Commodity Trading Strategies That Actually Work
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
Learning Commodity Trading the Hard Way
Chapter 20 is one of the best in the book. It is written by Hilary Till of Premia Research LLC, Joseph Eagleeye of Quartile Risk LLC, and Richard Heckinger of the Federal Reserve Bank of Chicago. These are people who have actually traded commodities, not just studied them from an office.
The chapter opens with a blunt statement: gaining expertise in commodity derivatives markets usually happens by working in niche commodity-processor companies, banks that specialize in hedging project risk, or fund companies with strict rules about keeping trade secrets proprietary. There is a knowledge gap in these markets, and this chapter tries to fill it.
Two Strategies That Work
The chapter covers two main categories of commodity trading strategies: trend-following and calendar-spread trading. Both have been around for decades, and both continue to generate returns for skilled practitioners.
Trend-Following
More than 70 percent of managed futures funds use trend-following strategies. These firms are run by commodity trading advisors (CTAs), and the investment category is dominated by systematic traders.
The word “systematic” is key. Automated programs screen markets using various technical factors to detect the beginning or end of a trend across different time frames. Moving averages, breakouts of price ranges, and other technical rules generate buy and sell signals. The trading is rules-based, and discretionary overrides are basically taboo.
The basic idea is simple: all markets trend at one time or another. A trend-following program might trade as many as 80 different markets globally on a 24-hour basis, trying to capture trends that typically last 1 to 6 months.
The skill comes from execution. Successful trend-followers cut losses on losing trades quickly and let the winners ride. They exit false trends fast and increase their bets on real trends. Alpha comes from this dynamic leverage: knowing when to push harder and when to pull back.
As Fung and Hsieh (2003) put it, trend-following alpha reflects the skill in “leveraging the right bets and deleveraging the bad ones.” Managers who fail to do this get negative alphas. Luck should not be rewarded.
Has Momentum Worked Historically?
Yes. And the evidence goes back over a century.
A 2012 AQR Capital Management white paper constructed a simple momentum strategy: an equal-weighted combination of 1-month, 3-month, and 12-month momentum strategies across 59 markets and 4 major asset classes (24 commodities, 11 equity indices, 15 bond markets, and 9 currency pairs) from January 1903 to June 2012.
The full-sample results: 20 percent gross annual return, 14.3 percent net of 2-and-20 fees, with a Sharpe ratio of 1.00 after fees. The correlation to both the S&P 500 and U.S. 10-year bonds was -0.05. That is basically zero correlation with traditional assets.
Decade by decade, momentum was profitable in every single period tested. The 1970s were the best (40.3 percent gross returns) and the 1930s were the weakest (9.7 percent gross returns). But it was always positive.
Why does this work? AQR’s researchers theorize that price trends exist partly because of long-standing behavioral biases like anchoring and herding. Non-profit-seeking participants like central banks and corporate hedging programs also contribute to trends. As long as these factors continue, momentum strategies should continue to work.
Calendar-Spread Trading
The second strategy is less well-known outside of professional trading circles. Calendar-spread trading involves trading the price difference between two delivery months of the same commodity futures contract.
In all commodity futures markets, a different price exists for each delivery month. October natural gas futures might trade at one price while December natural gas trades at another. A calendar-spread trader bets on how that gap will change.
Opportunities arise when there is predictable one-sided commercial or institutional flow in particular futures contracts. A proprietary trader takes the other side of this flow.
Seasonal inventory cycles are one example. Natural gas has a clear seasonal pattern. Storage facilities inject gas in the summer and draw it down in the winter. The futures curve reflects this: summer and fall contracts trade at a discount to winter contracts. A storage operator can buy summer gas and sell winter gas through futures, locking in their return for storing the commodity.
A speculator can profit by taking the other side of the hedging activity that storage operators create. When storage operators sell calendar spreads as part of their hedging, this creates a predictable price pressure that a speculator can trade against.
Commodity index rolls are another example. Unlike equity indexes, commodity futures indexes need explicit rules about when to roll contracts before they expire. In the wheat market, for instance, speculators have historically sold the front-month contract while buying the next-month contract before index roll dates, establishing a “bear calendar spread.” They would then unwind this position during the roll itself, hopefully at a profit.
The Natural Gas Curve
The chapter uses natural gas as a recurring example, and for good reason. Natural gas futures have a distinctive curve that reflects seasonal inventory patterns. Summer and fall delivery contracts are cheaper than winter contracts because that is when storage operators are injecting gas. Winter contracts are more expensive because that is when people need to heat their homes.
This curve is not random. It mirrors the average seasonal inventory build-and-draw pattern. Markets provide a return for storing natural gas. An owner of a storage facility can lock in that return through futures.
But here is the important thing: the chapter also warns that these patterns can change. And when they do, traders who are not paying attention can get destroyed. We will get to that in the next post about trading mistakes and blowups.
Why These Strategies Persist
You might wonder: if everyone knows about trend-following and calendar spreads, why do they still work?
For trend-following, the answer is behavioral. Markets trend because investors anchor to recent prices, herd into popular trades, and central banks and hedgers create non-economic flows. These behaviors are not going away.
For calendar-spread trading, the answer is structural. Physical commodity markets have real seasonal patterns driven by weather, storage capacity, and consumption cycles. As long as people need to heat their homes in winter and air-condition them in summer, natural gas spreads will have a seasonal component.
Both strategies also require skill to execute well. Knowing that trends exist is not the same as knowing when to get in and when to get out. Knowing that seasonal patterns exist in natural gas is not the same as sizing your position correctly and managing your risk.
My Take
What makes this chapter stand out is its practical focus. Most academic writing about trading strategies stays abstract. This chapter names specific strategies, shows specific data, and explains why they work in a way that a practitioner can actually use.
The AQR momentum data is particularly compelling. Over 100 years of positive returns with zero correlation to stocks and bonds is hard to argue with. Of course, past performance does not guarantee future results. But when a pattern holds across 11 decades, multiple asset classes, and dozens of markets, there is probably something real going on.
The calendar-spread discussion is valuable because it explains a type of trading that most retail investors never encounter. Understanding contango, backwardation, and seasonal patterns in futures curves is not just academic knowledge. It is how professional commodity traders make money every day.
Next up: the chapter gets darker. We will look at common trading mistakes and the catastrophic blowups that happen when traders ignore the lessons above.
This is Part 1 of a two-part series on Chapter 20. Continue to Part 2: Commodity Trading Mistakes and Catastrophic Blowups.
Previous post: International Commodity Markets: What the Research Shows
Next post: Commodity Trading Mistakes and Catastrophic Blowups