Trend Following Strategy: Rules That Ride Price Moves

Key Takeaways

• Trend following strategy uses breakout or moving-average rules to enter trades and volatility-scaled stops to exit them systematically.
• The 1983 Turtle Traders experiment showed novices using a simple trend system generated roughly $175 million in aggregate profits over five years.
• Abandoning the strategy during losing streaks is the key mistake, trend systems lose on 60–70% of trades and need big winners to survive.
• Trend following belongs in a portfolio as a crisis diversifier that often profits during sustained dislocations when other strategies struggle.

What It Is

A trend follower ignores whether a market "should" rise or fall. The method entries and exits are driven by rules tied to recent price action, such as new highs over a lookback window, moving-average crossovers, or breakouts from volatility bands. When a trend forms, the system rides it. When price reverses through the exit rule, the system cuts the position.

The most famous test of the approach was the Turtle Traders experiment in 1983. Commodities trader Richard Dennis and his partner William Eckhardt recruited 23 novices, gave them two weeks of training on a trend-following system, and funded their accounts. By the time the program ended roughly five years later, the group had reportedly generated about 175 million dollars in aggregate profits. Michael Covel documented the story in The Complete TurtleTrader.

The Intuition

Markets do not move smoothly to a fair value. They overshoot in both directions as news, positioning, and flows accumulate. Academic work on under-reaction and delayed over-reaction, and AQR's century-long backtest of time-series momentum, supports the idea that persistent trends are common across asset classes.

A trend follower does not need to know why wheat or the Japanese yen is moving. The rule is simple: when price trades above its N-period high, be long; when it trades below its N-period low, be flat or short. Small losses on false signals are the cost of waiting for a large, durable move that pays for them many times over.

How It Works

A basic trend system has four ingredients.

• Entry. A breakout rule is classic. The original Turtles used a 20-day high for entry on their short-term system and a 55-day high for the long-term system.
• Stop. The Turtles sized positions so a move of 2 times the 20-day average true range (ATR) equaled 2 percent of account equity. That ATR stop adjusts to each market's volatility.
• Exit. Exits were mirror breakouts. Long trades closed on a 10-day low (short-term) or a 20-day low (long-term).
• Position sizing. The Turtles used a concept called N, equal to the 20-day ATR. One unit of exposure was capped so 1 N of adverse movement cost 1 percent of equity. Volatile markets get smaller positions automatically.

CTA and managed-futures firms such as AHL, Winton, Man Group, and Campbell run institutional versions of the same idea across dozens of futures markets, often with multiple lookback windows and risk-parity weighting.

Worked Example

Suppose you run a 55-day breakout system on crude oil futures.

• Today's close is 82 dollars. The 55-day high is 81. That is a long entry.
• The 20-day ATR (N) is 2.00 dollars. A 2N stop is 4 dollars, so your initial stop sits at 78.
• Your account is 100,000 dollars. Risking 1 percent is 1,000 dollars. You buy 1,000 / 4 = 250 barrels (rounded down to contract size).
• Over the next three months, crude trades up to 105, and the 20-day low never hits your trailing exit. The trailing stop follows the 20-day low upward.
• When crude finally prints a new 20-day low at 96, the system exits. Gain per barrel is 96 minus 82 = 14 dollars.

You took many small losses on false breakouts along the way. One winning trend paid for all of them, which is the structural pattern of a trend-following equity curve.

Common Mistakes

1. Abandoning the system after a losing streak. Trend strategies spend long stretches in drawdown when markets chop. Most Turtle-style systems lose on roughly 60 to 70 percent of individual trades. The few winners have to be large, which requires not cutting them.

2. Using one market instead of a portfolio. Trend following relies on diversification across many uncorrelated futures. A single-equity backtest usually underperforms because the style needs currencies, rates, commodities, and indices to smooth out the ride.

3. Over-optimizing lookbacks. Tuning a breakout window to maximize historical return is a classic curve fit. Generic values such as 20, 50, or 100 days tend to forward-test better than hand-picked ones.

4. Skipping the volatility-scaled stop. Fixed-dollar or fixed-percent stops ignore that oil and bonds have different typical move sizes. ATR-based sizing is what makes the same rule work across asset classes.

5. Expecting trend to diversify stocks in calm markets. Trend often shines in crises because big dislocations trend, but it can drag in placid, range-bound years. It is a complement to a long-only portfolio, not a substitute.

Frequently Asked Questions

Q: What is trend following strategy in simple terms? Trend following means buying an asset when its price breaks to new highs and selling or shorting it when the price reverses through a defined exit level. The system follows price movement using rules, not forecasts or fundamental views.

Q: How does trend following strategy affect investment decisions? It removes discretion entirely. Entry, exit, and position size are all determined by formulas, so you never override the system based on a market opinion. The rule-based nature prevents both premature exits from winning trades and unlimited holding of losers.

Q: What is a real-world example of trend following strategy? The article's crude oil example shows a 55-day breakout entry at $82, an ATR-sized stop at $78, and a trailing 20-day low exit at $96 that captured a $14-per-barrel gain after the trend ran from $82 to $105.

Q: How can investors use trend following strategy in their portfolio? Apply the strategy across a diversified basket of uncorrelated futures markets, not a single equity. Use ATR-based position sizing so volatile markets get smaller positions automatically. Expect to lose on 60–70% of individual trades and plan for the few large winners that cover all losses.

Q: How is trend following strategy different from momentum investing? Trend following evaluates each market against its own past return (time-series) and can go net long, short, or flat. Momentum investing ranks assets against each other (cross-sectional) and is always fully invested on both sides of a relative bet.

Sources

1. TurtleTrader. "The Original Turtle Trading Rules." https://www.turtletrader.com/rules/
2. Covel, M. (2009). The Complete TurtleTrader. HarperBusiness. https://www.turtletrader.com/book/
3. Hurst, B., Ooi, Y.H., Pedersen, L.H. AQR. "Demystifying Managed Futures." https://www.aqr.com/-/media/AQR/Documents/Insights/Journal-Article/Demystifying-Managed-Futures.pdf
4. AQR. "A Century of Evidence on Trend-Following Investing." https://www.aqr.com/Insights/Trend-Following
5. TrendSpider Learning Center. "Richard Dennis Turtle Trading Strategy." https://trendspider.com/learning-center/richard-dennis-turtle-trading-strategy/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.