is not 1:1 (buy one product and sell one crude), we buy one product but sell some shares of the crude according to the current price of the product and the crude. Such an arrangement actually captures the essence of the product and the crude relationship.