<s> TECHNICALANALYSIS
Tae FINANCIALMARKETS
 
A COMPREHENSIVE GUIDE TO TRADINGMETHODS AND APPLICATIONSTECHNICALANALYSIS
mi FINANCIALMARKETS
A COMPREHENSIVE GUIDE TO TRADINGMETHODS AND APPLICATIONS
JOHN J. MURPHY
5Library of Congress Cataloging in Publication Data
Murphy, John J., [date]Technical analysis of the financial markets / John J. Murphy.. cm.Rev. ed. of: Technical analysis of the futures markets. ¢1986.Includes bibliographical references and index.ISBN 0-7352-0066-11. Futures market. 2. Commodity exchanges. I. Murphy, John J.Technical analysis of the futures markets. II. Title.HG6046.M87 1999332.64'4—de21 98-38531CIP
© 1999 by John J. Murphy
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Portions of this book were previously published asTechnical Analysis of the Futures Markets (New York Institute of Finance, 1985).
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NYIF and NEW YORK INSTITUTE OF FINANCEare wademarks of Executive Tax Reports, Inc.used under license by Prentice Hall Direct, Inc.To my parents,
Timothy and Margaretand
To Patty, Clare, and BrianContents
About the Author xxiiiAbout the Contributors XXVIntroduction XxVii
Acknowledgments XXXi
Philosophy of Technical Analysis 1
Introduction 1Philosophy or Rationale 2Technical versus Fundamental Forecasting 5
Analysis versus Timing 6
vilviii Contents\
Flexibility and Adaptability of TechnicalAnalysis 7
Technical Analysis Applied to Different TradingMediums 8
Technical Analysis Applied to Different TimeDimensions 9
Economic Forecasting 10Technician or Chartist? 10
A Brief Comparison of Technical Analysis in Stocks andFutures 12
Less Reliance on Market Averages and Indicators 14Some Criticisms of the Technical Approach 15Random Walk Theory 19
Universal Principles 21
Dow Theory 23Introduction 23
Basic Tenets 24
The Use of Closing Prices and the Presence ofLines 30
Some Criticisms of Dow Theory 31
Stocks as Economic Indicators 32
Dow Theory Applied to Futures Trading 32Conclusion 33Contents ix
 
Chart Construction 35Introduction 35
Types of Charts Available 36
Candlesticks 37
Arithmetic versus Logarithmic Scale 39
Construction of the Daily Bar Chart 40
Volume 41
Futures Open Interest 42
Weekly and Monthly Bar Charts 45
Conclusion 46
Basic Concepts of Trend 49Definition of Trend 49
Trend Has Three Directions 51
Trend Has Three Classifications 52
Support and Resistance 5S
Trendlines 65
The Fan Principle 74
The Importance of the Number Three 76
The Relative Steepness of the Trendline 76
The Channel Line 80
Percentage Retracements 85Contents
Speed Resistance Lines 87
Gann and Fibonacci Fan Lines 90Internal Trendlines 90
Reversal Days 90
Price Gaps 94
Conclusion 98
Major Reversal Patterns 99Introduction 99Price Patterns 100
Two Types of Patterns: Reversal andContinuation 100
The Head and Shoulders Reversal Pattern 103The Importance of Volume 107
Finding a Price Objective 108
The Inverse Head and Shoulders 110Complex Head and Shoulders 113
Triple Tops and Bottoms 115
Double Tops and Bottoms 117
Variations from the Ideal Pattern 121
Saucers and Spikes 125
Conclusion 128Contents xt
 
Continuation Patterns 129Introduction 129
Triangles 130
The Symmetrical Triangle 132
The Ascending Triangle 136
The Descending Triangle 138
The Broadening Formation 140
Flags and Pennants 141
The Wedge Formation 146
The Rectangle Formation 147
The Measured Move 151
The Continuation Head and Shoulders Pattern 153Confirmation and Divergence 155
Conclusion 156
Volume and Open Interest 157Introduction 157
Volume and Open Interest as SecondaryIndicators 158
Interpretation of Volume for All Markets 162
Interpretation of Open Interest in Futures 169 
ContentsSummary of Volume and Open Interest Rules 174Blowoffs and Selling Climaxes 175Commitments of Traders Report 175Watch the Commercials 176Net Trader Positions 177Open Interest In Options 177Put/Call Ratios 178Combine Option Sentiment With Technicals 179Conclusion 179Long Term Charts 181Introduction 181The Importance of Longer Range Perspective 182Construction of Continuation Charts for Futures 182
The Perpetual Contract™ 184Long Term Trends Dispute Randomness 184
Patterns on Charts: Weekly and MonthlyReversals 185
Long Term to Short Term Charts 185
Why Should Long Range Charts Be Adjusted forInflation? 186
Long Term Charts Not Intended for TradingPurposes 188
Examples of Long Term Charts 188Contents xiii
 
Moving Averages 195
Introduction 195
The Moving Average: A Smoothing Device with aTime Lag 197
Moving Average Envelopes 207
Bollinger Bands 209
Using Bollinger Bands as Targets 210
Band Width Measures Volatility 211
Moving Averages Tied to Cycles 212
Fibonacci Numbers Used as Moving Averages 212
Moving Averages Applied to Long TermCharts 213
The Weekly Rule 215
To Optimize or Not 220
Summary 221
The Adaptive Moving Average 222Alternatives to the Moving Average 223
Oscillators and Contrary Opinion 225
Introduction 225Oscillator Usage in Conjunction with Trend 226Measuring Momentum 228Contents
 
Measuring Rate of Change (ROC) 234
Constructing an Oscillator Using Two MovingAverages 234
Commodity Channel Index 237
The Relative Strength Index (RSI) 239
Using the 70 and 30 Lines to Generate Signals 245Stochastics (K%D) 246
Larry Williams %R 249
The Importance of Trend 251
When Oscillators are Most Useful 251
Moving Average Convergence/Divergence(MACD) 252
MACD Histogram 255
Combine Weeklies and Dailies 256
The Principle of Contrary Opinion in Futures 257Investor Sentiment Readings 261
Investors Intelligence Numbers 262
Point and Figure Charting 265
Introduction 266The Point and Figure Versus the Bar Chart 270
Construction of the Intraday Point and FigureChart 270
The Horizontal Count 274Price Patterns 275Contents xv
 
3 Box Reversal Point and Figure Charting 277Construction of the 3 Point Reversal Chart 278The Drawing of Trendlines 282
Measuring Techniques 286
Trading Tactics 286
Advantages of Point and Figure Charts 288P&F Technical Indicators 292
Computerized P&F Charting 292
P&F Moving Averages 294
Conclusion 296
x Japanese Candlesticks 297Introduction 297Candlestick Charting 297Basic Candlesticks 299Candle Pattern Analysis 301Filtered Candle Patterns 306Conclusion 308Candle Patterns 309
Elliott Wave Theory 319
Historical Background 319The Basic Tenets of the Elliott Wave Principle 320xvi Contents
 
Connection Between Elliott Wave and DowTheory 324
Corrective Waves 324
The Rule of Alternation 331Channeling 332
Wave 4 as a Support Area 334
Fibonacci Numbers as the Basis of the WavePrinciple 334
Fibonacci Ratios and Retracements 335Fibonacci Time Targets 338Combining All Three Aspects of Wave Theory 338
Elliott Wave Applied to Stocks VersusCommodities 340
Summary and Conclusions 341Reference Material 342
Time Cycles 343Introduction 343Cycles 344
How Cyclic Concepts Help Explain ChartingTechniques 355
Dominant Cycles 358Combining Cycle Lengths 361The Importance of Trend 361Left and Right Translation 362How to Isolate Cycles 363Contents Xvi
Seasonal Cycles 369
Stock Market Cycles 373
The January Barometer 373
The Presidential Cycle 373
Combining Cycles with Other Technical Tools 374Maximum Entropy Spectral Analysis 374
Cycle Reading and Software 375
Computers and Trading Systems 377Introduction 377
Some Computer Needs 379
Grouping Tools and Indicators 380
Using the Tools and Indicators 380
Welles Wilder’s Parabolic and Directional MovementSystems 381
Pros and Cons of System Trading 387Need Expert Help? 389
Test Systems or Create Your Own 390Conclusion 390
\ Money Management and Trading
Tactics 393
Introduction 393The Three Elements of Successful Trading 393XVI Contents
 
Money Management 394Reward to Risk Ratios 397
Trading Multiple Positions: Trending versus TradingUnits 398
What to Do After Periods of Success andAdversity 399
Trading Tactics 400
Combining Technical Factors and MoneyManagement 403
Types of Trading Orders 403From Daily Charts to Intraday Price Charts 405The Use of Intraday Pivot Points 407
Summary of Money Management and TradingGuidelines 408
Application to Stocks 409
Asset Allocation 409
Managed Accounts and Mutual Funds 410Market Profile 411
The Link Between Stocks and Futures:Intermarket Analysis 413Intermarket Analysis 414
Program Trading: The Ultimate Link 415
The Link Between Bonds and Stocks 416
The Link Between Bonds and Commodities 418
The Link Between Commodities and the Dollar 419Contents xix
Stock Sectors and Industry Groups 420
The Dollar and Large Caps 422
Intermarket Analysis and Mutual Funds 422Relative Strength Analysis 423
Relative Strength and Sectors 424
Relative Strength and Individual Stocks 426Top-Down Market Approach 427
Deflation Scenario 427
Intermarket Correlation 428
Intermarket Neural Network Software 429Conclusion 430
x Stock Market Indicators 433
Measuring Market Breadth 433Sample Data 434
Comparing Market Averages 435The Advance-Decline Line 436AD Divergence 437
Daily Versus Weekly AD Lines 437Variations in AD Line 437McClellan Oscillator 438McClellan Summation Index 439New Highs Versus New Lows 440New High-New Low Index 441Contents
 
Upside Versus Downside Volume 443The Arms Index 444
TRIN Versus TICK 444
Smoothing the Arms Index 445Open Arms 446
Equivolume Charting 447Candlepower 448
Comparing Market Averages 449Conclusion 452
+OPulling It All Together—A Checklist 453Technical Checklist 454
How to Coordinate Technical and FundamentalAnalysis 455
Chartered Market Technician (CMT) 456Market Technicians Association (MTA) 457The Global Reach of Technical Analysis 458Technical Analysis by Any Name 458Federal Reserve Finally Approves 459Conclusion 460
Advanced Technical Indicators 463
Demand Index (DI) 463Herrick Payoff Index (HPI) 466Contents xxi
Starc Bands and Keltner Channels 469
Formula for Demand Index 473
4
Market Profile 475
Introduction 475
Market Profile Graphic 478
Market Structure 479
Market Profile Organizing Principles 480Range Development and Profile Patterns 484Tracking Longer Term Market Activity 486
Conclusion 490
The Essentials of Building a Trading
System 4935-Step Plan 494
Step 1: Start with a Concept (an Idea) 495
Step 2: Turn Your Idea into a Set of ObjectiveRules 497
Step 3: Visually Check It Out on the Charts 497Step 4: Formally Test It with a Computer 497Step 5: Evaluate Results 500
Money Management 501
Conclusion 501xxii Contents
 
Eex. Continuous Futures Contracts 505Nearest Contract 506Next Contract 506Gann Contract 507Continuous Contracts 507
Constant Forward Continuous Contracts 508
. Glossary S11Selected Bibliography 523Selected Resources 527Index 531About the Author
 
John J. Murphy has been applying technical analysis for threedecades. He was formerly Director of Futures Technical Researchand the senior managed account trading advisor with MerrillLynch. Mr. Murphy was the technical analyst for CNBC-TV forseven years. He is the author of three books, including TechnicalAnalysis of the Futures Markets, the predecessor to this book. Hissecond book, Intermarket Technical Analysis, opened up a newbranch of analysis. His third book, The Visual Investor, appliestechnical work to mutual funds.
In 1996, Mr. Murphy founded MURPHYMORRIS, Inc.,along with software developer Greg Morris, to produce interactiveeducational products and online analysis for investors. Their Website address is:
www.murphymorris.com.
He is also head of his own consulting firm, JJM TechnicalAdvisors, located in Oradell, New Jersey.
xxiiiAbout the Contributors —
     
Thomas E. Aspray (Appendix A) is a Capital Market Analyst withPrinceton Economic Institute Ltd., located in Princeton, NewJersey. Mr. Aspray has been trading markets since the 1970s. Manyof the techniques he pioneered in the early 1980s are now used byother professional traders.
Dennis C. Hynes (Appendix B) is Managing Director andcofounder of R.W. Pressprich & Co., Inc., a fixed income bro-ker/dealer located in New York City. He also serves as the firm’sChief Market Strategist. Mr. Hynes is a futures and options traderand a CTA (Commodity Trading Advisor). He has an MBA inFinance from the University of Houston.
Greg Morris (Chapter 12 and Appendix D) has been devel-oping trading systems and indicators for 20 years for investorsand traders to be used with major technical analysis software pro-grams. He is the author of two books on candlestick charting (seeChapter 12). In August 1996, Mr. Morris teamed with JohnMurphy to found MURPHYMORRIS Inc., a Dallas-based firm ded-icated to educating investors.
XXVxxvi About the Contributors
 
Fred G. Schutzman, CMT (Appendix C) is the Presidentand Chief Executive Officer of Briarwood Capital Management,Inc., a New York-based Commodity Trading Advisor. He is alsoresponsible for technical research and trading system develop-ment at Emcor Eurocurrency Management Corporation, a riskmanagement consulting firm. Mr. Schutzman is a member of theMarket Technicians Association and is currently serving on theirBoard of Directors.Introduction _
   
I had no idea when Technical Analysis of the Futures Markets waspublished in 1986 that it would create such an impact on theindustry. It has been referred to by many in the field as the “Bible”of technical analysis. The Market Technicians Association uses itas a primary source in their testing process for the CharteredMarket Technician program. The Federal Reserve has cited it inresearch studies that examine the value of the technical approach.In addition, it has been translated into eight foreign languages. Iwas also unprepared for the long shelf life of the book. It contin-ues to sell as many copies ten years after it was published as it didin the first couple of years.
It became clear, however, that a lot of new material hadbeen added to the field of technical analysis in the past decade. Iadded some of it myself. My second book, Intermarket TechnicalAnalysis (Wiley, 1991), helped create that new branch of technicalanalysis, which is widely used today. Old techniques like Japanesecandlestick charting and newer ones like Market Profile havebecome part of the technical landscape. Clearly, this new work
xxviixxviii Introduction
needed to be included in any book that attempted to present acomprehensive picture of technical analysis. The focus of mywork changed as well.
While my main interest ten years ago was in the futuresmarkets, my recent work has dealt more with the stock market.That also brought me full circle, since I began my career as a stockanalyst thirty years ago. That was also one of the side effects of mybeing the technical analyst for CNBC-TV for seven years. Thatfocus on what the general public was doing also led to my thirdbook, The Visual Investor (Wiley, 1996). That book focused on theuse of technical tools for market sectors, primarily through mutu-al funds, which have become extremely popular in the 1990s.
Many of the technical indicators that I wrote about tenyears ago, which had been used primarily in the futures markets,have been incorporated into stock market work. It was time toshow how that was being done. Finally, like any field or disci-pline, writers also evolve. Some things that seemed very impor-tant to me ten years ago aren’t as important today. As my workhas evolved into a broader application of technical principles toall financial markets, it seemed only right that any revision of thatearlier work should reflect that evolution.
I’ve tried to retain the structure of the original book.Therefore, many of the original chapters remain. However, theyhave been revised with new material and updated with newgraphics. Since the principles of technical analysis are universal, itwasn't that difficult to broaden the focus to include all financialmarkets. Since the original focus was on futures, however, a lot ofstock market material has been added.
Three new chapters have been added. The two previouschapters on point and figure charting (Chapters 11 and 12) havebeen merged into one. A new Chapter 12 on candlestick chartinghas been inserted. Two additional chapters have also been addedat the end of the book. Chapter 17 is an introduction to my workon intermarket analysis. Chapter 18 deals with stock market indi-cators. We’ve replaced the previous appendices with new ones.Market Profile is introduced in Appendix B. The other appendicesshow some of the more advanced technical indicators and explainhow to build a technical trading system. There’s also a glossary.Introduction xxix
 
I approached this revision with some trepidation. I wasn’tsure redoing a book considered a “classic” was such a good idea. Ihope I’ve succeeded in making it even better. I approached thiswork from the perspective of a more seasoned and mature writerand analyst. And, throughout the book, I tried to show the respectI have always had for the discipline of technical analysis and forthe many talented analysts who practice it. The success of theirwork, as well as their dedication to this field, has always been asource of comfort and inspiration to me. I only hope I did justiceto it and to them.
John MurphyAcknowledgments
os Bay
The person who deserves the most credit for the second edition ofthis book is Ellen Schneid Coleman, Executive Editor at Simon &Schuster. She convinced me that it was time to revise TechnicalAnalysis of the Futures Markets and broaden its scope. I’m glad shewas so persistent. Special thanks go to the folks at Omega Researchwho provided me with the charting software I needed and, in par-ticular, Gaston Sanchez who spent a lot of time on the phone withme. The contributing authors—Tom Aspray, Dennis Hynes, andFred Schutzman—added their particular expertise where it wasneeded. In addition, several analysts contributed charts includingMichael Burke, Stan Ehrlich, Jerry Toepke, Ken Tower, and NickVan Nice. The revision of Chapter 2 on Dow Theory was a collab-orative effort with Elyce Picciotti, an independent technical writerand market consultant in New Orleans, Louisiana. Greg Morrisdeserves special mention. He wrote the chapter on candlestickcharting, contributed the article in Appendix D, and did most ofthe graphic work. Fred Dahl of Inkwell Publishing Services(Fishkill, NY), who handled production of the first edition of thisbook, did this one as well. It was great working with him again.
XxxiTECHNICALANALYSIS
iz FINANCIALMARKETS
 
A COMPREHENSIVE GUIDE TO TRADINGMETHODS AND APPLICATIONSPhilosophy ofTechnical Analysis
INTRODUCTION
Before beginning a study of the actual techniques and tools usedin technical analysis, it is necessary first to define what technicalanalysis is, to discuss the philosophical premises on which it isbased, to draw some clear distinctions between technical and fun-damental analysis and, finally, to address a couple of criticisms fre-quently raised against the technical approach.
The author's strong belief is that a full appreciation of thetechnical approach must begin with a clear understanding ofwhat technical analysis claims to be able to do and, maybe evenmore importantly, the philosophy or rationale on which it basesthose claims.
First, let’s define the subject. Technical analysis is the studyof market action, primarily through the use of charts, for the purpose offorecasting future price trends. The term “market action” includesthe three principal sources of information available to the techni-2 Chapter 1
 
cian—price, volume, and open interest. (Open interest is usedonly in futures and options.) The term “price action,” which isoften used, seems too narrow because most technicians includevolume and open interest as an integral part of their marketanalysis. With this distinction made, the terms “price action” and“market action” are used interchangeably throughout the remain-der of this discussion.
PHILOSOPHY OR RATIONALE
There are three premises on which the technical approach isbased:
1. Market action discounts everything.2. Prices move in trends.3. History repeats itself.
Market Action Discounts Everything
The statement “market action discounts everything” forms whatis probably the cornerstone of technical analysis. Unless the fullsignificance of this first premise is fully understood and accepted,nothing else that follows makes much sense. The technicianbelieves that anything that can possibly affect the price—funda-mentally, politically, psychologically, or otherwise—is actuallyreflected in the price of that market. It follows, therefore, that astudy of price action is all that is required. While this claim mayseem presumptuous, it is hard to disagree with if one takes thetime to consider its true meaning.
All the technician is really claiming is that price actionshould reflect shifts in supply and demand. If demand exceedssupply, prices should rise. If supply exceeds demand, pricesshould fall. This action is the basis of all economic and funda-mental forecasting. The technician then turns this statementaround to arrive at the conclusion that if prices are rising, forwhatever the specific reasons, demand must exceed supply andthe fundamentals must be bullish. If prices fall, the fundamen-Philosophy of Technical Analysis 3
 
tals must be bearish. If this last comment about fundamentalsseems surprising in the context of a discussion of technicalanalysis, it shouldn’t. After all, the technician is indirectlystudying fundamentals. Most technicians would probably agreethat it is the underlying forces of supply and demand, the eco-nomic fundamentals of a market, that cause bull and bear mar-kets. The charts do not in themselves cause markets to move upor down. They simply reflect the bullish or bearish psychologyof the marketplace.
As a rule, chartists do not concern themselves with the rea-sons why prices rise or fall. Very often, in the early stages of aprice trend or at critical turning points, no one seems to knowexactly why a market is performing a certain way. While the tech-nical approach may sometimes seem overly simplistic in itsclaims, the logic behind this first premise—that markets discounteverything—becomes more compelling the more market experi-ence one gains. It follows then that if everything that affects mar-ket price is ultimately reflected in market price, then the study ofthat market price is all that is necessary. By studying price chartsand a host of supporting technical indicators, the chartist in effectlets the market tell him or her which way it is most likely to go.The chartist does not necessarily try to outsmart or outguess themarket. All of the technical tools discussed later on are simplytechniques used to aid the chartist in the process of studying mar-ket action. The chartist knows there are reasons why markets goup or down. He or she just doesn’t believe that knowing whatthose reasons are is necessary in the forecasting process.
Prices Move in Trends
The concept of trend is absolutely essential to the technicalapproach. Here again, unless one accepts the premise that marketsdo in fact trend, there’s no point in reading any further. Thewhole purpose of charting the price action of a market is to iden-tify trends in early stages of their development for the purpose oftrading in the direction of those trends. In fact, most of the tech-niques used in this approach are trend-following in nature, mean-ing that their intent is to identify and follow existing trends. (SeeFigure 1.1.)4 Chapter 1
 
 
put ‘9 ("SPX) S&P 500 Stock Index
Monthly Line Chart
 
 
 
 
a a
 
Figure 1.1 Example of an uptrend. Technical analysis is based on thepremise that markets trend and that those trends tend to persist.
There is a corollary to the premise that prices move intrends—a trend in motion is more likely to continue than to reverse.This corollary is, of course, an adaptation of Newton’s first law ofmotion. Another way to state this corollary is that a trend inmotion will continue in the same direction until it reverses. Thisis another one of those technical claims that seems almost circu-lar. But the entire trend-following approach is predicated on rid-ing an existing trend until it shows signs of reversing.
History Repeats Itself
Much of the body of technical analysis and the study of marketaction has to do with the study of human psychology. Chart pat-terns, for example, which have been identified and categorizedover the past one hundred years, reflect certain pictures thatappear on price charts. These pictures reveal the bullish or bearishPhilosophy of Technical Analysis 5
 
psychology of the market. Since these patterns have worked wellin the past, it is assumed that they will continue to work well inthe future. They are based on the study of human psychology,which tends not to change. Another way of saying this lastpremise—that history repeats itself—is that the key to under-standing the future lies in a study of the past, or that the future isjust a repetition of the past.
TECHNICAL VERSUSFUNDAMENTAL FORECASTING
While technical analysis concentrates on the study of marketaction, fundamental analysis focuses on the economic forces ofsupply and demand that cause prices to move higher, lower, orstay the same. The fundamental approach examines all of the rel-evant factors affecting the price of a market in order to determinethe intrinsic value of that market. The intrinsic value is what thefundamentals indicate something is actually worth based on thelaw of supply and demand. If this intrinsic value is under the cur-rent market price, then the market is overpriced and should besold. If market price is below the intrinsic value, then the marketis undervalued and should be bought.
Both of these approaches to market forecasting attempt tosolve the same problem, that is, to determine the direction pricesare likely to move. They just approach the problem from differentdirections. The fundamentalist studies the cause of market movement,while the technician studies the effect. The technician, of course,believes that the effect is all that he or she wants or needs to knowand that the reasons, or the causes, are unnecessary. The funda-mentalist always has to know why.
Most traders classify themselves as either technicians orfundamentalists. In reality, there is a lot of overlap. Many funda-mentalists have a working knowledge of the basic tenets of chartanalysis. At the same time, many technicians have at least a pass-ing awareness of the fundamentals. The problem is that the chartsand fundamentals are often in conflict with each other