Mastering The Turtle Trading Strategy: A Beginner's Guide

In the 1980s, legendary commodity trader Richard Dennis conducted an experiment to prove that anyone could be taught to trade. He placed an ad in The Wall Street Journal, and from the thousands of applicants, 14 traders were chosen to become Turtle Traders. These traders were trained to follow a set of rules and made millions in the process. The turtles were given a list of markets to trade, including US treasury bonds, cocoa, coffee, cotton, oil, sugar, gold, and various global currencies. They were also given $1 million to work with. The turtles were taught to approach trading with the scientific method, which would be the foundation for all of their trading decisions. This method relies on observable, empirical, measurable evidence and is based on the steps of experimentation, data collection, and interpretation. The core concepts that the turtles internalized included not letting emotions fluctuate with the ups and downs of trading, being consistent and even-tempered, and judging oneself by the process rather than the outcome.

Know the state of the market

Knowing the state of the market is a crucial aspect of trading like a turtle. So, what does this entail?

Firstly, it refers to understanding the current price and direction of the market. For example, if a particular stock is trading at $40 per share and has been steadily increasing from a previous price, then that upward trajectory is the state of the market. It's important to focus on the present price and trend rather than getting caught up in the market of yesterday or tomorrow.

The state of the market also involves identifying the specific markets you want to trade in. Turtles were given a list of markets to trade, including US treasury bonds, cocoa, coffee, cotton, oil, sugar, gold, various global currencies, and more. They focused on highly liquid markets that allowed them to trade without significantly impacting the market with large orders.

Additionally, knowing the state of the market means being aware of market volatility. Turtles were taught to calculate daily volatility by tracking how much a market fluctuated on a typical day. For instance, if a stock usually trades at $50 but bounces between $48 and $52 on a given day, the volatility ("N") for that market would be 4. More volatile markets generally carry more risk.

Understanding the state of the market is a fundamental step in the Turtle Trading approach. It provides a foundation for making informed trading decisions and determining when to enter and exit trades. By focusing on current prices, trends, and volatility, traders can make more strategic choices.

In conclusion, knowing the state of the market involves understanding the current price, direction, specific markets, and volatility. This knowledge forms the basis for applying the Turtle Trading rules and strategies effectively.

Understand volatility

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In simple terms, it refers to how much the price of a security or market index fluctuates. Generally, the higher the volatility, the higher the risk.

When discussing volatility in the context of the Turtle Trading experiment, Richard Dennis, William Eckhardt, and the Turtles used the term to refer to a specific type of volatility: the daily volatility of a market. They used the term "M" to describe this daily volatility, which represented how much a market typically fluctuated up and down on a day-to-day basis.

For example, if a share of IBM traded at $125 on average but fluctuated between $123 and $127 from day to day, the Turtles would say that IBM had an "M" of four. This daily volatility measure was crucial for the Turtles' trading strategy, as it helped them determine the risk associated with a particular market and influenced their position sizing and risk management decisions.

The Turtles used a position-sizing algorithm that normalised the dollar volatility of their positions by adjusting the size of their trades based on the volatility of the market. This approach allowed them to diversify their portfolios and ensure that each position carried a similar level of risk.

Additionally, the Turtles used volatility to calculate their position sizes. They used the formula:

> Unit = 1% of Account / N x Dollars per Point

Where "N" represented the underlying volatility, calculated as the average price movement over the last 20 days.

Understanding and effectively managing volatility was a key aspect of the Turtles' trading strategy. By incorporating volatility into their position sizing and risk management calculations, they were able to make more informed trading decisions and better manage their risk exposure.

Know your equity

Knowing your equity is one of the five essential questions that William Eckhardt outlined for the Turtle Traders to be able to answer at all times. Here is a detailed explanation of what this means and why it is important:

Knowing your equity means knowing how much money you have available for trading at all times. This is important because the rules and strategies for trading are based on the size of your account in that moment. For example, if you have a certain amount of money in your account, you shouldn't bet all of it on a single stock or contract. Instead, you would bet a small percentage of your account value on each trade. This way, you don't lose all your money on a single trade and you have more opportunities to make trades and potentially profit.

The Importance of Knowing Your Equity

The Turtle Traders were given large sums of money each to trade with. This meant that they could afford to make trades across a diverse range of markets, including US treasury bonds, cocoa, coffee, cotton, oil, sugar, gold, silver, copper, gasoline, and various global currencies. However, for the typical retail investor or trader without this level of capital, it would be challenging to work across all of these markets.

Calculating Equity

To calculate your equity, you need to know the dollar volatility of the market and the dollar volatility of your position. The dollar volatility of the market refers to how much the price of a security fluctuates over a given period, usually on a daily basis. The dollar volatility of your position is calculated using a position-sizing algorithm that adjusts the size of your trade based on the dollar volatility of the market.

Equity and Risk Management

Knowing your equity is crucial for effective risk management in trading. By knowing how much money you have available, you can determine the appropriate amount of risk to take on each trade. This involves deciding on the correct position size and setting stop losses to limit potential losses.

Adapting to Changes in Equity

It is important to note that your equity will change over time as you make trades and the market fluctuates. Therefore, you need to regularly update your calculations and adjust your trading strategies accordingly. A key principle of the Turtle Traders was to "know what you are going to do when the market does what it will do." This includes being prepared for losses and knowing how to adapt your trading strategy when your equity decreases.

In conclusion, knowing your equity is essential for successful trading as it enables you to make informed decisions about position sizing, risk management, and adapting to market fluctuations. By following the principles outlined by the Turtle Traders, you can improve your trading skills and potentially achieve profitable results.

Learn the system

The Turtle Trading system is one of the most famous trend-following strategies. It is based on purchasing a stock or contract during a breakout and quickly selling on a retracement or price fall. The idea is that the "trend is your friend", so you should buy futures breaking out to the upside of trading ranges and sell short downside breakouts.

The Turtles were trained to be trend-following traders. This means they would take advantage of "trends" in the market. When they found a trend, they would follow it to profit from capturing most of the trend, up or down.

The Turtles were taught to rely on the scientific method to minimize the psychological impacts of trading that could cause mistakes and significant losses. The scientific method involves seven steps:

• Define the question
• Gather information and resources
• Perform an experiment and collect data
• Interpret data and draw conclusions that serve as a starting point for new hypotheses

The Turtles were taught very specific rules to implement a trend-following strategy. The rules for trading were at the heart of what they learned. They were drilled into the fact that making a consistent profit was about following the rules, not being more intelligent or luckier.

• Look at prices rather than relying on information from television or newspaper commentators to make trading decisions.
• Have some flexibility in setting the parameters for your buy and sell signals. Test different parameters for different markets to find out what works best for you.
• Plan your exit as you plan your entry. Know when you will take profits and when you will cut losses.
• Don't ever risk more than 2% of your account on a single trade.
• If you want to make big returns, you need to get comfortable with large drawdowns.
• Use the average true range to calculate volatility and use this to vary your position size. Take larger positions in less volatile markets and lessen your exposure to the most volatile markets.
• Decide ahead of time when you will cut any losses and move on. Keep losses small by limiting the impact of emotions on a trade.
• Build positions using what is referred to as "units". One unit is calculated by taking one per cent of the account and dividing it by N (volatility) times the dollars per point (market dollar volatility).

Know your risk aversion

Risk aversion is a key concept in trading and a critical component of the Turtle Trading strategy. It refers to an investor's willingness to take on risk and their comfort level with potential losses. Here are some detailed insights into risk aversion and its role in the Turtle Trading approach:

Understanding Risk Aversion

Risk aversion is about knowing your tolerance for risk and how much loss you are comfortable with. It's a crucial aspect of any investment strategy, including the Turtle Trading method. As a trader, you need to determine how much risk you are willing to take. Too little risk might result in missing out on substantial profits, while too much risk could lead to significant financial losses. Finding the right balance is essential.

The Turtle Trading Approach to Risk Aversion

The Turtle Traders were taught to consider risk aversion as one of the five critical questions that informed their decision-making. Here's how they approached it:

• Determining Risk Tolerance: The Turtles understood that each trader or client had a unique level of risk aversion. They assessed their own or their client's tolerance for risk, recognizing that some individuals are more comfortable with higher risks than others.
• Risk Management Strategies: The Turtles were trained to implement risk management techniques. This included using stop losses to limit potential losses and defining exit strategies to prevent emotional decision-making.
• Position Sizing and Diversification: The Turtles employed position sizing strategies to manage risk. They adjusted the size of their positions based on dollar volatility, aiming for similar risk per dollar invested across their portfolio. This diversification helped spread risk and ensured that a single loss wouldn't be catastrophic.
• Strict Rule Following: The Turtles followed a set of rules that guided their trading decisions. These rules included guidelines on position sizing, entries, exits, and stops, reducing the potential for emotional judgments that could lead to excessive risk-taking.

Applying Risk Aversion in Trading

When applying the concept of risk aversion to your trading, consider the following:

• Know Your Risk Tolerance: Be honest with yourself about how much risk you are comfortable with. Assess your financial situation, goals, and emotional tolerance for potential losses.
• Risk Management Techniques: Implement strategies to manage risk, such as setting stop losses and defining exit points. These techniques help minimize potential losses and provide a more disciplined approach to trading.
• Diversify Your Portfolio: Diversification is a powerful tool for managing risk. By spreading your investments across various assets, sectors, or markets, you reduce the impact of any single loss on your overall portfolio.
• Stay Disciplined: Stick to your trading plan and follow the rules you've set for yourself. Emotional trading can lead to impulsive decisions that may increase risk beyond your comfort level.

In conclusion, risk aversion is a critical aspect of successful trading. By understanding your risk tolerance, implementing risk management strategies, diversifying your portfolio, and maintaining discipline, you can make more informed trading decisions that align with your risk profile. This approach, exemplified by the Turtle Traders, can help you navigate the markets with a measured and thoughtful approach to risk.

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