Trend Following With Commodities: How To Implement A Classic Trading Strategy

In 2008, as the financial world burned down around us, and panic had well and truly set in, one group wasn’t panicking. The trend followers were making a killing.

While everyone else was losing their shirts, commodity trend followers raked in outsized returns by riding the trends in agricultural commodities, oil, metals, and stock indices.

It was my first real-world lesson in the power of trend following. Not from a textbook, not from a YouTube guru, but from watching actual trading accounts during a genuine crisis.

Since then, trend following returns on commodities have been somewhat cyclical and less impressive than back in the day. But it’s still worth considering as a strategy.

The returns to trend following tend to look different to most other strategies you’ll trade. Most strategies tend to make a little money most of the time, and lose a lot of money occasionally.

Trend following is the opposite.

It tends to lose money most days, and then occasionally make outsized returns.

And that tends to be harder psychologically, it makes trend following a genuine diversifier.

It’s also one of the few trading approaches with centuries of empirical evidence behind it. And it has worked particularly well in commodities, at least in the past.

Why Commodities Trend

The reason commodity trends persist isn’t magic. It’s structural.

Think about who trades commodity futures. You’ve got farmers hedging next season’s corn crop. Oil producers locking in prices for future production. Metal miners protecting against price drops.

These commercial hedgers aren’t trying to maximize profits from price movements. They’re trying to reduce uncertainty. And they’ll accept below-fair-value prices to do it.

This creates persistent order flow that pushes prices away from equilibrium.

Let me make this concrete: imagine you’re a natural gas storage operator. Every year, you need to hedge your inventory during certain seasonal cycles. You don’t care if you’re getting the absolute best price – you care about managing risk.

When dozens of storage operators all hedge at similar times, that creates a predictable pressure on prices. And that pressure creates trends.

Add in the fact that humans are slow to react to new information (underreaction) and then tend to overdo it once they finally catch on (overreaction), and you’ve got a recipe for persistent price movements.

These aren’t just theories. Research across more than 100 years of commodity data shows these effects in action. That’s not a typo – 100 years. We’re talking about effects that have persisted through world wars, depressions, technological revolutions, and everything in between.

Isn’t Trend Following Dead?

I’ve heard this a few times now. “Trend following is dead.” “The strategy doesn’t work anymore.” “Too many people are doing it now.”

That’s not entirely wrong, but it’s not really correct either.

What seems to be happening is that trend following tends to work in cycles. The 1980s were a golden age for commodity trend followers, with some CTAs (Commodity Trading Advisors) posting 30%+ annual returns.

Returns moderated in the 1990s and 2000s as more players entered the space and markets evolved. But the strategy didn’t die.

And during crisis periods? Trend following kept doing what it’s always done – delivering when you need it most.

During the 2008 financial crisis, trend followers gained 40%+ by shorting equities and going long volatility futures.

The strategy tends to be very noisy – there’s a lot of variance in returns. And there’s some evidence that in recent decades, trend following returns have been diminishing.

But just when you thought it was dead in the water, it delivered significant outperformance in 2022 – a year in which stocks and bonds both lost money.

While trend following returns had been low for years prior, the strategy delivered right when you needed it most.

If you’re expecting consistent month-to-month profitability, you’re going to be disappointed. Trend following is a strategy of patience, losing small most of the time, then making it all back (and then some) when significant trends emerge.

How to Actually Trade Commodity Trends

Let’s get practical. How do you actually implement this stuff?

There are three main approaches to trend following:

1. Price Breakout Systems

This is the OG approach. You enter when price breaks out of some range, and exit when it reverses beyond a threshold.

A classic setup is entering long when price breaks above the 20-day high, and exiting when it drops below the 10-day low. Fifty years of backtesting shows this simple approach delivered high returns on a diversified basket of commodities.

This was one of the first strategies I ever tried.

These days, I’d do it a bit differently – perhaps scaling an allocation based on the number of days since the 20-day high, scaling my position sizes with the volatility of each asset.

2. Moving Average Crossovers

Another classic is the moving average crossover.

A typical setup goes long when the 50-day moving average crosses above the 200-day moving average, and reverses when it crosses back below.

A smart way to approach this strategy is to spread your risk out across many different parameter values rather than just betting the farm on a single set of numbers (there’s nothing special about the 50-200 specification that gets a lot of attention).

3. Risk Management Architecture

This is what separates the pros from the amateurs. Proper risk management means:

• Volatility targeting: Adjusting positions inversely to market turbulence. When natural gas goes nuts around storage reports, you should have smaller positions.
• Correlation weighting: Allocating less capital to markets that move together. If you’re long crude oil and heating oil, you’re essentially doubling up on the same bet.

Notice that neither of these approaches involves predicting the future. You’re not trying to forecast where oil prices will be in six months. You’re simply reacting to what’s already happening in the market.

Trading Commodity Trends with a Small Account

“This all sounds great, Kris, but I don’t have $500,000 to trade futures contracts with.”

I hear you. But you don’t need that much.

Micro futures contracts have made commodity trading accessible to retail traders. These contracts are 1/10th the size of standard futures, with margin requirements often under $1,000.

The downside is that these tend to be illiquid. So you need to be careful.

For a trader with a $50K account, here’s how you might approach it:

1. Choose the right broker. Look for one offering micro products like MGC (micro gold) and MCL (micro crude oil).
2. Start with a few liquid markets. While there’s no doubt that diversification is a massive help with trend following, don’t try to trade 20 commodities right off the bat. Pick a few liquid markets – ideally as uncorrelated as possible – like crude oil and corn to start with. Add more as you develop your operational systems.
3. Use a simple system. You can also diversify across trading signals. But keep it simple at the start. A dual moving average crossover system is a good starting point. Keep it straightforward – you can always add complexity later.
4. Position size properly. This is absolutely critical. Inverse volatility weighting is a decent, practical approach.
5. Accept the tradeoffs. With a smaller account, you can’t replicate institutional-scale diversification across 50+ markets. That’s OK. Just accept that your returns will be more variable.

The truth is, you’ll face higher costs as a retail trader. Micro contracts have wider spreads and higher fees per notional dollar. But that doesn’t mean you can’t make it work.

Just be realistic about the constraints. You’re not going to match the returns of a $10 billion CTA. But you can still implement a valid strategy that captures major trends.

If you don’t love the idea of running a diversified futures strategy yourself, and don’t mind paying the associated fees, you can also invest in ETFs that wrap commodity trend strategies, such as DBMF and CTA.

DBMF price history. Source: TradingView

Most importantly, have the right expectations.

It would be unreasonable to expect trend following to do all the heavy lifting at the portfolio level. It’s more sensible to view trend following as a diversifier that won’t make money most of the time.

The Psychology of Trend Following

Here’s the real challenge: trend following is psychologically brutal.

You need to accept that you’ll be wrong more often than you’re right. Expect win rates below 40%. That means you lose money most days.

You’ll also face lengthy drawdowns. Like, multiple-year drawdowns.

Can you stick with a strategy that loses money for 4 years straight? Most can’t.

It’s the trading equivalent of venture capital – most investments fail, but the few that succeed more than make up for the losses.

The reality is that no one can predict when a market is going to start trending. So trend-followers just get themselves into roughly the right position in as many different ways as possible and lie in wait for things to happen. It’s extremely unglamorous.

If you think it would be too much for you, you don’t have to do it. There are other ways to diversify your portfolio risk – each with its own set of trade-offs. For example, paying up to buy index puts, which you expect to have negative expected value in the long run, but are extremely valuable when you need them most.

The only wrong way to approach it is to expect some sort of free lunch.

Why Trend Following Still Matters

Despite the challenges, trend following has unique properties that make it worth considering:

Return profile

Trend following tends to look different to most things you’ll trade.

Most of the edges out there tend to make a little money most of the time and lose a lot of money occasionally.

For most people, that’s emotionally attractive on a day-to-day basis.

Trend following is the exact opposite. It tends to lose money most days, but then makes outsized returns occasionally.

The fact that it’s so different to everything else makes it a genuinely useful diversifier.

Here’s an example from my own trading. The chart below shows the returns to a typical long-short quant equity strategy that I currently trade:

The quant factor grind. Source: Robot Wealth

It has a lovely return profile – it makes a little money most of the time.

But it looks a lot like most of the stuff I trade.

On the other hand, here’s a diversified trend strategy that I also trade:

The chaos of trend following. Source: Robot Wealth

You can see that it looks completely different.

It loses a little money most days, and then occasionally just rips.

The fact that it’s so different to everything else in my portfolio makes it an incredibly valuable addition. When you combine these things at the portfolio level, the whole is greater than the sum of the parts.

Inflation Protection

When inflation spikes, trend following has historically outperformed static commodity baskets by a wide margin. Why? Because it dynamically rotates into the markets showing momentum, which has historically tended to persist when inflation is high.

This was behind the outsized returns to trend following in 2022.

Crisis Alpha

Even more valuable is trend following’s performance during market crashes. Commodity trend returns show near-zero correlation to equities during major downturns.

During the 2008 financial crisis, many CTAs gained 18% while global equities fell 40%. Although it must be said that in subsequent crises, trend following didn’t do nearly as well.

Evolving Opportunities

Markets evolve, and as they mature, they tend to show weaker trend effects. But new or immature markets tend to be more amenable to trend following.

Examples include EU carbon futures, regional power markets, and crypto futures.

Getting Started: A Practical Plan

If you’re intrigued enough to give this a shot, here’s a simple plan to get started:

1. Set the right expectations. Seriously. Spend some time doing simple data analysis that shows you what to expect with trend following. Get comfortable with the mechanics and the psychology.
2. Start small, but remember that diversification helps. It’s worth going easy on yourself in terms of operational complexity when you’re starting out. But remember, this is a strategy that requires many trades to play out its edge, and the more you diversify (across markets, signals, and parameters), the smoother your ride.
3. Expect pain. You will almost certainly have long periods of watching the money you put into trend following slowly evaporate. That’s normal. Plan for it mentally. Understand that trend following is not supposed to drive your entire portfolio, it’s one piece of a much bigger puzzle.
4. Focus on process. Judge yourself on how well you execute your strategy, not on short-term P&L, which is mostly random.
5. Gradually expand. As you gain experience and confidence, gradually add more markets and signals to improve diversification.

The Unromantic Truth

Trading strategies go in and out of fashion. Most show periods of outperformance and periods of underperformance. The good ones make more money than they lose in the long run.

Trend following is perhaps the poster boy for this phenomenon. It’s often frustrating, but just when you think it’s dead, it comes back to life. Often, just when you need it most.

The uncomfortable truth of trend following is that you almost certainly can’t predict when a trend will start. So instead, you position yourself in the right places, across many markets and methods, and wait.

This patience comes at a cost.

You bleed small losses most of the time, in exchange for the occasional outsized gain when the trend takes off.

It doesn’t promise overnight riches. It doesn’t claim to be a crystal ball. It simply acknowledges that markets trend sometimes, and when they do, there’s money to be made by following along.

Don’t rely on trend following for your entire portfolio. But it’s worth considering as a useful part of the whole.