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.
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 commodity markets, which have relatively high price volatility.
Given the unique characteristics of 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.
Types of commodity trading strategies
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 that 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.
Tip: Multi-year price trends in commodities are common. Trend-following trading strategies in commodity futures can help to capture these moves.
Spread trading strategy
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 that experience extreme price swings, such as commodities, will eventually return to price levels in line with the “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.
Selecting a successful commodity trading strategy
The process of finding the perfect commodity trading strategy starts with defining your personal investment aims. Consider your risk profile and be realistic about your investment time horizon.
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.
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 and 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.
Tip: The eToro Academy is a great place to learn more about why and how to invest in commodities.
Commodity hedging strategies
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 which 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 continued 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 transport 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.
Tip: Gold is often purchased by investors as a hedge against both inflation and geopolitical risk.
Final thoughts
There are a range of commodity trading strategies available to those interested in the commodities market. The versatility of price movements can help to 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 trading and investing in commodities.
Quiz
FAQs
- How can I test a new commodity trading strategy?
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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?
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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?
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Paradigm shifts occur when fundamental aspects of the economy or financial markets are altered. The changes in the investment environment can cause trends to end and prices to pivot in another direction, often for a significant amount of time.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.