Position Sizing for Commodity Volatility

A commodity trader who takes the same lot size in gold, silver, oil and gas is taking four completely different risks. Gas can move in a day what gold moves in a week. Sizing by volatility is the standard answer, and it is simple enough to apply by hand before every trade.

The method

Measure the typical daily move of each market over the last few weeks. Decide the money you are willing to lose on a single trade. Set the stop at a sensible multiple of the typical move, so it sits beyond the noise. Divide the money at risk by the stop distance, in money per unit, to get the position size. The result is a position that is large in a quiet market and small in a loud one, with the same loss if the stop is hit.

Why commodities need it more

Commodity volatility is both high and uneven. Oil moves on inventory reports and producer meetings; gas on weather; silver on whatever gold is doing, amplified. A fixed lot size that was reasonable in gold last month can be reckless in gas this week.

As a rough order, from calmest to most volatile in percentage terms: gold, then oil, then silver, then gas. A trader who moves from gold to gas without resizing is typically taking several times the risk they intended.

Portfolio rules

• Set a cap on total commodity risk across all open positions, separate from the per-trade limit
• Treat oil and gas as partly correlated, and gold and silver as strongly correlated, when adding up exposure
• Reduce the per-trade risk ahead of scheduled reports, because the typical move understates the move on those days
• Recalculate the typical move weekly; commodity volatility changes faster than currency volatility

Stops

Volatility sizing only works if the stop is honest. A stop placed inside the daily noise to allow a bigger size defeats the purpose. The stop goes where the trade idea is wrong, usually beyond a structural level, and the size follows from that. If the resulting size is too small to be worth it, the trade is not worth taking.

What to watch

Watch the current typical move of each commodity you trade, the gap between that and its level a month ago, and the total money at risk across the book. A rising typical move with an unchanged position size is the warning to act on.