Trend Following in Commodities: A Complete Guide

There are three basic kinds of trading approaches:

1. Mean reversion

Here,  the trader expects the market to reverse to its average. So this is usually done when the stock or the commodity is overextended. Overextension can signal a reversal trade.

2. Breakout

This is a strategy in which the trader is expecting the market to break an important zone. This can be either a support or a resistance zone. The trader expects this zone to be vulnerable now and aims to take an entry in the same direction.

3. Trend Following

This is a trading approach in which the trader confirms the current trend. One way to figure this out is to use higher highs and higher lows for the uptrend, and lower highs and lower lows for the downtrend. Once the trend has been identified, the trader enters the trend and then rides it through the remainder. The main aim is not to predict the top or the bottom. The main aim is to enter during the ongoing trend and invest until it is sustained. 

In commodities, trend-following has historically been effective because commodity prices often move in extended directional phases driven by supply-and-demand imbalances.

Why Commodities Suit Trend Following

Commodities work very differently from equities. Movements in commodity markets are influenced by many fundamental factors. For example, the trend is dependent on different seasons' demand patterns and production cycles. It is also dependent on inventory levels. Finally, many commodity prices are affected by weather events, geopolitical disruptions, and currency fluctuations.

The combination of these factors has shown that commodity prices exhibit strong trends that can span weeks to multiple quarters. Commodities are thus the favourite asset class for trend followers. Here are some examples of which commodity tends to trend:

• Crude oil: A lot of times, the supply of crude is reduced or cut altogether. This leads to a large rally in crude oil
• Natural gas: The most important use of natural gas is experienced in the winter months. Hence, it usually spikes during winter demand
• Wheat: Agricultural commodities are impacted by seasons and weather. If there are drought conditions, then wheat tends to trend significantly
• Gold trends during risk-off economic cycles

Unlike equities, commodities do not depend on earnings growth to appreciate. They move in response to economic necessity and scarcity.

The Core Principles of Trend Following

Trending following seems to be fairly scientific and is based on the following three core principles:

Price is the Primary Signal

The best traders use just price as their main signal to determine trend direction. Commodity prices are used to predict direction, make economic forecasts, and even support fundamental valuations. A simple rule is that if the price is moving up, they buy; if it is moving down, they sell.

Losses are Controlled Early

It is well known that markets don’t trend much. A market which trends 30% of the time is considered very good. So risk management becomes overly important for trend followers. They are happy to accept frequent small losses until a strong trend emerges.

Profits are Allowed to Run

This is the most important phase of trend following, and it's easier said than done. In large commodity trends, one big winner can offset multiple small losers.

Tools and Indicators Used in Commodity Trend Following

Beginner traders can start with simple indicators to help determine direction. Here are some common approaches:

• Moving averages (20, 50, 200-day): The basic idea is that if the price is above the moving average, it's bullish, and if it's below, it's bearish. The next idea used is the crossover. And the final idea used is the direction of the moving average itself. 
• Donchian channels: These are used for breakout trading. If prices rise above the Donchian channel, it's bullish.  
• Higher-high and higher-low structures: These are not exactly indicators. This is part of the Dow theory, which suggests that the price forms a higher-high, higher-low pattern during a bullish phase.
• Trendline confirmation: This is not an indicator again. The basic understanding is that if the market is trending up, then the trendline will also be moving up.

The purpose of these tools is not prediction, but confirmation of direction and volatility.

How a Basic Trend Following System Works in Commodities

Once we have deciphered the direction, a complete trend following system can be made as follows: 

Entry Conditions:

• Buy when the price closes above a specific high or indicator. The trader can choose one of the following ways:
• Price is more than the moving average
• Price above the latest swing high
• Prince has given a breakout above the Donchian channel
• Sell (short) when the price closes below a specific low. 

Exit Conditions:

• Once the entry is done, the stoploss is mandatory. The initial stoploss can be based on either of the following:
• The latest swing low can be the initial stoploss
• If the price falls below the moving average, that can also be considered a stoploss.
• Some traders use a trailing stop-loss using ATR to ensure that they are able to capture the profits consistently

Position Sizing:

• This step is very important. Traders should adjust their lot sizes based on volatility. If volatility is high, the position sizing should be lower.

This structure keeps the trader on the right side of major commodity moves, without forecasting.

Why Beginners Struggle With Trend Following

While many top traders are trend followers, beginners still struggle with it. Some of the reasons are:

• Wrong expectations. Beginner traders sometimes expect trend following to have high accuracy and quick profits, which is not feasible
• Trend following is, in fact, the opposite. The win rate is usually lower (around 30%). And the strategies usually end up having a lot of small losers and few large winners

So, to be successful in trend following, the traders should have 

• Patience during sideways markets
• Emotional discipline during noise
• Trust in the system rather than intuition

Conclusion

Trend following is very lucrative in commodities. It is not about forecasting demand, predicting weather patterns, or estimating inventory. It is more about responding to price movement with discipline.

Commodities naturally generate strong, lasting trends driven by real-world economic dynamics, making them ideal for systematic trend-followers. 

The main issue is not identifying the trends. But to have very strong risk management, where the trader can accept small losses, capture and stay in long, profitable trending trades.