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Diversify Commodities in a Trading System


Some trading systems work well just trading one commodity, but most systems do much better trading a large number of diversified commodities. A diversified group of commodities tends to offer smoother and more reliable returns than a system focused on one commodity.

One Commodity Versus Many

Some traders only trade one commodity and they design a system around that commodity. The problem is that a system designed for one commodity might not hold up well into the future. A robust system should work well across many different timeframes and market environments. It should also work well across a wide variety of commodities.

You really find out how good a system is when you test is on a wide variety of commodities. I have noticed patterns on commodities when I traded them in the past and thought I was on to something. When I applied the same techniques to other commodities, I realized that it was probably just an anomaly for a particular market that wouldn’t last into the future.

Aside from testing purposes, using a group of commodities helps to keep your returns more consistent. If you only trade one commodity, you go through the inevitable rough periods of a major drawdown or ruin. The same thing applies if you trade very similar commodities like corn, soybeans and wheat. They typically are very correlated and your returns could be boom or bust.

Using a wide variety of diversified commodities will help insulate your system from the major swings. In any given year there will be a few commodities that make huge moves. Some might be trending higher, while others are trending lower. Other times, many commodities might be very quiet and trading in a prolonged range. The more commodities you trade, the more chances you have of steady returns.

Realize that this only applies to technical traders. Fundamental traders can’t possibly be expected to trade based on fundamentals of 30 plus markets at the same time. Also, most systems have either long or short positions on most of the time. If there are no open positions in a commodity, there is criteria to get in based on market conditions / signals at any given time.

The Capital Question

For many small investors it is difficult to be very diversified. The futures margin on 30 contracts can be around $100,000 for just one contract in each commodity. You have to assume that you could be fully invested in all commodities at any given time. Then, you have to give yourself enough slack on margin in case you have drawdowns.

A common rule of thumb is to give yourself a buffer of 3 times margin on your positions. Therefore, if the margin is $2,000 for a contract of wheat, you would set aside $6,000 for trading wheat. The same would apply across the board for all commodities.

Under these rough rules, it would take about $300,000 in your account to comfortably trade a well-diversified portfolio. That is above the level that most retail traders can swing, but there are options to scale down and still be diversified.

A common tactic is to trade one or more commodities from each sector – grains, energies, livestock, metals, softs and possibly financials. A sample portfolio might be: corn, crude oil, live cattle, silver, sugar, and the dollar index.

A smaller portfolio like this can keep you fairly diversified. There is a risk that you will miss some major moves during each year. For example, coffee could be the big trending market in the softs complex, while sugar hardly moves during the year.

The large managed futures funds typically trade all commodities so this doesn’t happen. For trend following funds, a large portion of the profits for the year can come from just a couple of strong trending market. For those who don’t have the capital or want to manage their own trading system, investing in managed futures is always an option.

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