Chapter 3-6 Commodity Trading Strategies

Once you know what time frames you wish to focus on, it’s time to decide what strategy to use as you look for setups. The best traders in the world are still just dealing with a set of probabilities within the context of a random environment. They use price patterns as a way to filter out price action to identify when the odds are stacked the highest in their favor.  Each time two market participants come together and do business, that transaction is recorded. This print can be seen on the time and sales window your charting provider offers. This so-called tape is the foundation for every price and volume chart. The chart simply displays graphically what extremes in price were printed during a specific period of time. By learning to interpret this information, you can glean a great deal of information about who is operating in that market, and in which direction the underlying supply-demand balance leans.  There is almost an infinite amount of commodity trading strategies that traders can use. Commodity traders will normally design a trading plan with a strategy that suits their risk tolerance, comfort levels, knowledge of the markets and various other parameters.

Basic Strategic Tenets

The most important characteristics for the speculator are discipline, patience, and objectivity. Discipline is the primary key to successful trading. You must be disciplined to follow the rules and game plan you have selected. A trader must also have patience to stick with positions as long as the market continues to move favorably. Boredom and impatience are major impediments to successful operations. Finally, all traders must know the rules: “Trade with the trend,” “Cut losses and let profits run,” and “Don’t overtrade.” Even unsuccessful traders can easily recite these basic tenets, yet most speculators end up losers because they constantly violate them. The few consistent winners, on the other hand, share a disciplined adherence to following these simple strategies.  Here are a few basic ways to trade a market.

Keeping Emotions in Check

The trader needs a good sense of emotional balance and market perspective to avoid being “seduced” by his profits or discouraged by his losses. Despite his best efforts at a disciplined and objective approach, the trader will encounter bad periods where nearly every trade goes sour. It is only human to become discouraged, but the trader must redouble his efforts to trade “by the rules” because the way to make losses back, with interest, is by following these rules.

We’ve all heard the old saying: When the going gets tough, the tough get going. In futures, the true test of a trader’s ability is in how he handles the losses and the bad times. Sometimes, after a series of losing trades, the trader should close out completely and get out of the market. Then, when he has cleared his head, has a positive attitude, and has reconfirmed his strategy, he can reenter the market.

One reason paper trading invariably outperforms real trading is that, with paper trading, there is only the desire to win with real trading, although there is still the desire to win, the fear of losing often becomes dominant. This is the major reason to avoid overtrading or over positioning.

The trader’s worst enemy is himself and his emotions, as he invariably reverses the basic emotions of hope and fear. Here is how it works. A trader buys corn at 2.45, and it quickly advances to 2.53, a profit of $400 per contract. He

fears that he will lose his profit, so he liquidates his position. On the other hand, if his 2.45 long position declines to 2.37 for a loss of $400, he starts to hope that his losing position will turn around, and he holds on to the position. This is the perfect example of reversing hope and fear.

What he should do is hold his profitable position, hoping that the market will continue to move favorably and his $400 profit will increase. On the other hand, he should liquidate his losing position, fearing that the market will continue south, and his $400 loss will increase.

Trend Following

The investors who make money on a reasonably consistent basis are the longer-term position traders who have learned how to combine trend following with viable strategy and money management.  Instead of trying to pick off tops and bottoms and scalping for small countertrend moves, they concentrate on trying to identify major price trends and trading in the direction of those major moves.

“Trend following” is a commodity trading strategy that most professional traders use and recommend. The theory is that prices that are in a trend have a higher probability of continuing in that direction. Therefore, the odds should be in your favor by taking trades in the direction of the trend.  The first is to identify and follow the trend. Markets tend to trend strongly, then move into a period of choppy congestion before the trend resumes. A trend follower tries to capture these price thrusts. She hopes that by capturing the sharp trend moves, she can make enough money to sustain her during the periods where the market stops trending and just chops. A trend follower makes her money when the markets are moving, and loses or treads water when the markets are basing. Trend followers try to get positioned in the line of least resistance, and grind out profits as they wait to score a home run once in a while as a strong trend moves in their favor.

To follow major trends, you should use-in addition to daily price charts-long-term (weekly and monthly) charts. These show more clearly the long-term trends and support and resistance levels, and they provide a good overall perspective of price action.

It is not sufficient to accurately identify a market trend.  One must also implement a viable strategy to capitalize on the trend, in order to maximize profits on winning positions and minimize losses on adverse positions. The best approach is a combination of first-class technique and a viable money management (strategic) approach.

Perhaps the greatest lone-wolf speculator of this century, Jesse Livermore said, “Big money is made by sitting, not trading.”  Knowing how and when to “sit” with a winning position and when to pyramid onto that position, while patiently avoiding excessive trades, is one of the trader’s most difficult tasks. Here is another Livermore quote: “You always find lots of early bulls in bull markets, and lots of early bears in bear markets, yet they make no real money out of it. People who can both be right and sit tight-they make the big money.” Speculators are invariably trying to sell rallies in bull markets and to buy reactions in bear markets-and losing money on most trades.

A preferred strategy is to trade in the direction of the major trend and against the minor trend. In a major uptrend, buy on minor trend reactions into support, or on a 40-60 percent reaction from any trading high, or on the third to fifth down-day of the reaction. In a major downtrend, sell on minor trend rallies into overhead resistance, or on a 40-60 percent rally from any trading low, or on the third to fifth up-day of the rally. (Note: A 50 percent retracement move represents classical technical analysis; 38 percent and 62 percent represent so-called Fibonacci retracements. These three retracements are worth close scrutiny, as they frequently delineate, and help project, tops and bottoms within trending moves.)

Analyze your markets and develop your tactics and strategies in advance and in privacy. Don’t ask anyone’s advice and don’t offer advice to others. Stick with your objective, disciplined analysis, and make revisions to your strategy only on the basis of pragmatic and objective analysis. Avoid giving or taking tips or market gossip. “Those who tell, don’t know; those who know, don’t tell.”

Aside from short-term swings that professionals consider to be “market noise” dominated by scalpers, prices tend to move in the direction of the dominant force, which is along the path of least resistance. Furthermore, once a major trend starts to develop, it picks up momentum and accelerates along the trend direction.

In a major bull market, as the advance develops, the buying power of the longs, plus the shorts who are covering their losing positions, tends to overpower the sell orders in the market. Likewise, in a major bear market, as the decline develops, the selling power of the shorts, plus the longs who are abandoning their losing positions, tends to overpower the buy orders in the market.

In a bear market, the longer the main bulls cling to their precarious long positions, the harder and farther the market is likely to ultimately fall. The experienced, well-financed professional operators will be in there pressing the market every time it appears vulnerable, or when they sense a buildup of sell stops underneath the market. The same reasoning applies to major bull markets.

Livermore said, “There is only one side of the market, and it is not the bull side or the bear side, but the right side.” Follow the real trend of the market; don’t permit your market opinion, or your position, which may be against the trend, to influence you to maintain a losing, against-the-trend position. A good maxim to follow is, “The trend is your friend.” Remember this when you want to take an against-the-trend position.

Most speculators have a definite bias to the long side of the market. Even when dealing in an obvious bear market, the trader will invariably be long, or be looking for a spot to buy. Instead, he should be short and looking for a spot to sell. The trend of the market should determine your position, not vice versa.

When you put on a position, there is no way to predict how far the move will carry. Therefore, you should follow the premise that each of your positions can result in a “mega-move” (moves of at least $6,000 per contract). This attitude will help you avoid any temptation (and there will be many) to capture small scalping profits. There is another old

saying, “No one ever goes broke taking profits.” That is true, but my response would be, “No one ever gets rich taking small profits.” You should try to hold out for the major move, and let your stop orders, which you can set to follow behind the major price move, get you out of the market.

A margin call is a clear signal that your position has gone too far against you. Do not add funds to meet a margin call, as this could be throwing good money after bad. You would be better advised to liquidate all or a portion of your position rather than meet the call. Which positions should be liquidated? Sound strategy suggests that you should keep the best-acting positions and dump the worst-acting ones. Say you are sitting with six positions and you have a profit on four and a loss on two. Close out the two with losses. There is no valid strategy in defending losing positions-better to dump losers and add to the profitable positions.

An extension of the strategy to hold the profitable positions and dump the losers is to buy the strength and sell the weakness.  What this means is, when you are putting on a long position, you buy the relatively strongest month; when you are putting on a short, sell the relatively weakest month. For example, if you are going long in an inverted market, you look to buy the front end that is selling at the premium and is the strongest month on the board; if you are going short in an inverted market, you look to sell the back end that is selling at the discount and is the weakest month on the board. In summary, you want to be long the front end and short the back end of an inverted market.

Market Fader

The second way to trade is to fade the market. These traders are banking on the fact that markets spend much of their time basing, as they build strength for the next trading phase. This is a grinding style and there are few home runs; they trade instead for many small gains. A trending market is a losing environment for a fader; instead they thrive in the basing chop that a trend leaves behind. A fader tries to get positioned against an exhausted trend in order to capture the moves caused by the trend followers as they take profits and execute stops.  Every time frame, style, setup, and strategy that you are familiar with acts as an arrow in your quiver. The successful traders that I know have built a trading style that incorporates facets of many different strategies.  They are familiar with many different strategies even if they never trade them. As a result, they gain great insight into how the different players in any given market are likely to trade, and use that knowledge to trade profitably against the majority.

Range Trading

Markets are often not in a trend, so a trend following strategy may not be as profitable under these circumstances. Range trading in commodities simply means buying near the bottom of a range (support) and selling at the top of a range (resistance).  This strategy can work very well for a long period of time, but you have to be careful when the market breaks out of its range.  Another way to look at this strategy is that one might look to buy a commodity after it has experienced a lot of selling and becomes oversold. Oppositely, one might look to sell a commodity after it has had a long rally and becomes overbought.

There are numerous indicators which measure overbought and oversold levels like RSI, Stochastics, Momentum and Rate of Change. These strategies work well when the market has no significant trend. However, a trader could have

a string of bad losses when a market forms a major trend, as markets can stay overbought or oversold for long periods of time.

Trading Breakouts

Trading breakouts in commodities means that a trader will look to buy a commodity as it makes new highs and sell a commodity as it makes new lows. New highs and lows can easily be spotted on a chart, as they are the peaks and troughs. Many professional traders use these techniques when they are managing large sums of money.

The philosophy for this strategy is simple – a market can’t continue its trend without making new highs or new lows. This strategy works best when commodities are trending strongly. It doesn’t matter whether the trend is up or down, as you are buying new highs and selling (shorting) new lows. The drawback of this strategy is that it performs very poorly when markets don’t establish strong trends.

Fundamental Trading Strategy

While trading breakouts and trading ranges usually come with specific setups for buying and selling commodities, fundamental trading leaves much more room for interpretation. For example, you might buy soybeans because the weather has been dry during the summertime and you expect a much smaller crop. Or, you expect demand to increase for crude oil from China, so you buy oil futures.

I do not recommend this type of trading for the new commodity trader, since opinions can easily be swayed the hype that is often reported in the news. Even worse, you will be left wondering where to get in and out of the trades. You can get lucky a couple of times trading off the news, but this type of trading claims a huge share of victims every year.

Swing Trading

Swing trading is typically defined as a trading practice whereby the underlying instrument is bought or sold at or near the end of an up or down price swing caused by daily or weekly price volatility. A swing trade position is typically open longer than a day, but shorter than trend-following trades or buy-and-hold investment strategies. Although a number of commodity trades that I’ve been involved in have been quick, others have lasted several months. The average duration of our commodity swing trades in 2009 has been 3-6 weeks.

Swing traders attempt to forecast changes in an instrument’s price caused by oscillations as it “swings” around the dominant trend line. The price is alternately bid up by optimism and then bid down by pessimism over a period of a few days, weeks, or months. Profits can be sought by engaging in either long or short trading at each reversal.

Identifying whether a market is currently trending higher or lower, trading sideways and when this will change, is a challenge for many swing trading and long term trend following trading strategies. A common misconception is that swing traders need perfect timing, to buy at the bottom and sell at the top of markets is impractical. Small consistent earnings that involve strict money management rules can potentially compound returns appreciably. It is crucial to understand that there are no fail-safe mathematical models that will always work so only use such parameters as research tools, also including both fundamental and technical analyses not as definitive decision engines but rather guidelines.

Risk of loss in swing trading typically increases in a trading range or sideways market as opposed to in a bull market or bear market. A market that is clearly moving in a specific direction, albeit up or down is more appropriate for swing trades. A sideways or non trending market increases the potential for whipsaws or false breakouts. In trending markets (either a bear market or a bull market), momentum may carry the traded instrument’s price for a much longer time in one direction only, making swing trading strategies that do not incorporate this trending less profitable than trend following strategies.

Handy Tips (Do/Don’t and Why)

Some general rules that are wise to abide by while swing trading are as follows:

  1. Go with the trend.
  2. When getting long buy when a market is oversold & when getting short sell when a market is overbought.
  3. A trade may have more validity if the daily, weekly and monthly charts are all saying the same thing.
  4. Have a target if the trade moves as you presume and also an exit strategy if the trade goes awry.
  5. Try to ignore the noise.
  6. Don’t forget to manage the trade

In addition to the general guidelines above, I believe implementing a specific set of trading guidelines is required to be successful. For instance, we are more likely to take a trade if both the fundamentals and technicals indicate that prices are too low or too high. However, if the fundamentals do not justify a move higher yet the prices are making fresh highs day after day and the technicals indicate there may be more upside, we would still consider taking the trade. We may simply suggest a smaller position or perhaps an option as opposed to a futures trade. There are numerous technical indicators used by traders and everyone has their favorites. The main indicators that I use for my analyses include open interest, volume, moving averages, stochastic and Fibonacci retracement levels. That is not to say we never inspect more exotic indicators such as Ichimoku clouds or the McClellan oscillators, but overanalyzing markets is often ineffective.

The goal of adhering to strict trading rules is to remove the subjective decision-making from swing trading. We suggest exercising caution when trading correlated asset classes or even when trading correlated commodities. In addition to an awareness of correlations and prudent money management, also be cognizant about the “risk to reward” dynamic when putting on your trades. A trade that requires risking $5,000 and offers a profit potential of $2,500 should not be entered.

As with all financial instruments, risk of loss trading commodity futures and options can be considerable. This risk can best be mitigated by using a trading strategy that is back tested on the particular equity, index, or commodity and continues to prove its worth with successful trades.

Swing trading should not be the only form of trading incorporated into managing one’s investment portfolio but it could serve as a valuable tool within their investment toolbox. We are convinced that in the current environment buy and hold is dead and regardless if swing trading is for you, investors will be forced to be more nimble and to be more active managing their portfolios.

To illustrate two commodities to swing trade look at the charts on corn and silver.


Since corn has bottomed out in early September with prices reaching a 3 ½ year low, MB Wealth has had a bullish bias and wants clients to be long via futures or options. After bottoming out, the price has resumed its uptrend and on a closing basis we’ve climbed higher without violating the support line over the last 3 months for any extended period. For further affirmation, once prices bounced off support, one could wait for movement above the 20 day moving average. The stochastic indicates whether the market is overbought or oversold and should be watched closely. This helps to time entry and exit and to place stops. Not only did the technicals suggest long exposure, but with wet weather, cooler temperatures and the slowest harvest in over 2 decades, the fundamentals also suggest higher prices are achievable.


Longer term charts sometimes help to confirm that it makes sense to go long or short a certain commodity. They can also help to give a trader more conviction and guide the sizing of the trade. As one can see, the $3.25 level has served as solid support for the last 3 years.


For the last 6 months the price of silver has been largely contained in a $2.00 – $3.00 trading range with a rising slope. This suggests that those with a bullish bias, including MB Wealth and their clients, should look to buy near the lower line and take profits near the upper line. Traders who do not believe that silver prices are moving higher or who want to do a counter trend trade would sell near the upper line and look to cover near the lower line. The stochastic shown at the bottom of the chart could help with entry, exit and stop placement. Finally, fundamental analysis of the historical relationship between gold and silver is also bullish for silver not to mention continued US dollar weakness and the inverse correlation.

On a longer term chart, we experienced over a 61.8% Fibonacci retracement at the end of 2008. This move lowered the price of silver to roughly to $10/ounce. For chartists, this would indicate an entry for those looking to get long.


Combine Strategies

Commodity trading strategies have their benefits and shortfalls. It is also possible to use a combination of strategies. For example, trend following strategies are dependent on having a couple of big movers each year. It is imperative that you do not miss one of these big moves.  With range trading, you can be lulled into a sense of security that the market will stay in its range. Eventually, one of the markets will break out of its range and have a big move. This is usually the situation where range traders lose big. They hold onto a position thinking the commodity market will fall back into its range and it just keeps moving against them. Or worse, they add to their positions and really make things bad.