Kirkpatrick’s Investment and Trading Strategies:
Tools and Techniques for Profitable Trend Following
By Charles D. Kirkpatrick II, CMT
$49.99; 149 pages
In this short, but informative-packed book, Kirkpatrick provides a step-by-step approach to back testing trend following strategies. The author has more than 47 years experience as a security analyst, portfolio manager, block desk trader, options trader and institutional broker. He is head of his own technical analysis research firm, and is a two-time winner of Market Technician Association’s Charles H. Dow Award.
According to Kirkpatrick, an investment program has three critical components that must be carefully managed to have success: entry strategy, exit strategy (also called risk management) and money management (managing portfolio risk). Unfortunately, many investors and professionals forget to focus on the last two, which are the most important. Money management is not covered in this book, as Kirkpatrick considers it complicated and deeply personal.
Kirkpatrick fully describes and tests the concepts used with his favorite investment and trading strategies. He examines stock selection systems and several technical indicators, and illustrates the best combination of indicators. Furthermore, he estimates that it will only take about one hour a week to keep track of your investments using any of his methodologies. His back testing focused on 6,272 U.S. common stocks from 1990 through year-end 2012 using daily closing prices, excluding dividends and ETFs.
The author uses algorithmic systems that are non-discretionary and uses proven mechanical strategies with a focus on generating trading profits. This type of trading requires specific trading rules to enter and exit individual stocks and the trader “must have the will power, discipline, and patience not to waver from it.”
A system is a specific set of buying and selling rules that are back-tested for verity and robustness (stability). The rules are derived from statistical methods of optimization. The author describes the best investment trend following methods based upon a lifetime of study. He also presents a walk-forward method of optimizing strategies, as well as out of sample testing with optimization which he feels is critical to proving that a developed system is robust.
Kirkpatrick spends considerable time reviewing the testing of relative strength strategies. He mentions the pioneering work of Robert Levy in the late 1960s. He used a 26-week look-back period for his relative strength calculation and ranking. The author used the 26-week period for more than 30 years in his work. Now, he tests not only estimated look back period, but also ideal buy and sell ranking, minimum transaction volume and a price necessary for profit and a protective stop. An interesting finding was that certain periods of relative strength did not work well, but no system works perfectly all the time.
If using relative strength analysis it is very important to not invest when market declines have started. Replacing stocks dropping in the ranking or being stopped out with other stocks with a higher ranking as the overall market is declining will have unacceptable drawdowns, therefore additional criteria needs to be used.
His primary method to protect against losses is technical analysis. He found that drawdown was the best measure of risk. He mentions that volatility doesn’t indicate the dollar amount or percentage of risk and that “volatility should never be used as the primary gauge of risk.” Losses emanate from drawdown not volatility. The Sharpe ratio measures both up and down volatility and is not a measure of risk. Upside volatility is desired while downside volatility is not.
A successful system generates a rising equity curve with a minimum drawdown. His analysis always begins with the slope of the equity curve. Kirkpatrick does not recommend including slippage and commissions in the stock selection process, but feels that they are important later on, if the system is profitable and robust. He found that after extensive testing that protective stops did not help performance and did not work well in limiting maximum drawdown.
Kirkpatrick discovered that the best use of moving averages is a double, trend filtered dual moving average crossover, which he says provides valid signals. And it is important to use different parameters for buying and selling. He also suggests using a forward line (29-day moving average moved 15 days ahead) and uses an average directional index (ADX) to determine trend strength. He found that ADX is superb for closing a trend-following position, and for that reason is his favorite indicator.
Overall, Kirkpatrick provides a fascinating and comprehensive analysis of back testing trend following strategies. One thing he has learned is, “Finding a system that has worked in the past is easy, finding one that will work in the future is difficult.” That is the crux of the matter, and one which investors should be well aware of.
Leslie N. Masonson is a trader, as well as the author of Buy DON’T Hold and All About Market Timing, (Second Edition). Reach him at firstname.lastname@example.org.