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

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.

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

There are three main approaches to trend following:

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.

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).

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.

“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.