Trend following. Catch big moves, sit through the pullbacks.

Trend following is the strategy of buying strength and selling weakness, riding established trends until they reverse. The approach has produced billions in profits for systematic CTAs (commodity trading advisors), the Turtle Traders, and disciplined retail traders for decades. It also produces the most uncomfortable equity curves in trading because most trades are small losses and the few winners are massive.

The honest version of trend following is mostly about patience. The entry rules are simple. The exit rules are simple. The discipline to follow them through 6 to 12 month drawdowns is what separates the traders who get the math from the ones who quit.

What trend following actually is

The thesis is that price trends persist longer than the average market participant expects. When a stock breaks out to new highs, the breakout often extends much further than the immediate buyers expected. When a stock breaks down to new lows, the breakdown often extends much further than the bears expected.

Trend following captures the persistence by entering on confirmed breakouts and holding until the trend reverses. The trader does not predict the move. The trader reacts to the trend after it has started and lets the math work over many trades.

The core mechanics

Entry: breakouts to new extremes.

The most common entry signal is a breakout to a new 20 day, 55 day, or 200 day high (for longs). The Turtle system used 20 day breakouts as the System 1 entry and 55 day breakouts as the System 2 entry. Donchian channels visualize these levels.

Modern trend followers may use moving average crossovers, ATR breakouts, or specific chart pattern breakouts as entry signals. The principle is the same. Enter when price confirms strength to new highs or weakness to new lows.

Position sizing: ATR based.

Position size is calculated using the volatility of the underlying. The Turtle formula was N = 20 day ATR. Position size = (account risk per trade) / (2 x N). This sizes each position so that a 2 ATR move against the trade represents the same dollar risk as every other trade in the portfolio.

The volatility based sizing means a $1,000 risk per trade buys more shares of a low volatility stock and fewer shares of a high volatility stock. Each trade has the same dollar at risk regardless of the individual price action of the underlying.

Exit: trailing stop based on volatility or moving average.

The exit is the inverse of the entry. For long trend follows, exit on a break to a new 10 day low or below a key moving average (50 day or 200 day depending on timeframe).

The trailing stop locks in profit as the trend extends. The stop moves only in the favorable direction, never against the position.

The math behind trend following

Trend following systems typically have win rates of 30 to 40 percent. Most trades are small losses (the trend never developed, the stop fires shortly after entry).

The few winners are the entire P and L. The big winners (10 percent of trades) often produce 5 to 10 times the risk per trade. The small losers (70 percent of trades) each cost 1 unit of risk. The math works because the winners are large enough to overcome the high frequency of small losses.

This math is uncomfortable to live with. The trader takes 7 small losses, then breaks even, then takes 3 more small losses, then catches a 10x winner. The equity curve is choppy with long flat periods punctuated by sharp gains.

The setup for retail trend following

Universe.

Liquid stocks with sufficient volatility. Avoid penny stocks (too erratic) and slow movers (no trends). The Russell 2000 or S and P 1500 are reasonable universes.

Some trend followers run the strategy on broader instruments. Futures across stock indexes, commodities, currencies, rates. The diversification across uncorrelated markets smooths the equity curve.

Timeframe.

Daily charts for the most reliable signals. Weekly charts for longer term trend following. Intraday timeframes have too much noise to produce clean trend signals.

Entry signal.

20 day or 55 day breakout for the simplest version. Donchian channels show these levels visually. Close above the upper channel for long entry. Close below the lower channel for short entry.

Position size.

Risk 0.5 to 1 percent of account per trade. Use the ATR based sizing formula: shares = (account x risk percent) / (2 x ATR x dollar per point).

Stop loss.

2 x ATR below entry for long trades. Move up as price extends to lock in profit. Most modern systems also use a maximum loss percentage as a backup.

Trailing stop.

10 day low for short term trend following. 20 day low for medium term. 50 day moving average or higher low pivot for longer term. Match the trailing stop to the intended trade horizon.

No profit target.

Trend following does not use profit targets. The trade exits when the trailing stop fires. The trader does not predict where the trend ends. Letting winners run is the only way the math works.

The psychological challenge

Trend following is emotionally hard for three reasons.

The drawdowns are long.

Trend following has periods of 6 to 18 months where no significant trends develop in the universe. During these periods, the system produces small losses without big winners. Drawdowns of 20 to 30 percent are normal.

The retail trader who quits during the drawdown locks in the loss and misses the recovery. The disciplined trader who keeps taking signals captures the next big winner that pays for the drawdown.

Giving back open profits feels terrible.

The trailing stop methodology means the trader gives back a portion of the open profit on every trade. A trade that was up 50 percent at the peak might exit at 30 percent profit when the stop fires.

The retail trader who tries to "lock in" the 50 percent by closing at the peak instead of trailing the stop ends up cutting winners short. The trader who lets the stop fire mechanically captures the math.

Frequent small losses test confidence.

The 60 to 70 percent loss rate is uncomfortable. Most days produce a stop out somewhere in the portfolio. The trader has to detach from individual trade outcomes and trust the system math.

The variants

Pure trend following.

Mechanical entries and exits with no discretion. The Turtle system is the canonical example. Modern CTAs follow this approach with proprietary refinements.

Trend following with overlay.

Mechanical signals filtered by additional rules. Only take signals in stocks above the 200 day moving average. Skip signals during high volatility regimes. Etc.

Discretionary trend following.

The trader uses trend following principles but applies judgment to entry and exit. Less mechanical but allows for adaptation to specific situations.

The mechanical version is harder to override emotionally and easier to backtest. The discretionary version requires more skill but can adapt to changing markets.

The famous practitioners

Richard Dennis and William Eckhardt. Developed the Turtle Trading system. Trained the Turtles in the 1980s. The Turtles collectively earned over $100 million following the rules.

Dunn Capital Management. Bill Dunn's firm has run mechanical trend following on futures for decades, producing consistent returns across multiple market regimes.

Man AHL, Winton Group, Aspect Capital. Major systematic trend following hedge funds with multi billion dollar AUM. All run variations of trend following with sophisticated risk overlays.

Ed Seykota. Profiled in Market Wizards. Pioneered computerized trend following in the 1970s.

Where the audit fits

The audit reads the trade record and identifies whether the trader is actually trend following or only thinks they are. For most retail self described trend followers, the pattern is cutting winners short or skipping signals during drawdowns. Both kill the math. The plan locks the mechanical rules. Five to seven pages.