A trend following system is a complete, rules-based approach to capturing market trends. Unlike discretionary trading, a system has specific rules for every decision: what to trade, when to enter, how much to risk, and when to exit. Building a robust trend following system requires understanding each component and how they work together.
What is a Trend Following System?
A trend following system is a mechanical trading approach that identifies trends and trades in their direction. Every decision is governed by predefined rules, removing emotion from the trading process. The system aims to catch big trends while managing risk through proper position sizing and exits.
System trading philosophy: Accept that you cannot predict which trends will be big. The system catches all trends, takes small losses on failed ones, and lets winners run to capture the occasional large move that pays for many small losses.
Components of a Trend Following System
Every complete trading system needs these five components:
1. Market Selection
Define which markets or stocks your system will trade. This could be a specific universe like the S&P 500, sector ETFs, or futures markets.
2. Entry Rules
Specific conditions that trigger trade entries. These must be objective and testable.
3. Position Sizing
How much capital to allocate to each trade. This is often the most important component.
4. Exit Rules
When to close positions, including both stop losses and profit-taking rules.
5. Risk Management
Overall portfolio risk limits and correlation management.
Classic Trend Following Entry Rules
These proven entry methods have worked for decades:
Donchian Channel Breakout
Enter long when price breaks above the highest high of the past N days. Enter short when price breaks below the lowest low. The original Turtle Trading system used 20 and 55 day channels.
Donchian Channel Entry
- Long entry: Price > 55-day high
- Short entry: Price < 55-day low
- Filter: Only trade in direction of 200-day MA trend
Moving Average Crossover
Enter when a faster moving average crosses above (long) or below (short) a slower moving average. Common pairs include 10/40, 20/50, or 50/200.
Moving Average Direction
Enter long when price is above a rising moving average. Enter short when price is below a falling moving average. This is simpler than crossovers and often performs well.
ATR Channel Breakout
Enter when price moves a certain number of ATRs from a moving average or recent closing price.
Entry is least important: Counter-intuitively, the specific entry method matters less than position sizing and exits. Most trend entry methods perform similarly when paired with good risk management.
Position Sizing Methods
Position sizing determines how much to risk per trade and is crucial for long-term success:
Fixed Fractional
Risk a fixed percentage of equity on each trade (commonly 1-2%). Position size varies based on stop loss distance.
Fixed Fractional Example
Account: $100,000 | Risk per trade: 1% ($1,000)
- Stock price: $50
- Stop loss: $45 (10% below entry, $5 risk per share)
- Position size: $1,000 / $5 = 200 shares
- Position value: $10,000 (10% of account)
Volatility-Based Sizing
Size positions based on each asset's volatility. More volatile assets get smaller positions. Often uses ATR as the volatility measure.
Equal Dollar Risk
Allocate equal dollar amounts to each position rather than equal risk. Simpler but less optimal.
Exit Rules for Trend Systems
Exits determine whether you catch big trends or cut them short:
Trailing Stop
Move stop loss up (for longs) as price advances. Common methods include ATR-based trails, moving average trails, or swing low trails.
Channel Exit
Exit longs when price hits the lowest low of N days. Often uses a shorter period than the entry channel.
Moving Average Exit
Exit when price closes below a moving average (for longs) or when the moving average turns against the trade direction.
Time Exit
Exit after a certain number of days regardless of profit/loss if the trade has not moved significantly.
Complete Exit Rules Example
- Initial stop: 2 ATR below entry price
- Trailing stop: Highest high minus 3 ATR (Chandelier Exit)
- Channel exit: Lowest low of past 20 days
- Use whichever is closest: Trailing or channel exit
Sample Complete System
Here is a complete trend following system example:
Simple Trend System Rules:
- Markets: S&P 500 stocks
- Entry (Long): 50-day high breakout when above 200-day MA
- Entry (Short): 50-day low breakdown when below 200-day MA
- Position size: Risk 1% of equity per trade
- Initial stop: 2.5 ATR from entry
- Trailing stop: 3 ATR from highest/lowest close
- Max positions: 10 simultaneous trades
- Max sector exposure: 3 positions per sector
Testing and Validation
Before trading real money, thoroughly test your system:
Backtesting
Test the system on historical data. Use enough data to capture various market conditions (at least 10-20 years for long-term systems).
Out-of-Sample Testing
Reserve a portion of historical data that was not used to develop the system. Test on this data to validate results.
Paper Trading
Trade the system in real-time without real money to verify execution and catch issues.
Key Metrics to Evaluate
- CAGR (Compound Annual Growth Rate)
- Maximum drawdown
- Sharpe Ratio
- Win rate and average win/loss ratio
- Number of trades per year
Track Your System Performance
Pro Trader Dashboard automatically calculates all key metrics for your trading system, helping you evaluate and improve your systematic approach.
System Trading Psychology
Even with a mechanical system, psychology matters:
- Trust the system: Follow rules even when individual trades feel wrong
- Accept drawdowns: Every system has losing periods; stick with it
- Do not optimize constantly: Over-optimization leads to curve-fitting
- Journal execution: Track whether you followed the rules exactly
Common System Mistakes
Avoid these pitfalls when building trend following systems:
- Over-optimization: Fitting system perfectly to past data but failing in live trading
- Too many rules: Complexity does not equal profitability
- Ignoring position sizing: The most important component is often overlooked
- Not accounting for costs: Commissions and slippage matter
- Abandoning during drawdowns: Switching systems at the worst time
- Not tracking execution: Failing to identify if poor results are from the system or execution
Adapting Systems to Different Timeframes
Trend following systems work across timeframes:
- Long-term (weekly): Fewer trades, lower costs, bigger moves captured
- Medium-term (daily): Balance of trade frequency and trend capture
- Short-term (intraday): More trades, higher costs, requires more attention
Summary
A trend following system provides a complete, mechanical approach to trading trends. The system must include rules for market selection, entry, position sizing, exit, and risk management. While entry rules get the most attention, position sizing and exits often have more impact on long-term results. Test systems thoroughly on historical data, validate on out-of-sample data, and paper trade before committing real capital. The key to system trading success is following the rules consistently through both winning and losing periods, trusting that the system's edge will show over time.