Commodity Trading Strategy — What Is It? (Backtest And Example)
Last Updated on April 18, 2023
Commodity trading offers plenty of opportunities to profit from the price movements of various commodities. But to succeed, you must first understand what it is and the strategies to use. It’s not easy developing a commodity trading strategy.
Commodity trading involves buying and selling various commodities and their derivatives products either to make profits or to hedge risks. Commodity trading works in the same way as speculating on any other market, in that buyers and sellers come together to exchange goods. In this article, we look at a commodity trading strategy (strategies).
Do you want to know more about commodities? Let’s dive in.
What is a commodity in trading?
A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Often, it is a naturally occurring material, such as oil, sugar, and precious metal, which is collected and processed for use in human activity. Commodities form the basis of our economy since those raw materials are needed for the production of food, energy, and clothing.
Commodity trading exchanges
In trading, commodities are regarded as a class of assets, which are bought and sold on exchanges, just like stocks. Well-known exchanges include the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), ICE, and London Metal Exchange (LME), which are the primary commodity markets. These commodity markets allow producers and consumers of commodity products to gain access to them in a centralized and liquid marketplace. They ensure that the commodities are standardized for quality and quantity so they’re priced the same regardless of who produced them.
Commodities are mainly traded via futures contracts. Both futures and forward contracts originate from the commodity market (several hundreds years ago).
In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders, but with the advent of the internet and online brokers, there are more options for participating in the commodity markets. And there are different motives for playing in the commodity market. Stakeholders in various industries, including governments, trade commodities to hedge future consumption or production, while speculators, investors, and arbitrageurs participate in the markets to make profits.
Furthermore, certain commodities, such as precious metals, have been thought of to be a good hedge against inflation, and a broad set of commodities as an alternative asset class can help diversify a portfolio. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
Commodity trading has been around for a long time, even from the dawn of human civilization. Tribal clans and kingdoms would trade with one another for food, supplies, and other items. The rise of mighty ancient empires such as the Greece and Rome empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities across continents through routes like the famous Silk Road that linked Europe to Asia.
What are the 6 category types of commodities?
Commodities are usually divided into three main categories: agricultural, energy, and metals. Agricultural commodities can further be divided into livestock and agricultural produce, while metals can be divided into precious metals and industrial metals.
In recent times, a new category, environmental, has emerged due to the quest to reduce environmental pollution and curb climate change. Furthermore, some people, including U.S. regulators, consider cryptocurrencies to be commodities.
So, the 7 categories we will discuss are as following:
- Energy: Energy commodities include crude oil used in transportation activities and production of plastics, natural gas used for electricity generation, and gasoline, which powers light-duty trucks and cars. Energy commodities have the biggest impact on our daily lives, as energy prices affect the cost of virtually everything we consume including our groceries, the clothes we wear, the electronic devices we use, and the heating/cooling of our homes and offices.
- Precious metals: These include gold, silver, palladium, and platinum. They are rare, naturally occurring metallic elements with high economic value and are unusual in that they are both industrial elements and trades. They are used in making jewelry, ornaments, coins, and many more.
- Base or industrial metals: These include copper, aluminum, iron ore, steel, zinc, and others. These metals are widely used in commercial and industrial applications. Their physical properties make them ideal raw materials for building and manufacturing many essential items we use in our daily lives, such as bridges, homes, office buildings, railroads, and airports.
- Agricultural produce: Agricultural produce include rice, coffee, sugar, soybeans, wheat, and corn – an important source of food for livestock and humans. They are used to make bread, beverages, and so on. There are also cotton, which is used to manufacture clothes, as well as lumber and rubber for furniture and latex respectively.
- Livestock: These include live cattle, feeder cattle, pork belly, and lean hogs, which are sources of meat and dairy for humans. There is also wool from sheep, which provides the fabric for the clothing industry and lanolin for skin- and hair-care products.
- Environmental: This is a new class of commodities that take the form of non-tangible energy credits, the value of which derives from the needs of market participants to produce and consume cleaner forms of energy. The markets for these products came about because of governments’ restrictions on greenhouse gas emissions (GHGs).
- Cryptocurrencies: These are digital currencies, such as Bitcoin, Ethereum, Solana, and so on. They are created using digital cryptography to process transactions in a decentralized manner — that is, outside the control of banks and governments.
What are the 10 most traded commodities?
The top ten most traded commodities in the world are:
- Brent crude oil: This is one of the two major types of oil used to benchmark global prices, along with West Texas Intermediate (WTI). Brent crude is a high-quality ‘sweet light’ oil, meaning it has a low sulfur content, and thus, is relatively easy to refine into gasoline and other products. It is mostly gotten from the North Sea and Nigeria.
- WTI crude oil: This is another high-quality sweet light oil. It has lower sulfur content than Brent crude. WTI oil is drilled in various US states, especially Texas, Louisiana, and North Dakota.
- Steel: It is an alloy of iron and carbon but may include other elements such as manganese, chromium, nickel, and tungsten. Steel is an important commodity because it is extremely strong and relatively low cost. It is used in construction, infrastructure, and manufacturing.
- Gold: This is a precious metal that is primarily used for jewelry production due to its shiny beautiful color. It is also used as an asset for investment because it is seen as a store of value.
- Silver: As with gold, silver is a precious metal that has been highly sought after for thousands of years. A large proportion of demand for silver is driven by jewelers and investors. But a huge part of the demand can also be attributed to its industrial uses in making solar panels, photographic films, and electrical contacts.
- Corn: Also known as maize, corn is an important agricultural commodity that provides food for both humans and animals. It is used primarily to produce animal feed, ethanol, corn syrup, and starch.
- Soybeans: Also known as soyabeans, they are an important agricultural commodity that is rich in protein and relatively cheap to produce. Soybeans are used to make a variety of food and agricultural products, including soybean meal (animal feed) and soybean oil. They are also used as meat and dairy substitutes such as tofu and soy milk.
- Copper: It is an important industrial metal given that it is an exceptionally good conductor of both heat and electricity, as well as being corrosion resistant and weatherproof, it is primarily used to manufacture electrical wire, pipes, roof tiles, and industrial machinery.
- Aluminum: This base metal is exceptionally light and corrosion resistant. It is often combined with other elements to form alloys that are used in the production of vehicles and planes, packaging materials, and tools for construction.
- Iron ores: These are the rocks and minerals from which iron can be extracted. While the vast majority of iron ores are used to produce pig iron, which is used in steel production, extracted iron is also used to produce cast iron, magnets, and catalysts for various industrial and chemical uses.
How can you trade commodities?
There are different ways you can trade commodities, depending on whether you want to take delivery of the asset or not. They include the following:
- Spot trading: Here, the commodities can be delivered to their owners after purchase. But for gold, some vendors also offer custodial services, such that a buyer may own the physical product (bullion) without taking delivery of it.
- Commodity futures: Futures contracts are agreements to purchase a set amount of a commodity at a time in the future. They are normally traded on the futures market before the purchase date and you can choose not to make/take delivery of the asset.
- Options on futures: These are contracts that allow you to speculate on futures using less money, but you must know what you’re doing to avoid holding worthless contracts after expiry.
- CFDs: CFDs or contracts for difference allow traders to speculate on the price of commodities without owning them. A CFD is a contract to exchange the difference in price between the time the trade is entered and exited.
- Stocks: Stocks of companies that are involved in the mining or production of commodities offer an indirect way of trading the commodity market.
- ETFs: You can also gain exposure to the commodity market through ETFs (exchange-traded funds) that invest in physical assets, commodity futures, options on futures, or shares of companies that mine or produce commodities.
Let’s go on to backtest commodity trading strategies:
Commodity Trading Strategy
Let’s make one thing clear from the start: we have been trading and backtesting for over 20 years, and our conclusion is that commodities are very hard to trade. Part of this is explained in this chart that shows the DBC commodity index from 2006:
Since 2006 the index has risen only 11%! There is no long-term tailwind as you have in stocks.
What is DBC? The ETF with the ticker code DBC tracks Brent crude oil, WTI crude oil, heating oil, gasoline, natural gas, gold, silver, aluminum, zinc, copper grade A, corn, wheat, soybeans, and sugar. Thus, it’s a benchmark of the commodities market.
Compare the performance of commodities (DBC) to those of stocks (S&P 500):
Commodities have hardy had any gains since 2006 (and still negative since the top in early 2008), while stocks have multiplied.
The reason is that commodities are not productive assets. Yes, they are used in everyday life, but on their own doesn’t produce any tangible value.
Stocks, on the other hand, produce economic value and you can benefit from productivity gains (thus increased living standards) and be protected from inflation (in the long run).
Commodity Trading Strategy no 1
Let’s start with a backtest that looks at the overnight edge: we buy the close and sell the open the next day in the ETF with the ticker code DBC. The equity curve looks like this:
Just as in the stock market, all the gains have come from the overnight edge and not when the stock exchange is open. That said, the average gain is a tiny 0.02% per day, less than half what you see in the stock market. We trade many different trading rules to increase the gains, thus increasing the chances of curve fitting, but it’s tough to find a real trading edge in commodities.
Commodity Trading Strategy no 2
Let’s backtest the simplest trend following strategy there is: the 200-day moving average strategy. We buy at the close when the close crosses above the 200-day moving average, and we sell at the close when the closes crosses below the 200-day moving average (a long strategy).
This is how the equity curve looks like:
The CAGR (annual return) is a moderate 3.3%, but still substantially higher than the buy and hold of 0.7%.
We did a strategy optimization for the moving average strategy, and the longer the average the better it performs. However, we can clearly see that’s this is not a tradeable strategy.
Does it get any better if we add short trades? Let’s run the 200-day moving average by flipping the rules (we are invested 100% of the time either long or short):
As you can see, the trading strategy improves. The CAGR jumps to 8.2% and the profit factor is 2.3. Trading the short side adds a lot of value by smoothing the returns and lowering the drawdowns.
We would say the strategy is hard to trade on its own but might work better in a portfolio of trading strategies. The most important thing in trading is to have many strategies that complement each other. If you have a loss in one strategy you hopefully have a gain in another one!
- What does correlation mean in trading? (Trading strategies and correlations)
- Uncorrelated assets and strategies – benefits and advantages (examples and backtests)
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies (including two strategies)
Commodity Trading Strategy no 3
Let’s look at the turtle trading strategy. The strategy (strategies) is built on the famous turtle experiment conducted in the 1980s by Richard Dennis and William Eckhardt. Dennis said trading can be taught, while Eckhardt thought it couldn’t. Dennis won the bet.
A group of random people was taught about trading and strategies for two weeks before they were given real money to trade. We won’t go into details about the strategies in this article, but instead, refer to what we have written about turtle trading strategies.
Commodity trading strategy – ending remarks
The commodity market is huge and is very influenced by macro factors and the overall economy. There are many different players in commodities: speculators, local traders, producers, sellers, arbitrageurs, hedgers, etc. One group is missing, though: long-term investors. There are many investors in productive stocks, but very few invest for the long term in commodities. Because of this, the commodity market is very different from the stock market and in our opinion makes commodities hard to trade.
Our experience tells us that any commodity trading strategy is more likely to become unprofitable compared to a stock trading strategy. We trade silver, gold, oil, and natural gas, but many strategies tend to fail after a few years.