Trend-Following in Commodities Trading

The trend is your friend. This statement has been circulating among commodity traders for a long time. It means that you should trade with the trend of the market to increase your chances of success.

What Is a Trend in Commodity Trading?

A trend means that prices are steadily moving higher or steadily moving lower over a period of time. It's considered an uptrend if prices are rising, and it's a downtrend when prices are declining.

The reasoning behind following the trend is that prices are more likely to continue in the same direction than they are to reverse, so you shift the odds more in your favor. Many professional money managers trade with a trend-following philosophy and many commodity trading systems are built around trend-following formulas.

The Turtles

Proof that trend-following works can be found in the story of "The Turtles." In 1984, a very successful futures trader named Richard Dennis made a bet with another trader, William Eckhardt, on whether he could give a group of individuals a simple set of trading rules that would make them successful. The trading rules consisted of a trend-following system and simple money management skills. It turned out that the experiment was an amazing success and some of the students even went on to pursue careers in trading. The Turtle Trader offers a great deal of valuable information on trend-following.

Tips on Following the Trend

You never know how high or how low a market will move, so you're likely to catch some very profitable moves in the commodity markets if you're following trends. There are two common way to enter the markets when you spot a trend:

• Buy on a pullback: If the market has been moving higher for 10 days in a row, wait for a two- to three-day period where prices decline, then buy.
• Buy when the market makes new highs: You'll never miss entering a trend this way, but it's the hardest thing for many traders to do—which is why it's one of the most successful techniques.

Volume and Open Interest

There's another old saying in the market and it goes something like this: Follow the trend until it bends. When it bends, a market reverses.

Trends are important when you're trading on a short-, medium- or long-term basis in any market, and commodities are no exceptions. There are a couple of things to remember when you're trying to assess if a trend is strong or weak. Using volume and open interest data should validate the strength of a trend.

Volume is the total number of futures contracts that trade. Open interest is the total number of open long and short positions on a futures contract.

There are a couple of simple rules to follow when it comes to volume and open interest. When the price of a commodity rises or falls, the rising volume and open interest that accompany the price move validate the move and the direction. They indicate that the price activity is attracting more market participation. Rising volume and open interest are a sign that a trend is likely to continue.

Conversely, when a price rises or falls and lower volume and declining open interest accompany the move, it means that market participants are retreating from the market. Falling volume and open interest are a sign that a trend is running out of steam and could reverse.

The Bottom Line

There are so many factors that influence commodity prices. Volume and open interest are just two of many metrics you'll want to watch when you're trading in the futures market. But these two tools can be useful as they tell us a great deal about herd mentality and market consensus.