How to trade Commodities Profitably

This article written by Rudolf Wittmer was originally published in the february 2014 issue of Traders' Magazine.

Rudolf Wittmer, who has a university degree in engineering, has been active as a fund manager and hedge-fund consultant in recent years and is a passionate trader who turned his hobby into a career more than 20 years ago. By constantly refining his trading models, he has made a name for himself as a systems trading specialist in Germany

Richard Davoud Donchian was born in 1905 and graduated from Yale University in 1928 with a degree in economics. After reading Jesse Livermore’s book “Reminiscences of a Stock Operator”, he shifted his focus of interest to financial markets. Due to high losses during the 1929 stock-market crash, he subsequently began totake a close look at technical analysis. He had come to the realisation that that was the only way you could generate consistent profits in the markets. In 1934, this led to the publication of 20 Trading Guidelines which to this day are still followed (or should be) intuitively by most traders, such as: “Limit your losses and let your profits run.” In 1948, Donchian founded “Futures, Inc”, the first publicly accessible commodity futures fund. This fund was based on two important principles: Diversification into non-correlated assets and position management according to a trend-following principle that came to be known worldwide by the term “4-Week Rule”. Note that until the seventies of the 20th century, the focus of futures trading at US markets had been on grain and foodstuffs, which had a significant impact on the portfolio structure in the Donchian fund.

The 4-Week Rule

The 4- week rule was henceforth used as a base rule for many trend following funds. The most striking thing about it was its simplicity:

Enter a long position and close out short if current price exceeds the highest price of the past four weeks.

Enter a short position and close out longs if current price falls below the low of the past four weeks.

Surely, things could hardly be any simpler than that. Buy when the future reaches a new 4-week high, and sell when it falls to a new 4-week low. Donchian has always emphasised that one should focus on long positions since their profit potential was significantly higher than that of short positions. In Figure 1, we have illustrated the principle of the 4-week rule.

Selection of Assets

Donchian has repeatedly stressed the benefits of good diversification. So for our small test portfolio we have selected one asset each from the five different segments – currencies, metals, energy, grain, and softs. We can see from the correlation matrix in Table 1 that, overall, it is fair to say that there is very little correlation between the euro, silver, crude oil, soybeans, and cotton.

The Rules in Detail

We use a stop order to enter the market on the 20-day high. The exit is made either via a new signal in the opposite direction or an “approaching” trailing stop. For a long position, the trailing stop will start at the low of the last 80 days and be reduced by two units every day, that is, on the second trading day the stop will be placed at the 78-day low (80 minus 2), on the third day at the 76-day low, and so on. At the least, the stop remains at the low of the previous six days.

Starting Capital and Number of Contracts

Since we apply the rule to a portfolio of contracts of various sizes, we have to choose an appropriate number of contracts to make sure that each position is weighted about the same. For this purpose, we have assumed a starting capital of one million dollars for each position.

We are willing to take a two per cent risk of loss for each position, which amounts to $20,000. We then divide this sum by three times the Average True Range (ATR) of the past 50 days, which will guarantee that using this rule carries the same risk for each market. As an example, Soybeans are quoted at eleven dollars a bushel. The position corresponds to a contract value of $55,000 since one contract is 5000 bushels. The ATR of the past 50 days is 25 points, which amounts to a value of $1250. This amount is multiplied by three, resulting in $3750. We then take our maximum risk capital of $20,000 and divide it by $3750, resulting in 5.33 contracts. We decide to round that figure down, which enables us to place a position of five contracts in the market. A note on the starting capital of one million dollars: This amount was chosen for a futures portfolio where the drawdown of 20 per cent should not be exceeded. For more aggressive traders, the starting capital may well be decreased to about $300,000.