NEW YORK INSTITUTE. OF FINANCE
`
`# TECHNICAL
`ANALYSIS
`THE FINANCIAL
`MARKB’TS
`
`A COIN/IPPUBDM5-“JSI‘VTE GTUIJJJI"E Tu TRAUJNG
`NIETHODS AND APPLICATIONS
`
`n h TN
`
`JOHN J. MURPHY
`
`Completely updated and expanded
`
`ofthe Futures Markets
`
`: 777777777777WWWGI
`.
`Technical Analysis
`5??
`
`MARKETS-ALERT - EXHIBIT 2027
`
`MARKETS-ALERT - EXHIBIT 2027
`
`

`

`
`TECHNICAL
`ANALYSIS
`
`
`9% [NANCIAL
`MARKETS
`
`
`
`A COMPREHENSIVE GUIDE TO TRADING
`METHODS AND APPLICATIONS
`
`

`

`TECHNICAL
`
`ANALYSIS _
`9% FINANCIAL
`
`MARKETS
`
`A COL/[PREHENSIVE GUIDE TO TRADING
`
`METHODS AND APPLICATIONS
`
`JOHN J. MURPHY
`
`NEW YORK INSTITUTE OF FINANCE
`
`
`
`

`

`NEW YORK INSTITUTE OF FINANCE
`Published by the Penguin Group
`Penguin Group (USA) Inc.
`375 Hudson Street, New York, New York 10014, USA
`Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario M4? 2Y3, Canada
`(a division of Pearson Penguin Canada Inc.)
`Penguin Books Ltd.. 80 Strand, London WC2R ORL, England
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`South Africa
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`Penguin Books Ltd., Registered Offices: 80 Strand. London WC2R ORL, England
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`While the author has made every effort to provide accurate telephone numbers and Internet addresses at the
`time of publication, neither the publisher nor the author assumes any responsibility for errors or for changes
`that occur after publication. Further, the publisher does not have any control over and does not assume any
`responsibility for author or third—party websites or their content.
`
`Portions of this book were previously published as Technical Analysis of the Futures Markets (New York
`Institute of Finance, 1985).
`
`Copyright © 1999 by John J. Murphy
`
`All rights reserved.
`No part of this book may be reproduced, scanned, or distributed in any printed or electronic form without per—
`mission. Please do not participate in or encourage piracy of copyrighted materials in violation of the author’s
`rights. Purchase only authorized editions.
`NEW YORK INSTITUTE OF FINANCE and NYIF are trademarks of Executive Tait Reports, Inc, used
`under license by Penguin Group (USA) Ir“.
`
`First edition: January 1999
`
`Library of Congress Cataloging—in~Publicatiou Data
`
`Murphy, John J.
`Technical analysis of the financial markets / John J. Murphy.
`p. cm.
`Rev. ed. of: Technical analysis of the futures markets. c1986.
`Includes bibliographical references and index.
`ISBN 978—0-7352—0066—1
`I. Murphy, John].
`1. Futures market.
`2. Commodity exchanges.
`Technical analysis of the future markets.
`II. Title.
`HG6046.M87 1999
`98-3 8531
`332.64‘4—(1021
`CIP
`
`pnmren IN THE UNITED sures or AMERICA
`
`35
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`33
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`32
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`31
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`PUBLISHER'S NOTE: This publication is designed to provide accurate and authoritative information in
`regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in ren-
`dering legal, accounting. or other professional services. If you require legal advice or other expert assistance,
`you should seek the services of a competent professional.
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`created to fit specific needs. For details. write: Special Markets. Penguin Group (USA) Inc., 375 Hudson Street,
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`

`

`To my parents,‘ '
`Timothy and Margaret
`
`‘_
`and
`To Patty, Clare, and Brian
`
`
`
`

`

`.Contentfi§,_.
`
`
`About the Author
`
`xxiii
`
`About the Contributors
`
`xxv
`
`Introduction
`
`xxvii
`
`Acknowledgments mi
`
`1%
`Philosophy of Technical Analysis
`
`Introduction
`
`1
`
`Philosophy or Rationale
`
`2
`
`Technical versus Fundamental Forecasting
`
`5
`
`Analysis versus Timing
`
`6
`
`1
`
`vii
`
`
`
`

`

`Flexibility and Adaptability of Technical
`Analysis
`7
`Technical Analysis Applied to Different Trading
`Mediums
`8
`,
`Technical Analysis Applied to Different Time
`Dimensions
`9
`
`Economic Forecasting
`
`10
`
`~ Technician or Chartist?
`
`10
`
`A Brief Comparison of Technical Analysis in Stocks and
`
`Futures
`
`12'
`
`E
`1
`;
`é
`5
`
`l
`
`g
`
`
`
` Con tents
`
`
`
`
`
`
`
`
`
`
`
`
`Less Reliance on Market Averages and Indicators
`
`14
`
`Some Criticisms of the Technical Approach
`
`15
`
`Random Walk Theory
`
`19
`
`Universal Principles
`
`21
`
`,
`
`I
`
`'
`
`.
`
`
`
`
`
`
`
`
`
`-
`
`23
`
`V
`
`-:v""“,~‘t’:’i
`
`V
`
`m
`Dew Theory
`
`Introduction
`
`23
`
`Basic Tenets
`
`24
`
`The Use of Closing Prices and the Presence of
`Lines
`30
`
`Some Criticisms of Dow Theory
`
`31
`
`Stocks as Economic Indicators
`
`32
`
`Dow Theory Applied to Futures Trading
`
`32
`
`Conclusion
`
`33
`
`
`
`

`

`Con tents Chart Construction
`
`4
`
`Introduction
`
`35
`
`Types of Charts Available
`
`36
`
`Candlesticks
`
`37
`
`Arithmetic versus Logarithmic Scale
`
`Construction of the Daily Bar Chart
`
`39
`
`40
`
`Volume
`41
`Futures Open Interest
`
`42
`
`Weekly and Monthly Bar Charts
`
`45
`
`Conclusion
`
`46
`
` b.‘v
`. r”
`Basra Concepts of Trend
`
`Definition of Trend
`
`49
`
`Trend Has Three Directions
`Trend Has Three Classifications
`
`51
`
`52
`
`Support and Resistance
`
`55
`
`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
`
`85
`
`3
`.9 5
`
`..
`
`35
`
`,
`
`49
`
`
`
`

`

`
`
`
`
`87
`Speed Resistance Lines
`Gann and Fibonacci Fan Lines
`Internal Trendlines
`90
`Reversal Days
`90
`
`90
`
`Price Gaps
`
`Conclusion
`
`94
`
`98
`
`M
`Mai6r Reversal Patterns
`Introduction
`99
`
`100
`Price Patterns
`Two Types of Patterns: Reversal and
`Contin‘iatiOIl
`1 UU
`The Head and Shoulders ReVersal Pattern
`The Importance of Volume
`107
`Finding a Price Objective
`108
`The Inverse Head and Shoulders
`Complex Head and Shoulders
`Triple Tops and Bottoms
`115
`Double Tops and Bottoms
`117
`Variations from the Ideal Pattern
`Saucers and Spikes
`125
`
`110
`113
`
`121
`
`Contents
`
`99
`
`1 03
`
`Conclusion
`
`128
`
`
`
`

`

`XI
`Contents
`
`
`129
`
`Con%inuation Patterns
`
`Introduction
`
`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
`Confirmation and Divergence
`155
`
`153
`
`Conclusion
`
`156
`
`Volliéme and Open Interest
`
`157
`
`Introduction
`
`1 57
`
`Volume and Open Interest as Secondary
`Indicators
`158
`
`Interpretation of Volume for All Markets
`
`162
`
`Interpretation of Open Interest in Futures
`
`169
`
`
`
`

`

`Con ten ts
`
`174
`
`Blowoffs and Selling Climaxes
`
`175
`
`Commitments of Traders Report
`
`175
`
`Watch the Commercials
`
`1 76
`
`Net Trader Positions
`
`177
`
`Open Interest In Options
`
`177
`
`Put/Call Ratios
`
`178
`
`Combine Option Sentiment With Technicals
`
`179
`
`Conclusion
`
`1 79
`
`181
`
`The Importance of Longer Range Perspective
`
`Construction of Continuation Charts for Futures
`
`182
`
`182
`
`The Perpetual ContractTM ' 184
`Long Term Trends Dispute Randomness
`Patterns on Charts: Weekly and Monthly
`Reversals
`185
`
`184
`
`185
`Long Term to Short Term Charts
`Why Should Long Range Charts Be Adjusted for
`Inflation?
`186
`
`
`
`Summary of Volume and Open Interest Rules
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`Long Term Charts Not Intended for Trading
`Purposes
`188
`Examples of Long Term Charts
`
`188
`
`
`
`

`

`XI"
`-
`Contents
`
`
`' Moving Averages
`
`195
`
`209
`
`Introduction
`
`.
`
`195
`
`The Moving Average: A Smoothing Device with a
`Time Lag
`197
`
`Moving Average Envelopes
`
`207
`
`Bollinger Bands
`
`
`
`Using Bollinger Bands as Targets
`
`210
`
`Band Width Measures Volatility
`Moving Averages Tied to Cycles
`
`211
`212‘
`
`Fibonacci Numbers Used as Moving Averages
`
`212
`
`Moving Averages Applied to Long Term
`Charts
`213
`
`The Weekly Rule
`
`., 215
`
`To Optimize or Not
`
`220
`
`Summary
`
`221
`
`The Adaptive Moving. Average
`
`222
`
`Alternatives to the Moving Average
`
`223
`
`
`
`2?
`OscilIa ors and Contrary Opinion
`
`225
`
`Introduction
`
`225
`
`Oscillator Usage in Conjunction with Trend
`
`226
`
`Measuring Momentum
`
`228
`
`
`
`

`

`xiv
`
`Contents
`
`W M
`
`easuring Rate of Change (ROC)
`
`234
`
`;
`i
`
`Constructing an Oscillator Using Two Moving
`Averages
`234
`
`Commodity Channel Index
`
`237
`
`The Relative Strength Index (RSI)
`
`239
`
`Using the 70 and 30 Lines to Generate Signals
`
`245
`
`Stochastics (K%D)
`
`Larry Williams %R
`
`246
`
`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
`
`257
`
`Investor Sentiment Readings
`
`261
`
`Investors Intelligence Numbers
`
`262
`
`Poifit and Figure Charting
`
`265
`
`Introduction
`
`266
`
`The Point and Figure Versus the Bar Chart
`
`270
`
`Construction of the Intraday Point and Figure
`Chart
`270
`
`The Horizontal Count
`
`‘ 74[\J
`
`Price Patterns
`
`275
`
`
`
`

`

`xv
`.
`Contents
`
`
`3 Box Reversal Point and Figure Charting
`
`277
`
`Construction of the 3 Point Reversal Chart
`
`278
`
`The Drawing of Trendlines
`
`282
`
`‘Measuring Techniques
`Trading Tactics
`286
`
`286 '
`
`Advantages of Point and Figure Charts
`
`288
`
`P&F Technical Indicators
`
`292
`
`Computerized P&F Charting
`
`292
`
`P&F Moving Averages
`
`294
`
`Conclusion
`
`296
`
`.
`
`297
`
`319
`
`g 93‘
`Japahemsge Candlesticks
`
`Introduction
`
`297
`
`Candlestick Charting
`
`297
`
`Basic Candlesticks
`
`299
`
`Candle Pattern Analysis
`Filtered Candle Patterns
`
`301
`306
`
`Conclusion
`
`308
`
`Candle Patterns
`
`309
`
` é
`
`Elliott'Wave Theory
`
`Historical Background
`
`319
`
`The Basic Tenets of the Elliott Wave Principle
`
`320
`
`
`
`

`

`
`
`. 2
`l
`
`‘
`
`_
`
`.
`
`xvi
`
`Contents
`
`Connection Between Elliott Wave and Dow
`Theory
`324
`
`Corrective Waves
`
`324
`
`The Rule of Alternation
`
`331
`
`Channeling
`
`332
`
`Wave 4 as a Support Area
`
`334
`
`Fibonacci Numbers as the Basis of the Wave
`Principle
`334
`Fibonacci Ratios and Retracements
`
`- 335
`
`338
`Fibonacci Time Targets
`Combining All Three Aspects of Wave Theory
`Elliott Wave Applied to Stocks Versus
`Commodities
`340
`
`338
`
`Summary and Concltsions
`
`341
`
`Reference Material
`
`34.4
`
`343
`
`
`
`Timg‘Cycies
`
`Introduction
`
`343
`
`.
`
`344
`Cycles
`How Cyclic Concepts Help Explain Charting
`Techniques
`355
`
`Dominant Cycles
`
`358
`
`- Combining Cycle Lengths
`
`The Importance of Trend
`Left and Right Translation
`
`361
`
`361
`362
`
`How to Isolate Cycles
`
`363
`
`
`
`

`

`
`
`
`contents
`
`-
`
`xvii
`
`Seasonal Cycles
`
`369
`
`Stock Market Cycles
`
`373
`
`The January Barometer
`
`373
`
`The Presidential Cycle
`
`373
`
`Combining Cycles With Other Technical Tools
`
`374
`
`Maximum Entropy Spectral Analysis
`
`374
`
`Cycle Reading and Software
`
`375
`
`Eh;
`,1“tr.
`I;
`
`Conii'iufers and Trading Systems
`
`377 .
`
`Introduction ,
`
`377
`
`Some Computer Needs
`
`379
`
`Grouping T0015 and Indicators,
`Using the'Tools and Indicators
`
`380
`380
`
`Welles ’Wilder’s Parabolic and Directional Movement
`
`Systems
`
`381
`
`Pros and Cons of System Trading
`
`387
`
`Need Expert Help?
`
`389
`
`Test Systems or Create Your Own
`
`390
`
`Conclusion
`
`390
`
`Mon'éay lidanagement and Trading
`Tactics
`
`~
`
`393
`
`Introduction . 393
`
`The Three Elements of Successful Trading
`
`393
`
`
`
`

`

`
`
`XW"
`
`Contents
`
`W M
`
`oney Management
`
`394
`
`Reward to Risk Ratios
`
`397
`
`Trading Multiple Positions: Trending versus Trading
`Units
`398
`
`What to Do After Periods of Success and
`Adversity
`399
`
`Trading Tactics
`
`400
`
`Combining Technical Factors and Money
`Management
`403
`
`403
`Types of Trading Orders
`From Daily Charts to Intraday Price Charts
`
`405
`
`The Use of Intraday Pivot Points
`
`407
`
`Summary of Money Management and Trading
`Guidelines
`408;
`
`Application to Stocks
`
`409
`
`Asset Allocation
`
`409
`
`Managed Accounts andMutual Funds
`
`410
`
`Market Profile
`
`411
`
`
`
`The flnk Between Stocks and Futures:
`Intermarket Analysis
`
`413
`
`Intermarket Analysis
`
`414
`
`Program Trading: The Ultimate Link
`
`The Link Between Bonds and Stocks
`
`415
`
`416
`
`1
`
`it
`3
`
`The Link Between Bonds and Commodities
`The Link Between Commodities and the Dollar
`
`418
`
`419
`
`
`
`

`

`xix
`
`Contents
`
`Stock Sectors and Industry Groups
`
`420
`
`The Dollar and Large Caps
`
`422
`
`lntermarket Analysis and Mutual Funds
`
`422
`
`Relative Strength Analysis
`
`423
`
`424
`Relative Strength and Sectors
`Relative Strength and Individual Stocks
`
`426
`
`Top-Down Market Approach
`
`427
`
`Deflation Scenario
`
`427
`
`lntermarket Correlation
`
`428
`
`lntermarket Neural Network Software
`
`429
`
`Conclusion
`
`430
`
`
` ‘L
`9 {'5’
`if. a...
`E:
`Stock M" ket Indicators
`
`433
`
`Measuring Market Breadth
`
`433
`
`Sample Data
`434
`Comparing Market Averages
`
`I 435
`
`The Advance-Decline Line
`
`436
`
`AD Divergence
`
`437
`
`‘
`
`Daily Versus Weekly AD Lines
`
`437
`
`Variations in AD Line
`
`437
`
`‘
`
`McClellan Oscillator
`
`438
`
`McClellan Summation Index
`
`439 "
`
`New Highs Versus New Lows
`
`440
`
`New High-New Low Index
`
`441
`
`
`
`

`

`XX
`
`Contents
`
`
`
`Upside Versus Downside Volume
`The Arms Index
`444
`
`443
`
`444
`TRIN Versus TICK
`Smoothing the Arms Index
`
`445
`
`446
`Open Arms
`Equivolume Charting
`Candlepower
`448
`Comparing Market Averages
`Conclusion
`452
`
`447
`
`449
`
`
`
`Pulligéfigfilt All Together—A Checklist
`
`453
`
`466
`
`4
`454
`Technical Checklist
`How to Coordinate Technical and Fundamental
`Analysis
`455
`Chartered Market Technician (CMT)
`Market Technicians Association (MTA)
`The Global Reach of Technical Analysis
`458
`
`456
`457
`
`458
`
`Technical Analysis by Any Name
`
`Federal Reserve Finally Approves
`
`459
`
`Conclusion
`
`460
`
`Advficed Technical Indicators
`
`.463
`
`463
`Demand Index (D1)
`Herrick Payoff Index (HPI)
`
`

`

`
`
`
`
`‘-Contents ' xxi
`
`
`
`490
`
`Starc Bands and Keltner Channels
`
`Formula for Demand Index
`
`Mar‘iiét Profile
`
`Introduction
`
`475
`
`Market Profile Graphic
`
`Market Structure
`
`479
`
`469
`
`475
`
`473
`
`478
`
`Market Profile Organizing Principles
`
`Range DeveIOpment and Profile Patterns
`
`Tracking Longer Term Market Activity
`
`480
`
`484
`
`486
`
`Conclusion
`
`m? ‘;
`hr
`\
`
`The Essentials of Building a Trading
`System
`
`493
`
`5~Step Plan
`
`494
`
`Step 1: Start with a Concept (an Idea)
`
`495
`
`Step 2: Turn Your Idea into a Set of Objective
`Rules
`497
`
`Step 3: Visually Check It Out on the Charts
`
`497
`
`Step 4: Formally Test It with a Computer
`
`497
`
`Step 5: Evaluate Results
`
`500
`
`'
`
`Money Management
`
`501
`
`Conclusion
`
`501
`
`
`
`

`

`
`
`
`
`._.,.<.:;:m‘1‘35:an
`
`IF
`
`t
`
`Contents
`
`
`
`Continuous Futures Contracts
`
`505
`
`Nearest Contract
`
`506
`
`Next Contract
`
`506
`
`Gann Contract
`
`507
`
`Continuous Contracts
`507
`Constant Forward Continuous Contracts
`
`508
`
`Glossary
`
`51 1
`
`Selected Bibliography
`
`523
`
`Selected Resources
`
`527
`
`Index
`
`531
`
`
`
`

`

`About the Author
`
`_
`
`"
`
`,
`
`I
`7
`'
`
`Inhn J= Murphy has been applying technical analysis for three
`decades. He was formerly Director of Futures Technical Research
`and the senior managed account trading advisor with Merrill
`Lynch. Mr. Murphy was the technical analyst for CNBC—TV for
`seven years. He is the author of three books, including Technical
`Analysis of the Futures Markets, the predecessor to this book. His
`second book, Intennarket Technical Analysis, opened up a new
`branch of analysis His third book, The Visual Investor, applies
`technical work to mutual funds.
`
`Inc.,
`In 1996, Mr. Murphy founded MURPHYMORRIS,
`along with softWare developer Greg Morris, to produce interactive
`educational products and online analysis for investors. Their Web
`site address is:
`
`www. murphymorris com.
`
`He is also head of his own consulting firm, JJM Technical
`Advisor3,1ocated in Oradell, New Jersey
`
`
`
`xxiii
`
`

`

`
`
`About the Contributors .
`
`
`
`
`
`
`Thomas“is. Apray (Appendix A) is a Capital Market Analyst with
`Princeton Economic Institute Ltd” located in Princeton, New
`Jersey. Mr. Aspray has been trading markets since the 19705 Many
`of the techniques he pioneered in the early 1980s are now used by
`other professional traders.
`Dennis C Hynes (Appendix B) is Managing Director and
`cofounder of R..W PreSSprich 81' Co., Inc., a fixed income bro-
`ker/dealer located in-New York City. He also serves as the firm’s
`Chief Market Strategist. Mr. Hynes is a futures and options trader
`and a CTA (Commodity Trading Advisor). He has an MBA in
`Finance from the University of Houston.
`Greg Morris (Chapter 12 and Appendix D) has been devel-
`oping trading systems and indicators for 20 years for investors
`and traders to be used with major technical analysis software pro-
`grams. He is the author of two books on candlestick charting (see
`Chapter 12). In August 1996, Mr. Morris teamed with John
`Murphy to found MURPHYMORRIS Inc., a Dallas—based firm ded-
`icated to educating investors.
`
`XXV
`
`
`
`

`

`XXVi
`
`About the Contributors
`
`Fred G. Schutzman, CMT (Appendix C) is the President
`and Chief Executive Officer of Briarwood Capital Management,
`Inc., a New York-based Commodity Trading Advisor. He is also
`responsible for technical research and trading system develop-
`ment at Emcor Eurocurrency Management Corporation, a risk
`management consulting firm. Mr. Schutzman is a member of the
`Market Technicians Association and is currently serving on their
`Board of Directors.
`
`
`
`

`

`
`
`Introduction
`
`
`
`
`
`
`I had no idea when Technical Analysis of the Futures Markets was
`published in 1986 that it would create such an impact on the
`industry. It has been referred to by many in the field as the "Bible”
`of technical analysis. The Market Technicians Association uses it
`as a primary source in their testing process for the Chartered
`Market Technician program. The Federal Reserve has cited it in
`research studies that examine the value of the technical approach.
`In addition, it has been translated into eight foreign languages. I
`was 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 did
`in the first couple of years.
`‘
`It became clear, however, that a lot of new material had
`been added to the field of technical analysis in the past decade. I
`added some of it myself. My second book, Intennarket Technical
`Analysis (Wiley, 1991), helped create that new branch of technical
`analysis, which is widely used today. Old techniques like Japanese
`candlestick charting and newer ones like Market Profile have
`become part of the technical landscape. Clearly, this new work
`
`xxvii
`
`
`
`
`
`

`

`
`
`meamww
`
`u.
`XXVI"
`
`Introduction
`
`needed to be included in any book that attempted to present a
`comprehensive picture of technical analysis. The focus of my
`work changed as well.
`While my main interest ten years ago was in the futures
`markets, my recent work has dealt more with the stock market.
`That also brought me full circle, since I began my career as a stock
`analyst thirty years ago. That was also one of the side effects of my
`being the technical analyst for CNBC-TV for seven years. That
`focus on what the general public was doing also led to my third
`book, The Visual Investor (Wiley, 1996). That book focused on the
`use of technical tools for market sectors, primarily through mutu~
`a1 funds, which have become extremely popular in the 19905.
`Many of the technical indicators that I wrote about ten
`years ago, which had been used primarily in the futures markets,
`have been incorporated into stock market work. It was time to
`showhow that was being done. Finally, like any field or disci-
`pline, writers also evolve. Some things that seemed very impor—
`tant tome ten years ago aren’t as important today. As my work
`L“ ""olved into a broader application of technical principles to
`nfiTY fnYT
`1161;) CV
`'Ju
`ll Hmncial markets, it seemed only right that any lcviSiOH of that
`leu
`earlier work should reflect that evolution.
`I’ve tried to retain the structure of the original book.
`Therefore, many of the original chapters remain. However, they
`have been revised with new material and updated with new
`graphics. Since the principles of technical analysis are universal, it
`wasn’t that difficult to broaden the focus to include all financial
`markets. Since the original focus was on futures, however, a lot of
`stock market material has been added.
`Three new chapters have been added. The two previous
`chapters on point and figure charting (Chapters 11 and 12) have
`been merged into one. A new Chapter 12,0n candlestick charting
`has been inserted. Two additional chapters have also been added
`at the end of the book. Chapter 17 is an introduction to my work
`on 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 appendices
`show some of the more advanced technical indicators and explain
`how to build a technical trading system. There’s also a glossary.
`
`
`
`

`

`Introduction
`
`‘
`
`xxix
`
`W I
`
`approached this revision with some trepidation. I wasn’t
`sure redoing a book considered a ”classic” was such a good idea. I
`hope I’ve succeeded in making it even better. I approached this
`work from the perspective of a more seasoned and mature writer
`and analyst. And, throughout the book, I tried to show the respect
`I have alwayshad for the discipline of technical analysis and for
`the many talented analysts who practice it. The success of their
`work, as well as their dedication to this field, has always been a
`source of comfort and inspiration to me. I only hope‘I did justice
`to it and to them.
`
`John Murphy
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`

`

`
`
`The person who deserves the most credit for the second edition of
`this book is Ellen Schneid Coleman, Executive Editor at Simon Sr
`’Schuster. She convinced me that it was time to revise Technical
`Analysis of the Futures Markets and broaden its scope. I’m glad she
`was so persistent. Special thanks go to the folks at Omega Research
`who provided me with the charting software I needed and, in par—
`ticular, Gaston Sanchez who spent a lot of time on the phone with
`me. The contributing authors—Tom Aspray, Dennis 'Hynes, and
`Fred Schutzmanm—added their particular expertise where it was
`needed. In addition, several analysts contributed charts including
`Michael Burke, Stan Ehrlich, Jerry Toepke, Ken Tower, and Nick
`Van Nice. The revision of Chapter 2 on Dow Theory was a collabu
`orative effort with Elyce Picciotti, an independent technical writer
`and market consultant in New Orleans, Louisiana. Greg Morris
`deserves special mention. He wrote the chapter on candlestick
`charting, contributed the article in Appendix D, and did most of
`the graphic work. Fred Dahl of lnkwell Publishing Services
`(Fishkill, NY), who handled production of the first edition of this
`book, did this one as well. It was great working with him again.
`
`xxxi
`
`

`

`TECHNICAL
`
`A COMPREHENSIVE GUIDE TO TRADING
`METHODS AND APPLICATIONS
`
`ANALYSIS
`SS FINANCIAL
`MARKETS
`
`
`
`

`

`
`INTRODUCTION
`
`Before beginning a study of the actual techniques and tools used
`in technical analysis, it is necessary first to define what technical
`
`analysis is, to discuss the philosophical premises on which it is
`
`based, 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 the
`
`technical approach must begin with a clear understanding of
`
`what technical analysis claims to be able to do and, maybe even
`
`more importantly, the philosophy or rationale on which it bases
`those claims.
`
`
`First, let’5 define the subject. Technical analysis is the study
`. of market action, primarily through the use ofcharts, for the purpose of
`forecasting future price trends. The term ”market action” includes
`the three principal sources of information available to the techni-
`
`
`
`

`

`2
`
`Chapter 7
`
`W c
`
`ian—«price, volume, and open interest. (Open interest is used
`only in futures and options.) The term ”price action,” which is
`often used, seems too narrow because most technicians include
`volume and open interest as an integral part of their market
`analysis. 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 is
`based:
`
`1. Market action discounts everything.
`
`2. Prices move in trends.
`
`3. History repeats itself.
`
`Market Actien Discounts Everything
`
`.
`
`The statement ”market action discounts everything” forms what
`is probably the cornerstone of technical analysis. Unless the full
`significance of this first premise is fully understood and accepted,
`nothing else that follows makes much sense. The technician
`believes that anything that can possibly affect the pricewfunda-
`mentally, politically, psychologically, or otherwise—As actually
`reflected in the price of that market. It follows, therefore, that a
`study of price action is all that is required. While this claim may
`seem presumptuous, it is hard to disagree with if one takes the
`time to consider its true meaning.
`All the technician is really claiming is that price action
`should reflect shifts in supply and demand. If demand exceeds
`supply, prices should rise. If supply exceeds demand, prices
`should fall. This action is the basis of all economic and funda-
`mental forecasting. The technician then turns this statement
`around to arrive at the conclusion that if prices are rising, for
`whatever the specific reasons, demand must exceed supply and
`the fundamentals must be bullish. If prices fall, the fundamen=
`
`
`
`

`

`
`
`
`
`PhiIOSOphy of Technical Analysis 3
`
`tals must be bearish. If this last comment about fundamentals
`seems surprising in the context of a discussion of technical
`analysis,
`it shouldn’t. After all,
`the technician is indirectly
`studying fundamentals. Most technicians would probably agree
`that 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 up
`or down. They simply reflect the bullish or bearish psychology
`of 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 a
`price trend or at critical turning points, no one seems to know
`exactly why a market is performing a certain way. While the tech—
`nical approach may sometimes seem overly simplistic in its
`claims, the logic behind this first premise—that markets discount
`everything-«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 of
`that market price is all that is necessary. By studying price charts
`and a host of supporting technical indicators, the chartist in effect
`lets the market tell him or her which way it is most likely to go.
`The chartist does not necessarily try to outsmart or outguess the
`market. All of the technical tools discussed later on are simply
`techniques used to aid the chartist in the process of studying mar-
`ket action. The chartist knows there are reasons why markets go
`up or down. He or she just doesn’t believe that knowing what
`those reasons are is necessary in the forecasting process.
`
`.
`
`Prices Move inTrends
`
`The concept of trend is absolutely essential to the technical
`approach. Here again, unless one accepts the premise that markets
`do in fact trend, there’s no point in reading any further. The
`whole purpose of charting the price action Of a market isto iden-
`tify trends in early stages of their development for the purpose of
`trading 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. (See
`Figure 1.1.)
`
`
`
`

`

`
`
`4
`
`Chapter 1
`
`
`paw/79
`(.5PX) sap 500 Stock Index
`02/27/98
`
`Monthly Line Chart
`
`lie-Wise
`
`
`
`9—135
`‘81? he
`534
`‘35
`
`Figure 1.1 Example of an uptrend. Technical analysis is based on me
`‘ premise that markets trend and that those trends tend to persist.
`
`There is a corollary to the premise that prices move in
`trends—a trend in motion is more likely to continue than to reverse.
`This corollary is, of course, an adaptation of Newton’s first law of
`motion. Another way to state this corollary is that a trend in
`motion will continue in the same direction until it reverses. This
`is 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 market
`action has to do with the study of human psychology. Chart pat-
`terns, for example, which have been identified and categorized
`over the past one hundred years, reflect certain pictures that
`appear on price charts. These pictures reveal the bullish or bearish
`
`
`
`

`

`5
`Philosophy of Technical Analysis
`”#MMHWWW‘m—w“
`
`psychology of the market. Since these patterns have worked well
`in the past, it is assumed that they will continue to work Well in
`the future. They are based on the study of human psychology,
`which tends not to change. Another way of saying this last
`premise—that history repeats itself—is that the key to under-
`standing the future lies in a study of the past, or that the future is
`just a repetition of the past.
`
`TECHNICAL VERSUS
`FUNDAMENTAL FORECASTING
`
`While technical analysis concentrates on the study of market
`action, fundamental analysis focuses on the economic forces of
`supply and demand that cause prices to move higher, lower, or
`stay the same. The fundamental approach examines all of the rel-
`evant factors affecting the price of a market in order to determine
`the intrinsic value of that market. The intrinsic value is what the
`fundamentals indicate something is actually worth based on th
`law of supply and demand. If this intrinsic value is under the cur—
`» rent market price, then the market is overpriced and should be
`sold. If market price is below the intrinsic value, then the market
`is undervalued and should be bought.
`Both of these approaches to market forecasting attempt to
`solve the same problem, that is, to determine the direction prices
`are likely to move. They just approach the problem from different
`directions. The fundamentalist studies the cause of market movement,
`while the technician studies the efiiect. The technician, of course,
`
`believes that the effect is all that he or she wants or needs to know
`and that the reasons, or the causes, are unnecessary. The funda—
`
`mentalist always has to know why.
`Most traders classify themselves as. either technicians or
`fundamentalists. In reality, there is a lot of overlap. Many funda—
`mentalists have a working knowledge of the basic tenets of chart
`analysis. At the same time, many technicians have at least a pass—
`ing awareness of the fundamentals. The problem is that the charts
`and fundamentals are often in conflict with each other. Usually at
`the beginning of important market moves, the fundamentals do
`
`
`
`
`
`

`

`
`
`6
`
`Chapter 1
`
`not ekplain or support what the market seems to be doing. It is at
`these critical times in the trend that these two approaches seem
`to differ the most. Usually they come back into sync at some
`point, but often too late for the trader to act.
`One explanation for these seeming discrepancies is that
`market price tends to lead the known fundamentals. Stated another
`way, marketprice acts as a leading indicator ofthe fundamentals or the
`conventional wisdom of the moment. While the known funda—
`mentals have already been discounted and are already “in the mar-
`ket,” prices are now reacting to the unknown fundamentals. Some
`of the most dramatic bull and bear markets in history have begun
`with little (at no perceived change in the fundamentals. By the time
`those changes became known, the new trend was well underway.
`After a while, the technician develops increased confidence
`in his or her ability to read the charts. The technician learns to be
`comfortable in a situation where market movement disagrees with
`the so-called conventional wisdom. A technician begins to enjoy
`being in the minority. He or she knows that eventually the reasons
`for market action Will become common knowledge. It is just that
`the technician isn’t willing to wait for that added confirmation.
`In acCepting the premises of technical analysis, one can see
`why technicians believe their approach is superior to the funda-
`mentalists.
`If a trader had to choose only one of
`the two
`approaches to use, the choice would logically have to be the tech-
`nical. Because, by definition, the technical approach includes the
`fundamental. If the fundamentals are reflected in market price,
`then the study of those fundamentals becomes unnecessary.
`Chart reading becomes a shortcut form of fundamental analysis.
`The reverse, however, is not true. Fundamental analysis