CREATING A COMMODITIES
TRADING STRATEGY

A well-defined strategy considers the market in question as well as your investment aims and risk tolerance, while good commodity trading strategies also consider the distinct characteristics of the sector. Discover the different commodity trading strategies and how they can be implemented.

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The price of an asset needs to move for traders and investors to make a return on their capital. This is why so many turn to the commodity markets, which have relatively high price volatility. However, where there is volatility, there is also high risk.

Given the unique characteristics of the commodity markets, a wide range of different strategies can be used to capture price moves. The right strategy will ultimately come down to your personal preferences and investment aims.

How to create a commodities trading strategy

The process of creating the perfect commodity trading strategy starts with defining your personal investment aims. Consider your risk profile and be realistic about your investment time horizon. When creating a commodity trading strategy, you should also consider the distinct characteristics of the sector you’re focusing on.

It is also worth determining whether you want to be an active trader, employing day-trading strategies, or a buy-and-hold investor, adopting a more hands-off approach.

Types of commodity trading strategies

The commodity markets are known for exhibiting short-term price volatility as well as long-term price trends. These price dynamics can make them a suitable market for traders with a wide array of trading strategies. Strategies can be tailored to short- or long-term perspectives, with the former aiming to generate returns by capitalising on instances of price spikes, and the latter by seizing prolonged trends that might persist for several years.

Trend-following strategy

Commodity markets tend to be popular with traders who prefer to trade trends, because certain price movements within these markets can be very long term in nature. The term “commodity supercycle” is used to explain scenarios in which price trends last for a period ranging between five and 20 years.

Pairs trading strategy

Pairs trading, or spread trading, involves taking long and short positions on similar assets at the same time. This approach offers a certain degree of insurance against market risk — the threat of the entire commodity market rising or falling in value.

A spread trading strategy will account for the fact that prices in different commodity markets tend to move in a similar direction. Macroeconomic factors are some of the most important price drivers of raw materials, influencing aggregate demand in the global economy.

For example, if you simultaneously open a long position on wheat and a short position on soybeans, the short position could potentially offset losses from the long position if the commodity sector turned bearish. On the other hand, if the price of wheat rose by 5% and soybean prices rose by 3%, the long wheat position would post a profit and outweigh the short soybean position, resulting in an overall net profit.

Mean reversion strategy

Mean reversion strategies rely on the assumption that the assets, such as commodities, that experience extreme price swings, will eventually return to price levels in line with “normal” long-term averages.

These strategies can be used to sell short if a market spikes in value, or “buy the dip” when a market suffers a price crash.

Commodity risk management strategies

The general principles of risk management can be applied to commodity strategies, but it is important to acknowledge the heightened potential for high price volatility within these markets. To try to minimise this increased risk, consider the following:

• Spreading risk — Diversify your portfolio by buying a range of different commodities or asset types. This can spread the risk of one position or instrument incurring significant losses.
• Trading in small size — Don’t allocate more capital than you are comfortable losing to any one position.
• Expanding your knowledge — Commodities can be traded using a range of instruments such as stocks, options, futures, ETFs and CFDs. Learning how each instrument works can reduce operational risk and provide access to lower-risk avenues for exposure to the sector.  

Commodity hedging strategies

A strategy which incorporates hedging involves opening new positions with the aim of mitigating risks on other existing positions. A long position in copper, for example, can be hedged by buying put options that would generate a profit if the price of copper were to fall.

Option holders have the right to take a position in an underlying asset at a future date, but are not obligated to do so. If copper prices continue to rise, the core position posts a profit, counteracting the loss taken on the hedging trade.

Commodities can also be used to hedge other assets, such as equities. Historically, the prices of stocks and oil have been negatively correlated. If oil prices rise, corporations face higher heating, production and transportation costs, which will impact their profits. Household budgets will also become constrained, all of which is bad news for stock valuations.

When this happens, if an investor is holding substantial stock positions as well as a position in oil, the losses incurred on the stock position could be balanced out by the gains generated by the oil investment.

Final thoughts

There are a range of commodity trading strategies available to those interested in the commodities market. The nature of the price movements can accommodate a range of trading styles, and investing in different instruments within the commodities market can help to offset risk in other positions.

Visit the eToro Academy to learn more about trading and investing in commodities.

FAQs

How can I test a new commodity trading strategy?

New strategies can be tested using a demo account. Demo accounts offer a risk-free way to test an approach using live market prices. It is possible to run live and demo accounts at the same time, enabling the trial of your new strategy even as you continue to actively trade with your established approach.

How long does it take for a trading strategy to generate returns?

Some trading strategies are designed to make quick profits, while others aim to catch price moves spanning multiple years. Establishing your personal preference in light of your investment time horizon is an important first step that will help you to identify the strategy that best fits your trading approach.

What is a paradigm shift?

Paradigm shifts occur when fundamental aspects of the economy or financial markets are altered. Changes in the investment environment can cause trends to end and prices to pivot in another direction, often for a significant amount of time.