Technical Analysis of the Financial Markets

"One way to get started in technical analysis is to read a good book on the subject. One of my favorites is Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications by John J. Murphy. It's an easy read."

-Ralph J. Acampora, CMT, Managing Director, Prudential Securities Inc.

"No one in this generation has contributed more to technical analysis than John Murphy. Through his series of books, he has both opened the door to many and raised the standard for all who use technical analysis. His books should be required reading for everyone in the securities business and are never more than a step away from my desk."

-Gail M. Dudack, Chief Investment Strategist, Warburg Dillon Read

"John Murphy appears to have done it again ... only this time in a more contemporary fashion. Technical Analysis of the Financial Markets is a must read for the novice and the professional and most important the Chartered Market Technician (C.M.T.) candidate. As a long-time pointand-figure chart devotee, I was enthused to see the book's point-and-figure chapter not only cover some of the more popular methods such as Chartcraft and Dorsey Wright, but also explore the usefulness of the original point-and-figure methodology which we practice here at Salomon Smith Barney"

-Alan R. Shaw, Managing Director, Salomon Smith Barney

Table of Contents

About the Author xxiii
About the Contributors xxv
Introduction xxvii
Acknowledgments xxxi

1 Philosophy of Technical Analysis

Introduction 1
Philosophy or Rationale 2
Technical versus Fundamental Forecasting 5
Analysis versus Timing 6
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
Less Reliance on Market Averages and Indicators 14
Some Criticisms of the Technical Approach 15
Random Walk Theory 19
Universal Principles 21

2 Dow Theory 23

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

3 Chart Construction 35

Introduction 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

4 Basic Concepts of Trend 49

Definition of Trend 49
Trend Has Three Directions 51
Trend Has Three Classifications 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
Speed Resistance Lines 87
Gann and Fibonacci Fan Lines 90
Internal Trendlines 90
Reversal Days 90
Price Gaps 94
Conclusion 98

5 Major Reversal Patterns 99

Introduction 99
Price Patterns 100
Two Types of Patterns: Reversal and Continuation 100
The Head and Shoulders Reversal Pattern 103
The Importance of Volume 107
Finding a Price Objective 108
The Inverse Head and Shoulders 110
Complex 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 128

6 Continuation Patterns 129

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 153
Confirmation and Divergence 155
Conclusion 156

7 Volume and Open Interest 157

Introduction 157
Volume and Open Interest as Secondary Indicators 158
Interpretation of Volume for All Markets 162
Interpretation of Open Interest in Futures 169

Summary of Volume and Open Interest Rules 174
Blowoffs and Selling Climaxes 175
Commitments of Traders Report 175
Watch the Commercials 176
Net Trader Positions 177
Open Interest In Options 177
Put/Call Ratios 178
Combine Option Sentiment With Technicals 179
Conclusion 179

8 Long Term Charts 181

Introduction 181
The Importance of Longer Range Perspective 182
Construction of Continuation Charts for Futures 182
The Perpetual Contract 184
Long Term Trends Dispute Randomness 184
Patterns on Charts: Weekly and Monthly Reversals 185
Long Term to Short Term Charts 185
Why Should Long Range Charts Be Adjusted for Inflation? 186
Long Term Charts Not Intended for Trading Purposes 188
Examples of Long Term Charts 188

9 Moving Averages 195

Introduction 195
The Moving Average: A Smoothing Device with a Time 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 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

10 Oscillators and Contrary Opinion 225

Introduction 225
Oscillator Usage in Conjunction with Trend 226
Measuring Momentum 228
Measuring Rate of Change (ROC) 234
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) 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 257
Investor Sentiment Readings 261
Investors Intelligence Numbers 262

11 Point 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 274
Price Patterns 275
3 Box Reversal Point and Figure Charting 277
Construction of the 3 Point Reversal Chart 278
The Drawing of Trendlines 282
Measuring Techniques 286
Trading Tactics 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 12

12 Japanese Candlesticks 297

Introduction 297
Candlestick Charting 297
Basic Candlesticks 299
Candle Pattern Analysis 301
Filtered Candle Patterns 306
Conclusion 308
Candle Patterns 309

13 Elliott Wave Theory 319

Historical Background 319
The Basic Tenets of the Elliott Wave Principle 320
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
Fibonacci Time Targets 338
Combining All Three Aspects of Wave Theory 338
Elliott Wave Applied to Stocks Versus Commodities 340
Summary and Conclusions 341
Reference Material 342

14 Time Cycles 343

Introduction 343
Cycles 344
How Cyclic Concepts Help Explain Charting Techniques 355
Dominant Cycles 358
Combining Cycle Lengths 361
The Importance of Trend 361
Left and Right Translation 362
How to Isolate Cycles 363
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

15 Computers and Trading Systems 377
Introduction 377
Some Computer Needs 379
Grouping Tools and Indicators 380
Using the Tools and Indicators 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

16 Money Managements and Trading Tactics 393

Introduction 393
The Three Elements of Successful Trading 393
Money 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
Types of Trading Orders 403
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 and Mutual Funds 410
Market Profile 411

17 The Link Between Stocks and Futures:
Intermarket Analysis 413

Intermarket 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 419
Stock Sectors and Industry Groups 420
The Dollar and Large Caps 422
Intermarket Analysis and Mutual Funds 422
Relative Strength Analysis 423
Relative Strength and Sectors 424
Relative Strength and Individual Stocks 426
Top-Down Market Approach 427
Deflation Scenario 427
Intermarket Correlation 428
Intermarket Neural Network Software 429
Conclusion 430

18 Stock Market Indicators 433

Measuring Market Breadth 433
Sample Data 434
Comparing Market Averages 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
Upside Versus Downside Volume 443
The Arms Index 444
TRIN Versus TICK 444
Smoothing the Arms Index 445
Open Arms 446
Equivolume Charting 447
Candlepower 448
Comparing Market Averages 449
Conclusion 452

19 Pulling It All Together-A Checklist 453

Technical Checklist 454
How to Coordinate Technical and Fundamental Analysis 455
Chartered Market Technician (CMT) 456
Market Technicians Association (MTA) 457
The Global Reach of Technical Analysis 458
Technical Analysis by Any Name 458
Federal Reserve Finally Approves 459 Conclusion 460

A Advanced Technical Indicators 463
Demand Index (DI) 463
Herrick Payoff Index (HPI) 466
Starc Bands and Keltner Channels 469
Formula for Demand Index 473

B Market Profile 475
Introduction 475
Market Profile Graphic 478
Market Structure 479
Market Profile Organizing Principles 480
Range Development and Profile Patterns 484
Tracking Longer Term Market Activity 486
Conclusion 490

C 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

D Continuous Futures Contracts 505
Nearest Contract 506
Next Contract 506
Gann Contract 507
Continuous Contracts 507
Constant Forward Continuous Contracts 508