The ability to predict volatile and often paradoxical market trends is a rare talent that is highly valued in the world of professional trading. The name of John Murphy is known to everyone who is at least vaguely familiar with the technical trading theory. Throughout the years of his practice, the trader and analyst with more than 30 years of experience has established 10 main rules of technical analysis. These universal principles are still relevant and will serve well both newcomers and successful traders.
Rule 1. Map the Trends
Even if you trade on a lower time frame, you still should pay close attention to long-term charts. Whether it is a week, several months, a year, or several years, the more you study the charts, the easier it is for you to identify the main trend. Once the long-term has been established, analyse the daily and intraday charts. This way, short-term trends will not deceive you, and trading in the same direction as the main trend will become even better.
Rule 2. Spot the Trend and Go With It
There are three types of market trends: long-term, short-term, and intermediate-term. Each of them requires you to analyse corresponding charts. As soon as you determine the trend, you start trading in its direction. Buy if the trend goes up and sell when it moves down. Intermediate-term trends deserve special attention. If you trade in the intermediate-term trend, use daily and weekly charts. They are also helpful to intraday traders. But in any case, you should stick to the prevailing long-term trend.
Rule 3. Find the Low and High of It
Never forget about resistance and support. On the chart, these levels are located near the high and the low respectively. The best place to buy is at support levels and sell at resistance levels. Resistance and support can easily become one another when the price breaks these levels. Thus, the old resistance level turns into the new support and the old support level becomes the new resistance.
Rule 4. Know How Far to Backtrack
A market correction is expressed as a percentage relative to the previous trend. A 50% retracement is most common, while a 30% retracement is most rare. The maximum retracement is two-thirds. When calculating a correction, it is helpful to turn to the reading of the Fibonacci grid. Thus, in case of a pullback during the uptrend, buy points are in the 33-38% retracement area.
Rule 5. Draw the Line
Trend lines are one more useful analytical tool. A trend line is drawn by two points - two successive lows for the uptrend and two successive highs for the downtrend. When the price pulls backs to the trend line frequently, the trend resumes. The breaking of a line, on the contrary, signals a trend change. A valid trend line should be touched by the price three times at least. Accordingly, the importance of the line rises according to its length.
Rule 6. Follow that Average
Moving averages are one of the base trend indicators. Tracking MAs will help you determine entry points in time and make sure that the trend is stable or, on the contrary, changes. MAs are usually used in pairs. The most popular combinations are 4-9-days, 9-8-days, and 5-20-days. The moment when the shortest MA crosses the longest one is considered to be a trading signal. The crossing of the 40-days MA by the price is also regarded as a strong signal.
Rule 7. Learn the Turns
Tracking oscillators is also important. This indicator is used by traders to determine whether the market is overbought or oversold. Unlike moving averages, oscillators tell nothing about the change of a trend. They send a timely reversal signal instead. The most widely used periods are either 9 or 4 days or weeks for RSI, and 14-days or weeks for Stochastics. Both oscillators work on a scale from 1 to 100 and vary depending on the reading of upper and lower borders. For RSI, these figures are 70 and 30, whereas for Stochastics, these values are 80 and 20. The market is overbought when the indicator crosses the upper border and oversold when the lower border is crossed. Both can indicate a trend reversal.
Rule 8. Know the Warning Signs
John Murphy recommends that traders use MACD, a system of indicators that combines the capabilities of moving averages with those of oscillators. A buy signal occurs when the faster line crosses above the slower one and both lines are below zero. The difference between the two lines gives a warning of trend changes.
Rule 9. Trend or Not a Trend
A trader can determine a trend, but the average directional index (ADX) will cope with this task even more efficiently. The rising ADX line will indicate the presence of a strong trend, while the falling one will signal the presence of an intermediate state of the market. ADX works even better both with moving averages and oscillators. It also helps to identify which set of indicators is most suitable for the current market environment.
Rule 10. Know the Confirming Signs
A special group of signal confirmation indicators comprises volume and open interest. Volumes usually precede prices. However, an increase in volume does not always lead to rapid price growth. It all depends on the direction of volume. When high volume takes place in the direction of the upward trend, it indicates a strong upward movement. In this light, rising open interest will mean that money is supporting the new trend and its strong rally. A gradual decrease in open interest along with increasing prices is the first sign of an upcoming trend change.
John Murphy’s rules are a vivid example of a comprehensive review of a broad and complex topic. Technical analysis is a baffling problem for many, especially at the beginning. But Murphy's practical and clear advice can help novice traders not to lose their path in the market.
