John Murphy's Ten Laws of Technical Trading

Which way is the market moving? How far up or down will it go? And when will it go the other way? These are the basic concerns of the technical analyst. Behind the charts and graphs and mathematical formulas used to analyze market trends are some basic concepts that apply to most of the theories employed by today's technical analysts.

John Murphy, StockCharts.com's Chief Technical Analyst, has drawn upon his thirty years of experience in the field to develop ten basic laws of technical trading: rules that are designed to help explain the whole idea of technical trading for the beginner and to streamline the trading methodology for the more experienced practitioner. These precepts define the key tools of technical analysis and how to use them to identify buying and selling opportunities.

Before joining StockCharts, John was the technical analyst for CNBC-TV for seven years on the popular show Tech Talk, and has authored three best-selling books on the subject: Technical Analysis of the Financial Markets, Intermarket Technical Analysis and The Visual Investor.

His most recent book demonstrates the essential visual elements of technical analysis. The fundamentals of John's approach to technical analysis illustrate that it is more important to determine where a market is going (up or down) rather than the why behind it.

The following are John's ten most important rules of technical trading:

1. Map the Trends
2. Spot the Trend and Go With It
3. Find the Low and High of It
4. Know How Far to Backtrack
5. Draw the Line
6. Follow That Average
7. Learn the Turns
8. Know the Warning Signs
9. Trend or Not a Trend?
10. Know the Confirming Signs

1. Map the Trends

Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale map of the market provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer term trends.

2. Spot the Trend and Go With It

Determine the trend and follow it. Market trends come in many sizes – long-term, intermediate-term and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing.

3. Find the Low and High of It

Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new low. In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies – the old "low" can become the new "high."

4. Know How Far to Backtrack

Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.

5. Draw the Line

Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes.

6. Follow that Average

Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if existing trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4- and 9-day moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the shorter average line crosses the longer. Price crossings above and below a 40-day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market.

7. Learn the Turns

Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. Most traders use 14-days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used as filters for intra-day charts.

8. Know the Warning Signs

Trade MACD. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel) combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. An MACD histogram plots the difference between the two lines and gives even earlier warnings of trend changes. It's called a "histogram" because vertical bars are used to show the difference between the two lines on the chart.

9. Trend or Not a Trend

Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX favors oscillators. By plotting the direction of the ADX line, the trader is able to determine which trading style and which set of indicators are most suitable for the current market environment.

10. Know the Confirming Signs

Include volume and open interest. Volume and open interest are important confirming indicators in futures markets. Volume precedes price. It's important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising open interest confirms that new money is supporting the prevailing trend. Declining open interest is often a warning that the trend is near completion. A solid price uptrend should be accompanied by rising volume and rising open interest.

"11."

Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.

- John Murphy

Definitions: Leonardo Fibonacci was a thirteenth century mathematician who "rediscovered" a precise and almost constant relationship between Hindu-Arabic numbers in a sequence (1,1,2,3,5,8,13,21,34,55,89,144,etc. to infinity). The sum of any two consecutive numbers in this sequence equals the next higher number. After the first four, the ratio of any number in the sequence to its next higher number approaches .618. That ratio was known to the ancient Greek and Egyptian mathematicians as the "Golden Mean" which had critical applications in art, architecture and in nature.

Stochastics - an oscillator popularized by George Lane in an article on the subject which appeared in 1984. It is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range; conversely, in down trends, closing prices tend to be near the lower end of the range. Stochastics has slightly wider overbought and oversold boundaries than the RSI and is therefore a more volatile indicator. The term "stochastic" refers to the location of a current futures price in relation to its range over a set period of time (usually 14 days).

Swing Charting

What do Point & Figure charts, Kagi charts, Renko charts, Filtered Waves, and Zig Zag have in common? They are all related to swing charting in some way. Swing charting follows a simple concept: additional information to the chart is made when a new price swing penetrates the level of the prior swing in the same direction. The basis of this type of charting is the filter. Once prices have moved by the distance specified by this filter, a new line is drawn next to the previous one. In a nutshell, it is a chart that shows up and down price movement of a minimum size regardless of the time it takes.

Another concept of swing charts is that it works similarly to a breakout system. A new high made after so many days is a buy signal and a sell signal occurs when a new low is made after so many days. This has been written about for years, by Gann, Merrill, Livermore, Donchian, Hochheimer, Wilder, and Keltner, to name a few. They all used some form of swing charting.

Many swing based systems use volatility as the basis for determining the parameters to use for determining the swing filter. This way, as the current volatility increases, the number of days used in the calculation of the swing filter decreases.

On of the more simple swing systems was Donchian's Four-Week Rule. Buy when the current price goes above the highs of the previous 4 full weeks. Sell (go short) when the price falls below the lows of the previous 4 full weeks. That's it. Guess what? In 1970, Dunn and Hargitt Financial Services rated it as the best of the popular systems of the day.

There are a host of different swing charting techniques. Some use 3 consecutive new highs as an up move and will remain as such until 3 consecutive new lows. The list is endless, but the concept is the same.

Arthur Merrill first wrote about filtered waves in his book, Filtered Waves, in 1977. His swing filter was merely a percentage of price movement. This technique removes actual price from the decision and can work on just about any time series. For all you engineers, it is just an amplitude filter; it helps remove undesirable information.

Zig-Zag is the term used by many charting programs, including StockCharts.com, for this filtered wave type of charting.

One simple example is to display price data identifying only moves of 5% or greater.




One can see that it filters out all the small price variations and only shows the moves of 5% or greater.

IMPORTANT: One caveat however, the last leg of Zig Zag is going to change as the most recent price changes until prices are reversed by the filter amount (5% in the above chart). The important item is the turning point, which is the point at which prices have reached at least the filter amount since they reversed. If you see a turning point, then prices have already moved at least the filtered amount in the opposite direction. Please read this paragraph again.

Below is the same price data but with a 10% filter being used. Notice how it removed some of the smaller waves.



Below is a chart using the exact same data, but with a filter of 15%. That is, only moves of 15% or greater are shown by Zig Zag. Notice that the small up-move in the last few days of the previous charts is gone. This is because prices have not moved upward by 15% since the down leg started.



Swing charting is a viable tool for trading and making investment decisions. It covers all the basics:

*stay with the trend
*limit losses
*follow well-defined rules

Elliott Wave Theory

According to the Elliott Wave Theory, stock prices tend to move in a predetermined number of waves consistent with the Fibonacci series. Specifically, Elliott believed the market moved in five distinct waves on the upside and three distinct on the downside. The basic shape of the wave is shown below.

R. N. Elliott believed markets had well-defined waves that could be used to predict market direction. In 1939, Elliott detailed the Elliott Wave Theory, which states that stock prices are governed by cycles founded upon the Fibonacci series (1-2-3-5-8-13-21…).


Waves one, three and five represent the 'impulse', or minor up-waves in a major bull move. Waves two and four represent the 'corrective,' or minor down-waves in the major bull move. The waves lettered A and C represents the minor down-waves in a major bear move, while B represents the one up-wave in a minor bear wave.

Elliott proposed that the waves existed at many levels, meaning there could be waves within waves. To clarify, this means that the chart above not only represents the primary wave pattern, but it could also represent what occurs just between points 2 and 4. The diagram below shows how primary waves could be broken down into smaller waves.




Elliott Wave theory ascribes names to the waves in order of descending size:

1. Grand Supercycle
2. Supercycle
3. Cycle
4. Primary
5. Intermediate
6. Minor
7. Minute
8. Minuette
9. Sub-Minuette

The major waves determine the major trend of the market, and minor waves determine minor trends. This is similar to the way Dow Theory postulates primary and secondary trends. Elliott provided numerous variations on the main wave, and placed particular importance on the golden mean, 0.618, as a significant percentage for retracement.

Trading using Elliott Wave patterns is quite simple. The trader identifies the main wave or Supercycle, enters long, and then sells or shorts, as the reversal is determined. This continues in progressively shorter cycles until the cycle completes and the main wave resurfaces. The caution to this is that much of the wave identification is taken in hindsight and disagreements arise between Elliott Wave technicians as to which cycle the market is in.

Here is an example of an Elliott Wave cycle. Ideally, Wave Two would not retrace more than 66%, but you can get a real sense of the wave patterns in action from the chart, just as well.


For more information, check out Elliott Wave Principle: Key to Market Behavior by Robert Prechter.

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Bollinger Band Tactics

Bollinger Band Tactics

Bollinger Bands draw their power through two important characteristics. First, they exhibit an underlying trend-range axis just like price or moving averages. Second, they constrict or expand as they move. The interaction between these two forces draws unique patterns as bars unwind through its boundaries. Candlesticks work especially well with bands. For example, a Doji that strikes through a constricting band effectively signals a short-term reversal.

BBs bend and twist in response to price movement. These undulations predict how far trends should stretch before central tendency forces them back toward a central axis. Complex relationships develop between price-band direction and price-band constriction. For example, a trend tends to pause when constricting bands oppose it. It takes great skill to predict the bands' ultimate impact on price but is well worth the effort. More than any other tool, BBs pinpoint hidden swings and telegraph whether the profit door lies open or closed.

Bands may swing through relative highs or lows and then pull back into proportional retracement to start another trend thrust. Or they can enter extended ranges that meander back and forth without direction. Movement frequently stops dead in its tracks when price rises into a falling band or drops into a rising one. Sideways bands can appear in both rangebound and trending markets. Price often fails to reach new high or low territory until bands expand to clear the path. In many ways, Bollinger Bands predict time better than they predict price.


Buy Signal: The top Bollinger Band rises toward a test of the intraday high as Worldcom drops. This sharp divergence signals the eventual breakout after price finally reverses off of the bottom band. Watch band slope closely when bars return to test important highs or lows. It often reveals the time and force needed to push price through a S/R barrier.

The skilled eye watches constricted bands in real-time to estimate the buying or selling force required to push them out of the way. They work extremely well during the second test of an important high or low. When markets finally break out, expanding bars often shoot into the band's edge where congestion forms a flag until the BB allows further movement. Bands constrict tightly around narrowing price in sideways markets. Apply NR7 methodology here to anticipate an impending positive feedback event.

Bollinger Bands signal early warning of trend change. Sharp price movement forces bands to expand outward. When these active markets finally turn sideways, the bands slowly tighten and roll toward price. Time passes and the BB door closes on rapid vertical movement. Experience enables the swing trader to quickly estimate the time required before bands will tighten and plan accordingly.

Strong buying or selling may push price well outside a band. A tall bar can even print completely through the barrier in extreme conditions. General tactics suggest that violent reversals often follow these major band violations. But trading against these events carries risk since markets can print a short series of these volatile bars before the reversal takes place. Also note that this price action rarely occurs during intraday markets, except at the open.

Reduce risk by dropping down to the next lower time frame and waiting for a reversal there before executing a countertrend position. Odds also improve if the thrusting bars run into other forms of S/R that allow cross-verification for the entry level. Stay defensive during the trade. Once price returns within the band's limits, the underlying trend can reappear quickly unless the pullback generates other reversal signals. Look for Dark Cloud Cover or a similar candle pattern that fills any gap created by the bar outside the band. This complex setup can produce windfall profits if managed properly.

Swing traders work the quiet middle ground of Bollinger Bands for consistent profits. Build strategies that enter countertrend positions at one band and exit at the other. These swing setups face far less whipsaws than breakout entries at band extremes. Keep in mind that the center band presents a natural profit obstacle that needs special consideration when calculating reward: risk. Make sure a safe exit near this center point still produces a decent profit for the trade.


Multiple Support-Resistance: A broad range sets up profitable swing conditions for KLA-Tencor. This 13-bar Bollinger Band combines with simple horizontal S/R to uncover natural reversal zones at band extremes. Enter a countertrend position when the prior bar prints a candlestick reversal outside the band line. Wait for a break of the center band if no clear signal arises. Exit if price does not expand quickly in the other direction or if the signal fails and the candle shadow gets taken out. Watch S/R closely for positive feedback that will eventually carry price out of the sideways market.

Use multi time frame Bollinger Bands to avoid expensive trend relativity errors. Look at the same market through 3 different time frames. This corresponds to one above and one below the chart that aligns with the holding period. Each setting produces a different range of band extremes and relative price location within the indicators. Match reward: risk to the central time frame but observe all intervening S/R on the other charts. Consider whether the holding period allows enough time to mount barriers and reach targets at other band levels.

Keep in mind that all bands change dynamically in response to price. This allows continuous feedback that shifts target values with each bar. Experience with this powerful indicator helps swing traders anticipate how it will move. The longer that price travels sideways, the tighter the bands become. Trend change for the bands themselves first begins with a turn by the band closest to the prior price trend. For example, when an uptrend prints along a top band, expect this side of the indicator to turn down before its twin when price moves into a range or downtrend.

Combine Bollinger Band study with momentum-based indicators. This helps filter directional movement from rangebound markets and improves trade timing. Add MA Ribbons to price and display the MACD Histogram across the lower pane. Price often remains well within band constriction during the early phases of new positive feedback events. As these indicators show rising momentum, shift attention to natural pattern/band breakout levels and look for entry within narrowing bars.