Why And How To Trade Commodities: A Complete Introduction

The pink area represents the dollar value of the stock component, the brown area represents the treasuries component, and the blue area represents the cash balance. The black line is the total value of the portfolio. 

Compare this with a portfolio that volatility targets stocks, treasuries, and gold (GLD):

The risk-adjusted returns (measured by the Sharpe ratio) of this portfolio is about 10% higher than the stock-bond version, and the average annual return is higher too – on a starting balance of $100,000, this version made about $260,000 while the stock-bond version made about $170,000. 

This is a simple example, but the power of diversification is obvious. 

The Inefficiencies That Make Commodities Interesting

Here’s where commodities get really interesting for traders like us – they’re full of market inefficiencies that we can potentially exploit.

External factors such as geopolitical events, weather, and economic conditions can create inefficiencies and drive fluctuations in the market prices of commodities.

Why? Because commodity markets have unique supply and demand characteristics that create (noisily) predictable patterns:

Seasonality

Agricultural commodities in particular show strong seasonal patterns based on crop cycles:

• Corn prices often decline during harvest (September to November) when supply floods the market
• Natural gas typically rises ahead of winter as heating demand increases
• Gasoline prices often increase before the summer driving season

These patterns aren’t foolproof (nothing in trading is), but they occur frequently enough that systematic traders can potentially build edges around them.

Storage Constraints

Unlike stocks, physical commodities need to be stored somewhere, and storage isn’t free. This is one contributor to what traders call “contango” or “backwardation” in futures markets:

• Contango: Future prices are higher than spot prices (normal for storable commodities)
• Backwardation: Future prices are lower than spot prices (often indicates physical shortages)
  
  

These term structure patterns create opportunities for spread trades and roll yield strategies that don’t exist in equity markets.

Commercial Hedging Pressure

Remember those farmers and manufacturers I mentioned? Their hedging activities can create systematic price pressures.

For example, producers selling forward contracts to hedge their output can drive futures prices below expected future spot prices, creating an opportunity for speculators to earn a risk premium by taking the other side of the trade.

How To Get Exposure: ETFs vs. Futures vs. CFDs

So you’re sold on commodities. Now, how do you actually trade them?

To access commodities, you typically need a trading account with a broker and a trading platform that supports commodity products.

You’ve got options:

ETFs and ETNs

Examples: GLD for gold, USO for oil, CORN for corn

Commodity Futures Contracts

Contracts for Difference (CFDs)

The Dangers: Where Commodities Can Bite You

Before you rush to load up on coffee and crude oil, a few warnings are in order:

Volatility Can Be Extreme

Commodity prices can move in ways that make even crypto traders blush. The famous cases are legendary:

• In April 2020, WTI crude oil futures briefly went NEGATIVE, hitting -$37 per barrel
• Natural gas has seen enormous moves in both directions, many times.
• In 1980, silver dropped 50% in four days after the Hunt brothers’ corner of the market failed

Here’s oil futures going negative in 2020:

This volatility means that position sizing is absolutely critical. Don’t bet the farm on commodities.

Expertise Requirements

While you can trade gold with relatively little specialized knowledge, many commodity markets have quirks that can trap the unwary:

• Natural gas has complex storage dynamics
• Agricultural markets have crop reports that cause massive moves
• Oil markets respond to OPEC meetings and geopolitical events

The more specialized the commodity, the more homework you might need to do before trading it.

Remember too that specialists are trading commodity markets. These are people who literally do nothing other than use their expertise to trade a particular commodity. That suggests you probably can’t compete on knowledge asymmetry, so stick to big, obvious edges that aren’t likely to be arbitraged away.

ETF Decay

If you’re using ETFs for long-term commodity exposure, beware of contango-related decay.

Remember how when a market is in contango, futures contracts are priced higher than the spot price? This means that the ETF must periodically “roll” its expiring futures contracts into new ones at a higher price. This rolling process creates a negative roll yield, which reduces the ETF’s overall return.

Several commodity ETFs have lost 80%+ of their value over time, even when the underlying commodity didn’t decline nearly as much.

The oil ETF USO is the poster child for this problem. From 2006 to 2022, it lost almost 90% of its value due to roll costs, while actual oil prices didn’t fall nearly as much.

Check out this chart of USO returns (purple line) alongside oil futures returns (blue line):

Simple Commodity Strategies For Retail Traders

Despite these challenges, there are some straightforward approaches that retail traders can consider:

The Natural Gas Winter Play

Natural gas typically rises in the fall as heating demand approaches. A simple strategy is to buy natural gas (via the UNG ETF or futures) in late August/early September and exit by December.

This doesn’t work every year, but it’s shown a statistical edge over time that makes sense fundamentally.

Gold as a Portfolio Hedge

Allocating a small portion of your portfolio to gold (via GLD or futures) has historically provided some protection during equity market stress. It’s not a perfect hedge, but it’s one of the more reliable ones accessible to retail traders. Investors can also consider gold IRAs, which are retirement accounts that hold physical gold and offer diversification and protection against economic downturns.

Diversified Trend Following

Using simple moving average crossovers (like 50-day vs. 200-day) across a basket of commodity ETFs can provide trend exposure without requiring futures accounts. 

Why I Think Commodities Deserve A Place In Your Arsenal

If I haven’t convinced you yet, here are a few final thoughts on why commodities deserve consideration:

Inflation Protection

With inflation being more of a concern lately than it has been for decades, commodities provide one of the few reliable inflation hedges. They’re real assets whose prices typically rise with inflation.

Growing Global Demand

As developing economies grow, their demand for commodities tends to increase dramatically. China’s growth drove a commodity supercycle in the 2000s. India and other developing nations could drive similar demand in the future.

Declining Correlations With Traditional Assets

Finding truly diversifying assets is more valuable than ever. Commodities can fill that role.

They’re Just Interesting

I’m going to end on a subjective note: commodity markets are fascinating. There’s something intellectually stimulating about trading markets driven by physical supply and demand rather than just financial abstractions.

When you trade wheat, you’re participating in a market that’s existed for thousands of years. There’s a tangibility to it that, say, crypto lacks.

Getting Started

If you’ve made it this far and want to dip your toes in commodity markets, here’s an example of a simple way to start. This is not financial advice – just an example of a broadly sensible approach for a beginner. 

1. Add a small position in GLD to your portfolio
2. Track a few commodity markets for several months. Observe their price movements and volatility.
3. Consider starting with liquid markets like gold or oil before diving into softs and exotic stuff. 
4. Consider a simple trend or seasonality system rather than discretionary trading. But do your own research and make sure you understand what you’re trading. Above all, don’t try to trade these things without a solid understanding of the edge you’re harnessing.
5. Stay tuned for the next article in this series.

Commodities can provide opportunities for adding diversified return streams. But they have their own idiosyncrasies and nuances that you should consider.