Technology for spread traders: new applications are breathing new life into grain spread trading strategies. This second of a two part series shows how to conduct objective spread analysis and how to develop mechanical systems for spread trading that can be backtested.(TECHNOLOGY & TRADING)

When trading moved into the modern age, with sophisticated trading system development software that gave individual traders the ability to test their ideas on the market without adding a professional programmer to the payroll, certain disciplines were left behind. This wasn't because these methods lacked merit, but they simply didn't easily transfer into most popular trading software.

One of those disciplines was spread trading. Spread trading offers a unique mix of low margins, pronounced trends and hidden opportunities that appeal to many traders, but because most programs don't cleanly handle spreads, on either the testing or the execution side, they have been left out of most individual traders' toolboxes.

This second of two parts on spreads will look at specific applications in spreads to demonstrate how new technologies are extending the power of computers to these time-tested markets.

ALL CRACKED UP

The crack spread displays the relationship between energy contracts traded by integrated oil companies. Crack spreads provide a natural economic hedge against adverse price movements. Given a target optimal product mix, an independent oil refiner can work to hedge itself against adverse price movements by buying oil futures and selling futures based on its primary refined products, according to the proportions of its optimal mix.

Refiners who wish to hedge their price exposure will use a crack ratio usually expressed as X:Y:Z, where X represents a number of barrels of crude oil, Y represents a number of gallons of gasoline and Z represents a number of barrels of distillate fuel oil. The only constraint is that X = Y + Z. The hedger buys X barrels of crude oil and sells Y gallon of gasoline and Z barrels of distillate in the futures market. Widely used crack spread ratios include 3:2:1, 5:3:2 and 2:1:1. The 3:2:1 crack spread is the most popular of these, and widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1" and the "Chicago 3:2:1."

Different numbers of contracts must be traded for each component of the spread. For this reason, calculating the minimum move value so …