Looking for a trend following system that you can just take and use?
Not a good idea.
Here’s why…
Ever heard of the turtle traders?
You should if you want to be a true trend trader because trend trading systems only got really popular because of them.
In the 1980s, two legendary traders by the name of Richard Dennis and William Eckhardt had a debate on whether trading could be taught.
Particularly, Richard Dennis believed that it was possible to teach anyone to become successful in trading.
Whereas William Eckhardt believed that good traders were born.
This started an experiment of hiring people and teaching them to trade, where these people later came to be known as the turtle traders.
The result was phenomenal and some traders went on to make millions of dollars in the market.
Their experiment proved that trading can be taught.
However, there’s one thing to note…
And that is not all the traders were successful.
In fact, many of them did not make money despite using the same system.
Why?
Because the trading system did not suit their trading style.
When I was at the prop firm, we were all taught the same trading strategy.
However, despite being taught the same strategy, we all had different results.
And that’s because we all traded the strategy according to our own personality.
In fact, prop firms do NOT encourage every one of their traders to trade the same way.
While the strategy is the same, we have a degree of freedom in how we entered and exited our trades.
And that’s what you want to do as well.
So instead of blindly following someone else’s trading system, you want to build one that suits your trading style.
Ready?
Let’s get to it.
Building Your Trend Following System
The idea of a trend following system is simple…
Only trade in the direction of the trend.
But how do you identify the trend?
That’s where filters come in.
Filters are basically ways to help you identify whether the market is in an uptrend, a downtrend, or going sideways.
And there are two main types of filters you can use:
- Price
- Indicators
Price
The best way to identify whether a market is in an uptrend or downtrend is by visually seeing it on the charts.
When the market is in an uptrend, it forms higher highs and higher lows.
And when the market is in a downtrend, it forms lower highs and lower lows.
Just by visually seeing this on the chart, you will be able to determine whether or not you should be looking for a Long or Short entry.
Indicators
The next way of identifying whether the market is trending or not is by using indicators.
There are a plethora of indicators that traders use to identify whether a market is trending.
The most common ones are using moving averages.
For example, traders typically use two moving averages – a lower period moving average and a higher period moving average.
When the lower period moving average is above the higher period moving average, the market is considered to be in an uptrend.
And when the lower period moving average is below the higher period moving average, the market is considered to be in a downtrend.
Once you have identified whether the market is in a trend or not, you then want to get into the intricacies of your trend following system.
Here are 3 main elements of a trend following system:
- Entries
- Exits
- Risk Management
Let’s get into each one of them.
Entries
In my opinion, real trend-following traders have to be psychologically very strong.
That’s because by nature of a trend following system, it only has an average of a 30% win rate.
And because of that, they have to take every single trade…
If they miss just one trade, it may mean that they would have missed out on the one trade that would have recovered all their small losses and become profitable.
On the other hand, prop traders don’t have that pressure to take every single trade because they have many trade opportunities in a day and take small profits each time.
However, prop traders have the pressure to be profitable every month, whereas trend-following traders can have losing months and even years, but are profitable in the long run.
Alright, so now that you have established a way to identify trends in the market, you need to decide on your entry rules.
When using a trend following system in an uptrend, there really are only two ways to get into a trade:
- Buying a Breakout
- Buying a Pullback
You can either exclusively choose to enter based on one of them, or you can choose to enter based on both of them.
However, it’s much easier to focus on just one.
The turtle trading system purely focuses on entering trades on a breakout when the market hits a new X day high or low (i.e. 20-day high).
When to Go Long
Here are a few ideas to get into a Long trade when you have identified an uptrend:
- A pullback bounce to an Exponential Moving Average (EMA).
- A pullback when there’s hidden divergence.
- A bullish candlestick pattern formed on a higher low.
- A bullish candlestick pattern formed on a support level.
- A break above the previous swing high.
- A break above the Donchian Channel indicator.
- A bullish chart pattern formed.
When to Go Short
Here are a few ideas to get into a Short trade when you have identified a downtrend:
- A pullback bounce to an Exponential Moving Average (EMA).
- A pullback when there’s hidden divergence.
- A bearish candlestick pattern forming on a lower high.
- A bearish candlestick pattern forming on a resistance level.
- A break below the previous swing low.
- A break below the Donchian Channel indicator.
- A bearish chart pattern formed.
Exits
Most new traders focus on entries.
They always search for the “latest” or “best” way to get into a trade.
But finding an entry is actually the least significant element of your trend following system.
That’s because an entry doesn’t determine whether you are profitable or not.
What determines whether you make money or not comes down to where and how you exit.
And determining the optimal exit for your trading system is no easy task.
You can have good entries but still not make money.
Conversely, you can have bad entries but your system is profitable in the long run.
As a popular saying goes, “It’s not where you start. It’s where you finish.”
So where you exit can make the difference between a profitable trading system, and a non-profitable trading system.
And when it comes to defining your exit for your trend following system, there are 2 types of exits:
- How you protect your losses
- How you take profits
Defining Your Stop Loss
In my opinion, placing a Stop Loss is far easier than where you Take Profit.
But there are many different ways you can place your Stop Loss.
Here are a few ways you can strategically place your Stop Loss:
- A few pips away from the previous swing low/high.
- A few pips away from the entry candlestick’s low/high.
- A multiple of the Average True Range (ATR) indicator from your entry (i.e. 2 ATR).
- A multiple of the ATR away from the previous swing low/high.
- A Trailing Stop Loss of a multiple of ATR.
- A Trailing Stop Loss of a fixed 1R (Refers to R-Multiples).
Defining Your Take Profit
True trend-following traders do not use a Take Profit level.
That’s because they believe that you should let the market decide how much you can get out of a trade.
And because of this, trend-following traders do not place a Take Profit level, but a Trailing Stop Loss to let the market take them out of a trade.
That means that the Trailing Stop Loss serves as both a Stop Loss and a Take Profit mechanism.
However, with that said, there are times where you might want to have a Take Profit level.
For example, if you that there will be a piece of high-impact news about to come out later in the day, you might want to get out a part of your position at the nearest support or resistance level.
Or when there is a key support or resistance level and you want to take a part of your position off the table to secure your profits.
So here are a few methods you can use to place your Take Profit levels:
- At key support & resistance levels.
- At the previous swing low/high level.
- A fixed R-Multiple (i.e. 5R).
- A Trailing Stop Loss of a multiple of ATR.
- A Trailing Stop Loss of an R-Multiple (i.e. 2R).
- A Trailing Stop Loss that’s just a few pips away from the previous swing low/high.
- A Trailing Stop Loss that’s a few pips away from a moving average.
If there’s one element to spend most of your time one, it would be testing different exits.
That’s because while you can have the same entry for each of the above Take Profit methods, each of the methods will produce an entirely different result.
And it can mean the difference in a losing trading system and a winning one.
Risk Management
Risk management is the one thing that traders tend to neglect or totally avoid.
That’s because people don’t want to face the reality of losses.
However, losses are an inevitable part of trading.
It’s impossible to win every single trade.
So when the loss comes, you have to ensure that no one single trade can wipe out your entire trading account.
I remember years ago when on the very first day I joined a prop firm, one of the senior traders got fired on the spot.
The boss came to his desk and shouted at him, “What the F*** are you doing? Why are you not out of your position yet!?”
Then the boss told the senior trader to get out of his seat and told him to pack up and f*** off.
He had been there for 2 years and in just one trade, he got fired.
The boss then had to sit in his seat and exited his positions for him.
Apparently, this senior trader was in a trade where the market just went against him very badly.
And he had held on to multiple positions because as the market went against him, he just kept adding more positions on his conviction that the market would reverse in his favor.
Unfortunately, he did not manage his risk well and had traded bigger than he should.
That triggered an alert on the boss’ screen in his room and he came storming out trying to find out what is happening.
You see, this senior trader had actually been doing decently well for the month and was actually in profit.
However, just this one trade caught him off guard and if he took losses then, he would have wiped out all the profits he made for the month and would be in the red.
Hence, his ego and pride got in the way of his good trading up until then.
And just that one trade, not only did he lose money, but he also lost his job.
That was a BIG lesson for me, especially on the first day of my job!
And that is that you MUST manage your risk well, or just one loss can wipe you out.
Understanding Risk In Terms of R-Multiples
In the book Trade Your Way to Financial Freedom by Dr. Van K. Tharp, he introduced the concept of R-Multiple as a way to determine your risk.
So let’s say you determine $100 as your maximum risk you can lose per trade, then $100 will be considered 1R.
And if you made $300 on the trade, it means you made 3R.
The goal is to not lose more than 1R on any given trade and to accumulate as many Rs as you can in the long run.
And what that means is that you will have to lose 3 consecutive trades before you’re at breakeven again.
Understanding Expectancy
It’s important to understand that for a trend-following system, the typical win rate is around 30%.
That means 70% of the time you will lose 1R.
And 30% of the time you should win at least 2.5R on average in order to be profitable.
This comes from the expectancy formula:
(% win x amount won) – (% loss x amount loss)
So it becomes:
(30% x 2.5R) – (70% loss x 1R) = 0.05R
That means on average you will win 0.05R per trade.
This means your trading system has a positive expectancy.
But if you get a negative number from the expectancy calculation, then you have a negative expectancy system.
So if your 1R is $100, then you will be making an average of $5 per trade.
And if you want to make $5000, then you will need to have a total of 1000 trades.
Risk Per Trade
So how do you determine how much exactly should your 1R risk be?
There are basically two ways that traders allocate their risk per trade:
- Fixed Percentage – This is a fixed percentage of your trading capital per trade.
- Fixed Dollar – This is a fixed dollar amount you place on each trade regardless of the size of your trading capital.
You want to always go for a Fixed Percentage risk allocation model.
That’s because the nature of trend following system is that you will take many small losses until you get that huge win.
That means you need to have sufficient capital to stay in the game until you get that big win.
Most traders use the 1-percent or 2-percent rule.
That means that you do not risk more than 1% or 2% or any given trade.
I know of some traders that only risk just 0.5% per trade.
It comes down to what you’re comfortable with.
Doing so should allow you to stay in the game long enough that when the big wins come, you will still have sufficient capital to get into the trade.
Testing Your Trend Following System
After you have created the rules for your trend following system, you need to test it.
You can’t just create a trading system for the first time and start trading real money with it.
Imagine car manufacturers just coming up with a car design idea for the first time, then build it and start selling to people without testing the car’s safety.
Would you drive a car that has never been tested for safety before?
Unless you’re a daredevil, you certainly don’t want to be doing that.
Neither do you want to trade real money on a trading system that has not been tested before.
So how do you test your newly-built trend following system?
There are two tests you can do:
- Backtesting
- Forward Testing
Backtesting
Backtesting is when you test your trading system’s performance on historical data.
There are two ways to do that – automated or manual.
If you know how to code, you can program your trend following system into what’s called an Expert Advisor (EA).
And then you can backtest your EA on Metatrader 4 (MT4).
If you don’t know how to code and your strategy is simple enough, you can either use free EA coding software online like this…
Where you can input your trend following system’s rules without having to write a single line of code.
Or you can simply pay someone to code your trading system for you.
Depending on the complexity of your trading system, it can cost anywhere from $50 to over $1,000.
But if you’re like me and you don’t mind doing it the good old-fashioned way, then you can choose to go with manual backtesting.
That means you manually go through the charts from the past and mark where you would enter trades and where you would exit trades.
Then you’d have to manually record your trading system’s performance on a spreadsheet.
Forward Testing
Forward testing is when you test your trading system in a live environment.
That means you either use a demo account or a live account to test your system.
If your backtest shows good results, you can choose to trade a small live account.
But if you’re worried about risking real money, then go with a demo account.
However, do note that if you’re manually entering trades and not letting an EA execute your trades, trading on a live account is vastly different from trading a demo account.
When you have money on the line, all your emotions will come to play.
Greed and fear will be your two biggest enemies, and that’s why it’s important to have solid entry and exit rules in place so you know exactly when to get in and out of a trade without getting your emotions involved.
Managing Your Psychology
Building a robust trend following system that is profitable in the long run can be challenging.
But once you have built a positive expectancy trend following system, being able to trade your system with discipline is even more challenging.
And that’s because when you keep getting losses after losses and losing real money, your psychology can affect you.
You might get fearful and exit your trade too soon.
Or you might even fail to place a trade because you have had a streak of losses already.
So building the technical aspects of your trend following system is half the battle won.
But to be able to trade your trend following system according to the rules you have set is where the real battle is won.
When you have both, then you will have what it takes to be profitable in the long run.
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