Diary of a Trend Following Trader: The rules of the game

Today I reveal the rules used by the original Turtle traders who earned an average annual rate of return of 80%. Over the next few months I will use these rules to trade thirteen different commodities, and this series of articles will allow you to follow my progress.

The rules of the game

The original Turtle trading system, as taught by Richard Dennis, was governed by strict rules. These rules fall under six different headings:

  1. What markets to buy and sell: The Turtles were given a list of 21 different futures markets to choose from. These markets were chosen because they had a tendency to trend well, and because they had sufficient trading volume. The Turtles were given the discretion to not trade any of the ten commodities on the list. However, because they were not supposed to trade markets inconsistently, if they chose not to trade a market then they were not able to trade that market at all. It’s worth noting that if you trade too few markets you greatly reduce your chances of getting aboard a trend.
  2. How much to buy or sell: The decision as to how much to buy or sell, known as position sizing, is critical to good money management which is the key to long-term success as a trend following trader. The Turtles used a volatility-based position sizing algorithm that meant they would hold fewer contracts of a market that was more volatile relative to the other markets they traded. This strategy, which is still common among trend followers today, meant that trades in different markets would result in the same potential gain or loss. This increased the effectiveness of their diversification strategy. Another consideration when it comes to how much to buy or sell, is your ability to survive a string of losses until such time as you profit from a trend.
  3. When to buy or sell: The decision to enter a particular trade was defined by a precise set of rules. The Turtles used two very simple entry systems which were based on Richard Donchain’s channel breakout system. The two different systems were the shorter-term 20-day breakout system, and the long-term 55-day breakout system. A breakout was defined as the price exceeding the high or low of the preceding 20, or 55 days, depending on which system the Turtles chose to use. The key difference between the two systems, known as System 1 and System 2, was that in System 1 breakout entry signals would be ignored if the last breakout would have resulted in a winning trade. While in System 2 all breakouts would be taken whether the previous breakout had been a winner or not.
  4. When to get out of a losing position: The Turtle traders always used a stop loss. Usually a stop loss is an order placed with a broker to automatically sell (or buy) a security when it reaches a certain price. However, because the Turtles didn’t want to reveal their positions or their trading strategies to a broker, they used a mental stop loss, and these were non-negotiable exit points. The Turtles set their stops such that they would never lose more than 2% of their capital on any one trade. The Turtles would build positions in chunks which they called Units, and each Unit represented 1% of their account equity. Therefore when they added additional Units to a trade, they would raise the stops such that all the stops for the entire position would be placed 2 Units, or 2%, below the most recently added unit. The strategy of using stop losses is absolutely critical to a successful trend following system.
  5. When to get out of a winning position: Getting out of profitable trades too early is one of the most common mistakes made by those using a trend following system. In order to ride a trend it is often necessary to let the price move against you for a period of time. Turtles using System 1 would exit an entire position if the price made a 10 day low for long positions, and a 10 day high for short positions. The System 2 exit was a 20 day low for long positions and a 20 day high for short positions. The Turtles knew that where you took a profit could make the difference between winning and losing. As The Orignail Turtle Trading Rules point out, “For most traders, the Turtle System Exits were probably the single most difficult part of the Turtle System Rules. Waiting for a 10 or 20 day new low can often mean watching 20%, 40% even 100% of significant profits evaporate.”
  6. How to buy or sell: Dennis and Eckhardt advised the Turtles to use limit orders rather than market orders. A limit order is an order to buy or sell a stock at a specific price or better. Limit orders were favoured because they increase the chance that an order will be filled at a better price, and they tended to have less impact in terms of moving the price. In fast moving markets the Turtles were advised not to panic and rather to wait for the market to stabilise before placing their orders. If several markets gave entry signals simultaneously the Turtles would prioritise the strongest market, i.e. those the one that had the biggest breakout. Because the Turtles traded futures markets they also had to contend with expiry and rollover of contracts. They would not rollover a near month contract to a more distant contract if the more distant one did not display the same price movement. Where they did roll over contracts they would do so before the volume and open interest declined too much.

It’s important to realise that most breakouts do not result in trends, and therefore most trades result in losses. However, on average the winning trades more than make up for the losing ones – something which was demonstrated by the Turtles tremendous success. During the first four years the Turtles earned an average annual compound rate of return of 80%.

Although The Original Turtle Trading Rules are fairly simple, as Richard Dennis once commented, “you could publish my trading rules in the newspaper and no one would follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80% as good as what we taught our people. What they couldn’t do is give them the confidence to stick to those rules even when things are going bad.”

It will surprise some people to learn that the entry decision is the least important aspect of a successful trend following system. In fact, according to Tom Basso, who was president and founder of Trendstat Capital Management, “I’ve done studies and they’ve been published, and there have been other studies way beyond what I did, where you take markets, do random number generator to buy or sell, put a good stop loss behind it, do good money management with it, and you get a positive return on investment. So if you’re flipping a coin to buy and sell, how important can the buy and sell decision model be?”

Over the next few months I will use this trend following strategy to trade thirteen different commodities, and the Diary of a Trend Following Trader will allow you to follow my progress.

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