Turtle Trading: what is it and what are the rules?

We look at a famous experiment in trading history, and the rules employed by the test.

In the 1980s, the famous trader Richard Dennis, who had made his name and fortune trading a range of markets, made a bet. He wagered his friend, William Eckhardt, that anyone could be taught to trade, ‘grown’ in a similar way to how he had seen baby turtles being grown in Asia.

These ‘turtles’, as the students became known, were given Dennis’s own money and taught a series of rules relating to a complete trading system, covering the markets to trade, position-sizing, entries, stops, exits and tactics. The aim was to provide an entirely mechanical approach that, while it would not be successful 100% of the time, would provide a set of rules that would eliminate emotion and judgment, leaving the traders with the rules and nothing else. Dennis argued that he could publish his rules in a national newspaper and only a few people would use them, because most traders do not follow rules rigidly, opting to improvise when they feel like it and thus deviating from the rules and hitting performance.

What is turtle trading?

Turtle trading is a renowned trend-following strategy used by traders in order take advantage of sustained momentum. It looks for breakouts to both the upside and downside and is used in a host of financial markets.

Dennis’s idea was to create a mechanical strategy that allows traders to follow rules and not have to rely on ‘gut feeling’. A group of novice traders were trained to follow the rules and then, if successful, were given $1 million each to manage.

Turtle trading rules

  1. Markets traded: the turtles traded futures contracts, looking for highly liquid markets that would allow them to trade without moving the market without a large order. The turtles traded commodities, FX, metals, energy, bonds and the S&P 500.
  2. Position-sizing: the turtles traded using a position-sizing algorithm, which normalised the dollar volatility of the position by adjusting the size of the trade based on the dollar volatility in the market. This system looked to improve diversification, by ensuring that each position was the same size in each market. More liquid markets would see fewer contracts traded, and less liquid markets would trade more contracts. To gauge the volatility of a market, the system looked at the 20-day exponential moving average of the true range
  3. Entries: two different entry systems were used. The first used a simple 20-day breakout, defined as a 20-day high or low, or a 55-day breakout. Winning positions would be added to, up to a maximum of four entries. The turtles were told to ensure that they took all the signals on offer, since missing a signal could lead to missing out on a big winner, which would drag down overall returns.
  4. Stop losses: the turtles were taught to use stop losses at all times, in order to ensure that losses did not become too large. Crucially, they determined their stop loss before they entered the position, defining their risk before the trade was placed. Thus, they avoided major losses after the fashion of famous trader Nick Leeson, who allowed his losses to spiral out of control. More volatile markets had wider stops, in order to avoid being ‘whipsawed’ out of a trade.
  5. Exits: getting out of a position too early can seriously limit the possible win on that trade. This is a common mistake with trend-following systems. The trading systems that the turtles learned involved taking many trades, only a few of which turned into big winners. Many others were small losses. The system one exit rule was a 10-day low for long positions, and a 20-day high for shorts, while system two utilised a 20-day high or low. They did not use stop exit orders, but watched the price in real time.
  6. Tactics: finally, the turtles were taught some specifics about using limit orders and how to deal with fast-moving markets, including how to wait for calm before placing orders, rather than rushing in and trying to get the ‘best’ price, as so many new traders do. They were also taught to buy the strongest markets, and sell the weakest, in order to benefit from momentum.

Some of the students proved unable to follow the rules, with one in particular convinced that Dennis had withheld information. In actual fact, this student’s poor performance was due to an inability to follow the rules.

The system is designed to exploit trending markets, which can mean a trader will suffer sustained drawdowns in range-bound markets that move sideways for an extended period. The test of the turtles was their ability to follow the rules even during these periods of underperformance. Since no trader has a crystal ball, it is impossible to know when a test of a 20-day high or low will result in a breakout. Traders must be prepared for a loss, and indeed one useful form of mental preparation is to assume each trade placed will be a loser, resulting in a pleasant surprise when a winner comes along.

Why use turtle trading rules?

The turtle experiment provides us with useful information about how to become a successful trader. One key lesson is that a system is crucial; without a clearly defined set of parameters for entries, exits, position-sizing and stop losses, a trader is merely using his gut instinct. At some point this will lead him down the path of overtrading and using excessively large position-sizing.

The second lesson is that of psychology. While Dennis did not include a specific psychology element, the trouble that some students had in following the rules, or their desire to tinker with the rules, or miss certain entries, shows that humans have the greatest difficulty following a set of rules even when the system has proved to be remarkably effective.

We talk a lot about the importance of trading psychology, because it is a vital skill for traders to master. However, it is not easy. The turtle trading experiment is fascinating because it shows that a set of rules is vital, but equally vital is the mindset to follow those rules. A string of small losses can be disheartening, but the market is not there to fulfil our desires, and we need to realise that many perfectly good trades will simply be stopped out because of market movements. The truly successful trader will be able to ride out these periods of underperformance, and by correctly managing his losses and his risk-reward ratio, his winners will be larger than his losses, resulting in profits over a long time period.

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