If you’re like most traders, you’ve probably spent most of your time in equity markets, perhaps with the occasional dabble in forex or crypto. But there’s a whole world of commodity trading that many retail traders ignore.

I’ve found commodities to be fascinating markets for a few reasons I’ll get into shortly. But here’s something that might grab your attention right away: commodities often zig when stocks zag.

Commodity markets can therefore help you harness your greatest edge as a systematic trader: the ability to trade multiple uncorrelated return streams simultaneously, leading to a portfolio that is greater than the sum of its parts.

That alone makes them worth a closer look.

 

What Are Commodity Markets?

Commodities are physical goods that are mostly standardized and interchangeable, regardless of who produced them.

We typically break commodities into a few major categories:

• Energy: Crude oil, natural gas, gasoline, heating oil
• Metals: Gold, silver, platinum, copper
• Agricultural: Corn, wheat, soybeans, sugar, coffee
• Livestock: Live cattle, feeder cattle, lean hogs

 

And these categories are traded either in the spot market or in derivatives markets. Here’s the difference between them:

 

Spot Commodities

The spot commodity market is exactly what it sounds like – trading the physical commodity for immediate delivery. Here, you’re dealing with actual barrels of oil, bushels of wheat, or ounces of gold that change hands.

 

Who’s trading spot markets?

• Producers: Miners, farmers, oil drillers selling their output
• End users: Manufacturers, refineries, food producers buying inputs
• Wholesalers/Distributors: Moving commodities through the supply chain
• Some investors: Particularly in precious metals 

The spot market is where the rubber meets the road (sometimes literally, in the case of rubber). Prices here reflect current supply/demand dynamics with all their messy real-world constraints.

If you want to buy a barrel of WTI crude oil on the spot market, you’d better have somewhere to put it. 

 

Derivatives

Derivatives markets let you gain exposure to commodity price movements without the hassle of physical delivery. These include:

• Futures contracts: Standardized agreements to buy/sell a commodity at a future date
• Options on futures: The right (but not obligation) to buy/sell futures contracts
• Swaps and CFDs: OTC agreements to exchange cash flows based on commodity prices
• ETFs/ETNs: Exchange-traded products tracking commodity prices or indices
  

 

Who’s trading derivatives?

• Commercial hedgers: Producers and consumers managing price risk
• Speculators: Traders looking to profit from price moves
• Asset allocators: Institutional investors seeking commodities exposure
• Arbitrageurs: Exploiting price differences between related instruments
• Retail traders: That’s you and me, usually via futures, ETFs or CFDs

These markets are primarily about transferring price risk rather than transferring the physical commodity itself.

 

Diversification: The Free Lunch You Actually Can Get

One of the most compelling reasons to add commodities to your portfolio is diversification. Unlike stocks and bonds, which tend to be heavily influenced by interest rates and economic outlook, commodities often dance to their own tune.

For example, platinum prices might surge due to mining strikes in South Africa. Natural gas might skyrocket during a particularly cold winter. Coffee might jump because of a frost in Brazil. These events have little to do with whether interest rates are going up or down.

 

This independence gives commodities a low correlation to traditional assets over long periods, which is exactly what you want when building a portfolio:

• When post-pandemic inflation hit in 2021 and 2022, commodities shot up – in fact, they were one of the driving causes of inflation in that period.
• During the 2020 COVID crash, gold initially fell but then rallied strongly
• When equities crashed in 2008, gold went up
• In the 1970s inflationary cycle, commodities soared while stocks struggled

 

Now, these correlations aren’t stable – they can and do change. But on the whole, judiciously adding commodities to a portfolio of stocks and bonds has historically improved risk-adjusted returns.

As a simple example, here’s a simple volatility-targeted ETF portfolio (where each component gets the same volatility target) of US stocks (VTI) and treasuries (TLT) over about 25 years:

The pink area represents the dollar value of the stock component, the brown area represents the treasuries component, and the blue area represents the cash balance. The black line is the total value of the portfolio. 

 

Compare this with a portfolio that volatility targets stocks, treasuries, and gold (GLD):

The risk-adjusted returns (measured by the Sharpe ratio) of this portfolio is about 10% higher than the stock-bond version, and the average annual return is higher too – on a starting balance of $100,000, this version made about $260,000 while the stock-bond version made about $170,000. 

 

This is a simple example, but the power of diversification is obvious. 

 

The Inefficiencies That Make Commodities Interesting

Here’s where commodities get really interesting for traders like us – they’re full of market inefficiencies that we can potentially exploit.

Why? Because commodity markets have unique supply and demand characteristics that create (noisily) predictable patterns:

Seasonality

Agricultural commodities in particular show strong seasonal patterns based on crop cycles:

• Corn prices often decline during harvest (September to November) when supply floods the market
• Natural gas typically rises ahead of winter as heating demand increases
• Gasoline prices often increase before the summer driving season

These patterns aren’t foolproof (nothing in trading is), but they occur frequently enough that systematic traders can potentially build edges around them.

 

Storage Constraints

Unlike stocks, physical commodities need to be stored somewhere, and storage isn’t free. This is one contributor to what traders call “contango” or “backwardation” in futures markets:

• Contango: Future prices are higher than spot prices (normal for storable commodities)
• Backwardation: Future prices are lower than spot prices (often indicates physical shortages)
  
  

These term structure patterns create opportunities for spread trades and roll yield strategies that don’t exist in equity markets.

 

Commercial Hedging Pressure

Remember those farmers and manufacturers I mentioned? Their hedging activities can create systematic price pressures.

For example, producers selling forward contracts to hedge their output can drive futures prices below expected future spot prices, creating an opportunity for speculators to earn a risk premium by taking the other side of the trade.

How To Get Exposure: ETFs vs. Futures vs. CFDs

So you’re sold on commodities. Now, how do you actually trade them?

 

You’ve got options:

ETFs and ETNs

Pros:

• Trade like stocks (no special account needed)
• No futures rollover to manage
• Smaller capital requirements
• No risk of physical delivery

 

Cons:

• Potential for significant tracking error over time due to roll costs
• Limited to popular commodities
• Higher expense ratios than stock ETFs
• Some use futures contracts anyway

 

Examples: GLD for gold, USO for oil, CORN for corn

 

Futures Contracts

Pros:

• Direct exposure to the commodity
• Highly liquid markets
• Leverage (which can be good and bad)
• More commodity choices

 

Cons:

• Requires specialized futures account
• Contract rollovers to manage
• Risk of physical delivery if not closed in time (although most brokers will ensure this doesn’t happen)
• Higher capital requirements
• Steeper learning curve 

 

Contracts for Difference (CFDs)

Pros:

• Easily accessible for retail traders
• No physical delivery concerns
• Trade both long and short easily
• Smaller position sizes possible

 

Cons:

• Not available in all jurisdictions 
• Higher spreads than futures
• Counterparty risk, depending on your broker
• Execution risk depending on your broker

The Dangers: Where Commodities Can Bite You

Before you rush to load up on coffee and crude oil, a few warnings are in order:

Volatility Can Be Extreme

Commodity prices can move in ways that make even crypto traders blush. The famous cases are legendary:

• In April 2020, WTI crude oil futures briefly went NEGATIVE, hitting -$37 per barrel
• Natural gas has seen enormous moves in both directions, many times.
• In 1980, silver dropped 50% in four days after the Hunt brothers’ corner of the market failed

Here’s oil futures going negative in 2020:

This volatility means that position sizing is absolutely critical. Don’t bet the farm on commodities.

Expertise Requirements

While you can trade gold with relatively little specialized knowledge, many commodity markets have quirks that can trap the unwary:

• Natural gas has complex storage dynamics
• Agricultural markets have crop reports that cause massive moves
• Oil markets respond to OPEC meetings and geopolitical events

The more specialized the commodity, the more homework you might need to do before trading it.

Remember too that specialists are trading commodity markets. These are people who literally do nothing other than use their expertise to trade a particular commodity. That suggests you probably can’t compete on knowledge asymmetry, so stick to big, obvious edges that aren’t likely to be arbitraged away.

ETF Decay

If you’re using ETFs for long-term commodity exposure, beware of contango-related decay.

Remember how when a market is in contango, futures contracts are priced higher than the spot price? This means that the ETF must periodically “roll” its expiring futures contracts into new ones at a higher price. This rolling process creates a negative roll yield, which reduces the ETF’s overall return.

Several commodity ETFs have lost 80%+ of their value over time, even when the underlying commodity didn’t decline nearly as much.

The oil ETF USO is the poster child for this problem. From 2006 to 2022, it lost almost 90% of its value due to roll costs, while actual oil prices didn’t fall nearly as much.

Check out this chart of USO returns (purple line) alongside oil futures returns (blue line):

Simple Commodity Strategies For Retail Traders

Despite these challenges, there are some straightforward approaches that retail traders can consider:

The Natural Gas Winter Play

Natural gas typically rises in the fall as heating demand approaches. A simple strategy is to buy natural gas (via the UNG ETF or futures) in late August/early September and exit by December.

This doesn’t work every year, but it’s shown a statistical edge over time that makes sense fundamentally.

Gold as a Portfolio Hedge

Allocating a small portion of your portfolio to gold (via GLD or futures) has historically provided some protection during equity market stress. It’s not a perfect hedge, but it’s one of the more reliable ones accessible to retail traders.

Diversified Trend Following

Using simple moving average crossovers (like 50-day vs. 200-day) across a basket of commodity ETFs can provide trend exposure without requiring futures accounts. 

Why I Think Commodities Deserve A Place In Your Arsenal

If I haven’t convinced you yet, here are a few final thoughts on why commodities deserve consideration:

Inflation Protection

With inflation being more of a concern lately than it has been for decades, commodities provide one of the few reliable inflation hedges. They’re real assets whose prices typically rise with inflation.

Growing Global Demand

As developing economies grow, their demand for commodities tends to increase dramatically. China’s growth drove a commodity supercycle in the 2000s. India and other developing nations could drive similar demand in the future.

Declining Correlations With Traditional Assets

Finding truly diversifying assets is more valuable than ever. Commodities can fill that role.

They’re Just Interesting

I’m going to end on a subjective note: commodity markets are fascinating. There’s something intellectually stimulating about trading markets driven by physical supply and demand rather than just financial abstractions.

When you trade wheat, you’re participating in a market that’s existed for thousands of years. There’s a tangibility to it that, say, crypto lacks.

Getting Started

If you’ve made it this far and want to dip your toes in commodity markets, here’s an example of a simple way to start. This is not financial advice – just an example of a broadly sensible approach for a beginner. 

 

1. Add a small position in GLD to your portfolio
2. Track a few commodity markets for several months. Observe their price movements and volatility.
3. Consider starting with liquid markets like gold or oil before diving into softs and exotic stuff. 
4. Consider a simple trend or seasonality system rather than discretionary trading. But do your own research and make sure you understand what you’re trading. Above all, don’t try to trade these things without a solid understanding of the edge you’re harnessing.
5. Stay tuned for the next article in this series.

 

Commodities can provide opportunities for adding diversified return streams. But they have their own idiosyncrasies and nuances that you should consider.