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Developing a Commodity Trading System

Developing a Commodity Trading System

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A commodity trading system can prove to be an invaluable tool to new and experienced commodity traders. A simple system can be developed in a matter of days, while others can take years of research, development and fine-tuning.

Decide on a Time Frame
The first thing you will need to decide when you are developing a commodity trading system is the timeframe you would like to trade. Do you feel comfortable with holding trades for a couple days or are you a long-term trader who likes to hold for several weeks or months? Systems are also developed for day trading commodities and futures, but I wouldn’t recommend that for the novice.

Markets to Trade
Next, there must be a commodity market or group of markets to trade under the system. The markets you trade should fit with your risk tolerances. For example, you probably wouldn’t want to trade a futures market that has a daily trading range of $2,000 when you only want to risk $400 per trade. Many commodity trading systems will trade several commodity markets from different sectors at the same time, while other only trade one market.

Trading System Indicators
This is where technical analysis comes in to play to trigger your trade entries and exits. There are an endless number of indicators and variables you can use. A simple trend following system might use something like a break above a 20-day high that would trigger a buy order. A simple range trading system might use an indicator like RSI that measures when a commodity market is overbought or oversold. The system could generate a buy signal after an RSI drops to extremely oversold levels and then starts to turn higher.

The above are very simplified examples and are only meant for learning purposes. The fact is that you will have to experiment with a variety of indicators that meet your objectives and produce consistent results over time.

Money Management
It is unlikely that any commodity trading system will be profitable without the use of good money management rules to control risk. The main components of controlling your risk are through the use of stop losses and deciding on an appropriate amount to risk on each trade. Commodities and futures are highly leveraged and can move quickly and often further than you might expect. Don’t let one bad trade destroy your trading.

Back Test Your System
You may be wondering how you will know if you created a good system or whether you should risk your hard earned money to find out. Fortunately, there is a technique called “back testing” that will give you a good idea of whether you have a viable commodity trading system.

Back testing is a process of inputting your trading rules and running them against historical price data from a period of several years – the more, the better. A computer program can run through the data fairly quickly and give you the results that your trading system would have achieved if implemented during the data period. It will tell you how many trades would have been taken, the profit or loss, maximum drawdown in your equity and other information to tell you the quality of your system.

You first want to make sure the system produced a profit. Next, check the maximum drawdown. That is the largest loss in equity that the system experienced from the peak in equity to the point where the equity bottomed afterwards. A system may not work if a drawdown of $25,000 occurs on a system where you only have $20,000 to trade. Make sure you have enough trades for a good sample size – at least 30 trades. By the way, even if your system produces good results in back testing, it is no guarantee that the system will be successful in the future.

Implement Trades
Placing the trades that a commodity trading systems generates may seem like the easy part, however many traders actually screw this up. A lack of discipline is to blame for this. An attractive part of a trading system is that you just take every trade it generates without questioning the system. You have no idea what trades will work. Worst of all, you may miss the one trade that turns out to be the best gainer for the year. Your emotions and second-guessing should not be a part of a system.

A disciplined trader will execute the trades as if he was a robot. That may be offensive to some people, but that is what you need to do. If you system gets too far off track, adjustments may need to be made. It is a good idea to set a limit on your equity to stop trading in things go bad. For example, you may pre-determine that you will stop trading the system if you are down 30% on your initial equity.

Example of a Commodity Trading System

I will use a simplified trend-following system to show you the basic components of a commodity trading system. The starting equity of the account will be $50,000 and only one contract will be traded per signal. Trading will stop if the equity falls below $30,000.

Commodity Markets to Trade: 10-year t-notes, sugar, cotton, gold, crude oil and soybeans.

Entries: A buy order is placed when one of my commodity markets makes a 20-day high in price. A sell order is placed when a market makes a 20-day low in prices.

Exits: A trade will be exited (closed) if the futures price of one of my long positions hits a 10-day low. Short positions will be exited if the futures price hits a 10-day high.

Stop Losses: After entry, a stop loss will be placed at 4% of the equity in the account. For example, with a $50,000 account, I would risk $2,000 on each trade. That figure will adjust along with the changing equity.

This is a very simple system that may not work in the long run. It obviously needs some adjustments to make it a viable system. That is where back testing will come in handy. Once you have done your homework and believe you have a viable commodity trading system, you should have the confidence to commit real dollars to trading and have the discipline to follow the rules.

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