Turtle Trading System Explained; A Beginner's Guide

Imagine a group of ordinary individuals, with no prior trading experience, being taught a specific set of rules and then consistently outperforming professional money managers. This is the essence of the Turtle Trading System, a strategy that gained prominence in the 1980s. Understanding this system provides valuable insights into rule-based trading and risk management.

What is the Turtle Trading System?

The Turtle Trading System is a comprehensive, rules-based trading strategy developed by Richard Dennis and William Eckhardt in the 1980s. They sought to prove that trading could be taught to anyone, regardless of their background. They recruited a group of individuals, the "Turtles," and taught them a specific set of rules for identifying trends, entering trades, and managing risk. The Turtles went on to achieve remarkable success, demonstrating the power of a disciplined, systematic approach to trading.

The core idea behind the Turtle Trading System is to identify and capitalize on trends in the market. Instead of trying to predict market movements, the Turtles reacted to them, following a predefined set of rules to enter and exit trades. This systematic approach helped them to manage risk effectively and avoid emotional biases.

Why is the Turtle Trading System Important?

The Turtle Trading System remains relevant for several reasons. Firstly, it demonstrates the power of a rules-based approach to trading. By removing emotion and subjectivity from the equation, traders can make more rational decisions. Secondly, it highlights the importance of risk management. The Turtles were taught to manage their position sizes and use stop-loss orders to limit potential losses. Finally, the system provides a framework for identifying and capitalizing on trends, which can be a profitable strategy in various markets.

Think of it like a recipe for baking a cake. You follow the instructions carefully, measure the ingredients precisely, and bake for the specified time. If you deviate from the recipe, the cake might not turn out as expected. Similarly, in trading, following a set of rules can increase your chances of success. The Turtle Trading System provides that recipe for trend-following.

How the Turtle Trading System Works; A Step-by-Step Guide

The Turtle Trading System consists of several key components, each designed to address a specific aspect of trading. Here's a breakdown of how the system works:

1. Market Selection: The Turtles traded a variety of liquid markets, including currencies, commodities, and bonds. The key was to focus on markets with sufficient volatility and trading volume.
2. Position Sizing: This is arguably the most crucial aspect of the Turtle Trading System. The Turtles used a concept called "N," which represents the average true range (ATR) of a market. They calculated their position size based on N to ensure that their risk was consistent across different markets.
3. Entry Rules: The Turtles used two main entry systems: System 1 and System 2. System 1 was based on a 20-day breakout, while System 2 was based on a 55-day breakout. A breakout occurs when the price exceeds the highest high or falls below the lowest low of the specified period.
4. Stop-Loss Orders: The Turtles used stop-loss orders to limit their potential losses. Their initial stop-loss was typically set at 2N, meaning two times the average true range.
5. Exit Rules: The Turtles also had specific exit rules. For System 1, the exit was based on a 10-day breakout in the opposite direction of the trade. For System 2, the exit was based on a 20-day breakout in the opposite direction.
6. Adding to Positions: The Turtles pyramided into winning positions, adding to their position size as the market moved in their favor. They typically added to their position at 0.5N intervals.

Each of these steps is crucial for implementing the Turtle Trading System effectively. Let's delve deeper into each component to understand how they work in practice.

Understanding 'N' and Position Sizing

The concept of "N" is central to the Turtle Trading System's risk management approach. "N" represents the average true range (ATR) of a market, which is a measure of its volatility. The Turtles used N to calculate their position size, ensuring that their risk was consistent across different markets, regardless of their price levels or volatility.

Here's how the Turtles calculated their position size:

Position Size = (Account Risk / N) / Dollars per Point

Where:

• Account Risk is the percentage of your trading account you're willing to risk on a single trade (typically 1-2%).
• N is the average true range of the market.
• Dollars per Point is the amount of money you make or lose for each point the market moves.

For example, if you have a $50,000 trading account and you're willing to risk 1% per trade, your Account Risk would be $500. If the N for a particular market is 0.50 (50 pips), and the Dollars per Point is $10, your position size would be:

Position Size = ($500 / 0.50) / $10 = 100 contracts

This means you would trade 100 contracts of that market, risking no more than $500 on the trade.

Entry and Exit Rules Explained

The Turtle Trading System used two main entry systems, System 1 and System 2, based on different breakout periods. A breakout occurs when the price exceeds the highest high or falls below the lowest low of a specific period.

• System 1: This system used a 20-day breakout. If the price exceeded the highest high of the past 20 days, the Turtles would enter a long position. If the price fell below the lowest low of the past 20 days, they would enter a short position.
• System 2: This system used a 55-day breakout. It was similar to System 1 but used a longer breakout period, making it more suitable for longer-term trends.

The Turtles also had specific exit rules to protect their profits and limit their losses. For System 1, the exit was based on a 10-day breakout in the opposite direction of the trade. For System 2, the exit was based on a 20-day breakout in the opposite direction.

These entry and exit rules provided a clear framework for making trading decisions, removing the need for subjective analysis. The Turtles simply followed the rules, regardless of their personal opinions or biases.

Practical Examples of the Turtle Trading System

Let's look at a couple of hypothetical examples to illustrate how the Turtle Trading System works in practice.

Example 1: EUR/USD – System 1

Assume you're trading the EUR/USD currency pair using System 1. Your trading account has $25,000, and you're willing to risk 1% per trade, which is $250. The current average true range (N) for EUR/USD is 0.0050 (50 pips), and each pip is worth $10 per standard lot.

1. Calculate Position Size: Position Size = ($250 / 0.0050) / $10 = 5 standard lots
2. Entry: The 20-day high is 1.1000. The price breaks above 1.1000, triggering a long entry at 1.1001.
3. Stop-Loss: The initial stop-loss is set at 2N, which is 100 pips below the entry price (1.0901).
4. Exit: The 10-day low is 1.1050. The price breaks below 1.1050, triggering a short exit.

Example 2: Gold (XAU/USD) – System 2

Assume you're trading gold (XAU/USD) using System 2. Your trading account has $100,000, and you're willing to risk 1% per trade, which is $1,000. The current average true range (N) for gold is $10, and each dollar is worth $100 per contract.

1. Calculate Position Size: Position Size = ($1,000 / $10) / $100 = 1 contract
2. Entry: The 55-day high is $1,900. The price breaks above $1,900, triggering a long entry at $1,901.
3. Stop-Loss: The initial stop-loss is set at 2N, which is $20 below the entry price ($1,881).
4. Exit: The 20-day low is $1,920. The price breaks below $1,920, triggering a short exit.

These examples demonstrate how the Turtle Trading System can be applied to different markets and trading systems. The key is to follow the rules consistently and manage your risk effectively.

Common Mistakes and Misconceptions

While the Turtle Trading System can be effective, there are several common mistakes and misconceptions that traders should avoid:

Another common misconception is that the Turtle Trading System is a guaranteed path to riches. While the original Turtles achieved remarkable success, trading involves risk, and there are no guarantees. The system provides a framework for managing risk and capitalizing on trends, but it's not a magic bullet.

Practical Tips for Implementing the Turtle Trading System

Here are some practical tips for implementing the Turtle Trading System effectively:

• Backtest the System: Before trading the system with real money, backtest it on historical data to evaluate its performance and identify potential weaknesses.
• Start with a Demo Account: Practice trading the system with a demo account to get comfortable with the rules and develop your trading skills.
• Manage Your Emotions: The Turtle Trading System is designed to remove emotion from trading decisions. However, it's important to manage your emotions and avoid making impulsive decisions.
• Adapt to Market Conditions: While the Turtle Trading System provides a framework for trend-following, it's important to adapt to changing market conditions. For example, you might need to adjust your position sizes or entry rules based on market volatility.

The Turtle Trading System offers a valuable framework for systematic trading and risk management. By understanding its core principles and adapting them to modern markets, traders can improve their decision-making and increase their chances of success. Remember, consistent application and disciplined risk management are key to unlocking the potential of this strategy.