Developing a Commodity Trading Strategy: A Beginner’s Guide
Commodity trading is one of the oldest and most straightforward types of trade in the world. Practiced for centuries, trading commodities is as simple as standing up in front of a crowd with your latest crop, raw material, or asset and exchanging it for another good or money. Modern commodities traders follow these same principles, substituting face-to-face interaction and physical commodities for commodity-backed assets and digital exchanges.
Very little has really changed.
Commodities as an asset class include a range of physical goods and raw materials that power the global economy. There are many different commodities, ranging from bullion to brent oil. Commodities include precious metals such as palladium, gold, platinum, and silver, as well as industrial metals like zinc, iron ore, and aluminum. Livestock such as hogs and cattle are considered agricultural commodities. Soft commodities include perishable items such as grains, soybeans, wheat, and more. Finally, the energy commodities market includes natural gas, crude oil, natural resources, and coal. The Chicago Mercantile Exchange has historically been one of the largest and most active commodities trading marketplaces globally.
For a primer on commodities, check out Commodities Explained.
The prices of commodities are based on supply and demand in their associated industries, and the equilibrium between those two forces is constantly shifting due to changes in the global economy. Commodity traders, then, play the changes in these prices over the long-term and short-term, in order to extract profit from other speculators. The goal of commodity trading is two-fold: first, generate returns, and second, use commodities as a diversifier for stock and bond portfolios. Investors can use commodity ETFs, commodity stocks, commodity futures, and other investment vehicles to implement trading strategies.
What is Commodity Trading?
Commodity trading involves the exchange of commodities and commodity-backed assets, most frequently futures contracts, based on the price of a physical commodity. In the purchase or sale of a futures contract, for instance, investors are "betting" on the expected future value of a commodity. For example, if it is believed the price of crude oil will increase, investors will either go long or buy those futures to take advantage of higher prices in the future. If it is believed the commodity price will decrease, investors will either go short or sell those futures. Profits are made when these pricing trends work out in favor of the trader.
Commodity trading began before the evolution of modern financial markets and can be traced back to the development of ancient trade routes for goods. Over the years trading in commodities has become more complex, but also more accessible. Today, commodity traders can employ many different strategies on several exchanges as they look for an edge in the market. The method an individual investor chooses will be determined by their investment goals and risk tolerance.
It is interesting to note that two successful hedge fund founders, Jim Simons and Ray Dalio, both got their starts trading commodities. Perhaps there is something about the commodities market that draws strong “systems thinkers”.
Implementing Commodity Trading Strategies
Investors can choose to outsource commodity trading or build their own strategies. For some investors, outsourcing trading is simply a strategic extension of how they invest. For others, outsourcing helps reduce brokerage costs and complexity and allows them to focus on the investment strategies where they believe they can add the most value. Investors that prefer to have control over their portfolio or believe they have an effective trading strategy may choose to build their own investment approach. In all cases, commodity investing should fit your specific needs.
Work With a Commodity Trend Advisor
A Commodity Trend Advisor (CTA) is also known as a commodity trading advisor. This is a regulatory term in the United States for any individual or entity that provides investment advice and services regarding the value or advisability of commodity trading. In this context, trading refers to the exchange of futures contracts, retail off-exchange foreign exchange contracts, retail off-exchange foreign exchange swaps, or options on futures. Significant leverage is used for this type of investing, which means trading is more complex. Investors should also be careful about the brokerage charges and potential fees related to new trading accounts. CTAs often utilize trend-following strategies to capitalize on price movements within asset prices. Investors looking to completely outsource commodity trading may want to consider using a CTA.
Build a Portfolio of Actively Managed Mutual Funds and ETFs
Actively managed mutual funds and ETFs involve a professional portfolio manager or team of managers to determine the best investments to include in a portfolio. This tactic assists in ensuring that your portfolio is diversified and adaptive. By outsourcing the investment specifics and back-office work to these managers, a commodity trader can quickly build a portfolio of managed assets to meet the needs of their portfolio without having to spend extra time on day-to-day management.
One example of an actively managed commodities fund is the Harbor Capital Partners All-Weather Inflation Focus ETF (HGER), which “targets liquid and inflation-sensitive commodities, accounts for the multiple forms of inflation, addresses the impact of futures roll yields,” and eliminates the need for K-1 tax filing, offering traders an all-in-one solution for an inflation hedged commodity investment strategy.
Go Passive with Index ETFs
Active management isn’t required when building a commodity trading strategy. Passive, index exchange-traded funds can work in this application as well. As their name implies, index ETFs track a commodity benchmark — say, the price of gold, or a collection of oil futures — with the goal of matching the index overall. Like index funds, they include a “basket” of assets and can offer investors diversification benefits compared to trading futures manually through a brokerage.
Examples of commodity ETFs that are popular among commodity traders include Invesco’s DB Commodity Index Tracking Fund (DBC), which tracks the DBIQ Optimum Yield Diversified Commodity Index Excess Return and the firm’s Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC), which follows a similar index and eliminates the K-1 tax reporting for investors. Investors can choose to buy-and-hold these index ETFs or use them as part of a trading strategy.
Building a Unique Commodity Trading Strategy
While the above options are popular among new commodity investors, some experienced traders prefer to maintain more control over the process by building and managing their own trading strategies. That way, they can define exactly what they want to accomplish when they start trading, whether targeting fluctuations in spot prices, or looking for diversifying strategies to complement their existing portfolios.
The first step is determining your investable universe. Do you want to trade a single commodity or a basket of commodities? Both approaches have merit, it just depends on how targeted you want your trade to be.
Single Commodity Strategies: A single commodity strategy involves focusing on one specific underlying commodity. Having one particular commodity in the portfolio brings with it the risk of high volatility, but also the possibility of high returns. This is a high-risk, high-return strategy. One example that is focused on a single commodity is captured by the Invesco DB Oil Fund (DBO), an ETF that tracks the DBIQ Optimum Yield Crude Oil Index Excess Return.
Multiple Commodities Strategies: On the flip side, some traders prefer to look at a basket of related commodities rather than focusing on just one at a time. Thematic relatives — such as precious metals or energy commodities — often move as a group, enabling traders to create strategies that are diversified across an industry or investment vertical for better risk management, as in commodity momentum trades. While building a multiple commodities strategy, investors should look at the entire investable universe they are targeting and consider which commodities will provide diversification to their portfolio. They should also look for correlations between assets, look at historical performance and consider how a particular commodity has responded during inflationary periods. Remember, several types of commodities typically perform well as a hedge against inflation, and help guard against market volatility.
Commodity Momentum: Momentum trades involve following the price trends in an asset class, buying into the commodities that are performing well, and selling those that are starting to decline. Commodity momentum trades must be based on careful research so that the trader can accurately identify those assets on the way up and set expectations for when they will exit the trade.
Commodity Trend Following: Like momentum trades, commodity trend following strategies involve trading in and out of assets based on broader market trends. In this case, traders invest in those commodities that are on an uptrend and move to short-term treasuries, cash, or short positions when the targeted assets are not trending positively. The trader uses technical analysis to identify these trends and set the guardrails for their trade.
Commodity Trading with Composer
Research and analysis are critical when creating a commodity trading strategy — the trader needs to determine which assets offer true diversification, consider correlations to the broader market, understand past performance and determine when to enter and exit a trade. The Composer app allows investors to backtest commodities to determine correlations with other asset classes and portfolios, helping to assess the level of risk in the trade as well as potential returns.
With Composer, investors can use technical analysis to trade commodities based on price and volatility trends, track real-time price movements, and access pre-made commodity strategies built by our experts. Investors can also quickly add these automated strategies to a broader portfolio, balancing commodity trading with other stock market and ETF-based strategies.
Best of all, it’s simple. Composer’s no-code visual editor and backtesting software make technical trading accessible to every trader, even those just starting out. Let your creativity run wild!
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