Types of Commodity Trading Strategies
Commodity trading strategies are plans for buying and selling commodity futures and options to profit from movements in price. It is important to construct a strategic plan before you begin trading commodities and risk any capital.
Watching the financial news and reading a commodity newsletter for the latest trading tips will not provide a trader with the necessary skills to succeed in the commodities markets. Many commodity trading strategies employ technical analysis when it comes to entering and exiting risk positions in the futures and futures options markets. That said, technical analysis provides only a part of the picture. Fundamental, supply and demand analysis is a critical compliment that will help a trader avoid unexpected changes that tend to occur when it comes to the evolution of output and consumption in raw material markets.
Using these tools, consistent strategies that you test through simulations over time will allow a budding trader to understand risk and reward as well as the volatile nature of markets. Many commodity trading strategies revolve around either a range trading or breakout methodology. Each type of strategy has pros and cons, so it is up to the individual trader to choose which type of strategy might work best.
Range Trading Strategy
Range trading in commodities simply means attempting to make purchases near the bottom end of a range (support) and selling at the top of that range (resistance). The success of this strategy depends on the ability to buy a commodity after selling makes the price fall to an oversold condition. Oversold means that the market has absorbed all selling and buying is likely to emerge. Conversely, one might look to sell a commodity after a long rally that makes the price rise to an overbought condition where the buying declines and selling emerges.
There are numerous indicators which measure overbought and oversold levels like the Relative Strength Index, Stochastics, Momentum, and Rate of Change metrics. These strategies work well when the market has no definable and consistent trend. However, it is possible that markets can remain in an overbought or oversold territory for long periods of time. The risk of range trading is that the market moves below technical support or above resistance.
A strategy centered on trading breakouts in the world of commodities means that a trader will look to buy a commodity as it makes new highs or look to 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 of previous moves. Many professional traders use these techniques when they are managing large sums of money and looking for a major trend to develop. Commodities are volatile instruments and it is not uncommon for them to double or half in price or more over relatively short time spans.
The philosophy for this strategy is simple: A market cannot continue its trend without making new highs or new lows. This strategy works best when trends are strong and long-lasting. It does not matter whether a trend is up or down, as the trader is buying new highs and selling(shorting) at new lows. One critical drawback of this strategy is that it performs poorly when markets are not able to establish strong trends and trade in ranges.
Fundamental Trading Strategy
While trading breakouts or ranges usually have specific rules as to when to buy and sell, fundamental trading depends on factors that will affect supply and demand for the commodity in question. As an example, a trader might buy soybeans because the weather is dry during the summertime leading to expectations for a smaller crop. On the other hand, one might expect demand to increase for crude oil from China, leading to a long position in oil futures.
Traders and investors that are new to the markets tend to have difficulty with fundamental trading as it involves a tremendous amount of homework and number crunching. Moreover, fundamental positions usually need more time and patience and require more risk because developments can take a long time to unfold.