Kirkpatrick & Dahlquist, Technical Analysis, 2d ed.

Don’t yawn at the prospect of yet another book on technical analysis. This one is far superior to the usual fare. It is also, for those aspiring for credentials, the official companion to the Market Technicians Association CMT program.

Technical Analysis: The Complete Resource for Financial Market Technicians, 2d ed. by Charles D. Kirkpatrick II and Julie Dahlquist (FT Press, 2011) is a hefty 700-page book. Thankfully it is not a compendium of technical indicators. Instead, in 23 chapters it covers such topics as the principle of TA (trend), sentiment, market strength, chart pattern analysis, trend confirmation, system design and testing, and money and risk management. These topics may be time-worn, but the authors approach them with a welcome conceptual freshness and illustrate many of them with data not readily available elsewhere.

The result is a thorough but eminently readable book for those who are learning the art of technical analysis. For those steeped in TA, it provides an opportunity to step back and rethink some assumptions as well as to become acquainted with new metrics.

Today I’ll share an oscillator for market timers and a method that system traders can use to place protective stops.

Ned David Research is well known for its innovative data studies, and the authors include several in their text. Here’s one, using the ratio of the NYSE advance-decline line to its 32-week simple moving average to create an oscillator. “They found that from 1965 to 2010 when the ratio rises above 1.04, the per annum increase in stock prices as measured by the NYSE Composite Index was 19.3%, and when it declined below 0.97, the stock market declined 11.2% per annum.” (p. 139)

As those of you who have followed my blog know, I have written in the past about the difficulties with using protective stops. Kirkpatrick and Dahlquist, relying on John Sweeney’s notion of maximum adverse excursion (see his Campaign Trading [1996] and Maximum Adverse Excursion [1997] as well as my post about the former), explain one method of determining where a protective stop should be placed. Since this stop is designed “to prevent loss if something goes wrong with the system,” we can calculate the maximum heat the system has taken in the past when it was successful. Anything beyond that point can be considered system failure. Sweeney’s maximum adverse excursion, the amount “by which the value of the entered position in each trade goes against the initial value before it is closed at a profit,” is viewed as the tipping point between profit and loss. “It is similar to a drawdown except limited to winning trades. … If the system is trouble free, that price is the level beyond which a profitable trade should not go in the future. A price just beyond that level is where the protective stop should be placed.” (p. 574)

Technical Analysis is a first-rate book that every trader and investor—even those who believe that TA is voodoo—should read. It is a skillful, comprehensive overview of the field.