Top Ten Principles of Technical Trading & Analysis- A summary of John Murphy’s Book

When it comes to trading the financial markets (Forex, Commodities, Futures & Stocks), John Murphy has been acclaimed as a very popular author, columnist, and speaker on technical analysis. His Ten laws of technical trading is a very comprehensive guide, a starting point for those who want to learn and enhance their technical trading skills e.g.: how to chart, learn the use of trend lines, the science behind candlesticks, trading patterns, Fibonacci retracement, pivot points, supply & demand, support & resistance and so forth etc.

Technical Analysis or sometimes known as Technical Charting is the study of price sentiment or price action of any trading instrument/asset. It entails the detailed study of historical price movements and then gathering that information to make a predetermined bias/prediction for any future price movement (then one can profit if their analysis predicts the correct movement of the market). It all sounds pretty simple, but I would stress it’s very much the contrary.

Every single trader has developed a unique approach to technical trading. It’s purely subjective to which method of technical analysis one wishes to use to create a successful winning strategy. I am only going to summarise and reference the main points covered in John J Murphy’s book.

Where is the forex trading market heading? How high or low will it go? When will it go in the opposite direction.? These are the holy grail type of questions that every trader asks every day trading the markets.

The ten most vital rules of technical trading summarised are below:

1. Trend mapping

2. Identify the trend and follow

3. The Lows and Highs of a trend are purposeful

4. Understand how far to backtrack

5. Draw the line

6. Track the average

7. Study the turns

8. Be acquainted with the warning Signs

9. Trend or not a trend

10. Be acquainted with the confirming signs

1. Mapping Trends:

First, he explained the critical nature of studying an instrument with a long-term perspective i.e. start analysing the monthly chart and then weekly trading charts, therefore taking what we call a top-down approach. Once you establish a long-term perspective of the currency pair or trading instrument then you can filter down to the daily charts to determine a potential entry point area. A short-term market view can frequently deceive you as you may be trading against the overall trend without knowing.

2. Identify the trend and follow:

Determine your trend and follow it. One of the most basic – and underrated – rules of trading is to trade in the direction of the prevailing trend. Learn how to identify trends, and what to do when a market is moving sideways. As the famous saying goes, ‘the trend is your friend’. The below shows that a downtrend persisted for approx. 119 days. The selling pressure outstood any buyers trading GBPUSD for that particular period.

3. The Lows and Highs of a trend are purposeful:

Find the support and resistance levels. Support levels are the best place to place buys or go long on any trades. A trend that is moving in a downtrend will continually make new lows (support levels). Resistance levels are the best place to sell or short a trade. Once a strong resistance area has been breached or broken (a strong resistance area is when price sentiment has been tested numerous times of highs of previous sessions), it will regularly provide support on following pullbacks (see what we mean by a pullback in a bullish breakout). To explain it in other words, the old “high” or “highs” becomes the new “low”. Same as, when a support level has been broken, it will normally create selling pressure in following rallies, the old “low” can become a new “high”.

4. Understand How far to backtrack:

In case of a pullback, where do you enter? Up or down all market go through corrections that involves the review of the former trend. You can calculate the corrections in a current trend using uncomplicated percentages. The instrument or tool which can be found on your trading platform is called a Fibonacci Retracement. A good tip is to download a demo trading platform and start applying this Fibonacci retracement tool to historical price action. This is what traders refer to as historical back testing and is a very effective method to check the validity of a technical.

A fifty per cent retracement (price movement in opposite direction) of an earlier forex trading trend is very common. Usually, a maximum retracement is the golden mean of 61.8%. Fibonacci retracements of 38% and 78% are also interesting to watch.

5. Draw the line:

Drawing forex trend lines is a simple and effective technique to predict any change in direction. All you need is a guide for drawing a straight line connecting three points on a chart. For an uptrend, lines are drawn along three successive lows whilst downtrend lines are drawn along two consecutive peaks. The price of the instrument e.g. currency pair will every so often pull back to trend lines before recommencing their trend. The break in trend lines usually indicates a change in trend. A line which touched three times is a valid trend line. The longer a trend line has been in effect the more times it has been tested, and the more significant it becomes.

6. Track That Average:

Track the Moving Averages Indicator. The Moving Averages Indicator is available on all trading platforms in the market. Moving averages provide a consensus, indication or additional bias to buy or sell. They inform you that if a current trend is persisting it helps verify a change in direction of a trend. Moving averages do not inform you beforehand, as it’s a lagging indicator (hence its calculation is based on previous sessions’ price action). A chart combining two moving averages is the most appropriate way to find a potential entry for a short or long trade.

Some well-known trial and tested moving average combinations are 4- and 9- day moving averages, 9- and 18- day, and 5- and 20-day. I’ll put it short it’s worth researching and applying.

7. Study the Turns:

To learn the turns always track oscillators. Oscillators help us to identify a currency pair or other that is overbought or oversold. While moving averages offer validation of a forex trading market trend alteration, oscillators frequently warn us when the market has rallied or fallen too far and the likelihood of it turning soon. The two well-known indicators are the Relative Strength Index RSI and Stochastics. John Murphy goes into greater depth on how to apply these indicators.

In brief, it is stated to work on a scale of 0 to 100. For RSI, a reading over 70 means a trading instrument is overbought (inflated in price) while a reading below 30 means oversold (unreasonably low in price).

80 and 20 values are unique for the Stochastics indicator which means overbought and oversold respectively. Such tools work well and can be applied to all different asset classes.

8. Be acquainted with the Warning Signs:

Gerald Appel developed a MACD The Moving Average Convergence Divergence indicator. This is very popular and is used by many traders. It’s a combination of a moving average crossover system with overbought and oversold elements of an oscillator (RSI or Stochastics). Indication of a buy is when the fast-moving line intersects below the slow-moving line above the zero line. Weekly indicators have priority over daily indicators. A MACD histogram outlines the difference between the two lines and gives even prior warning of trend fluctuations. The vertical bars used show the difference between the two lines on the chart and are referred to as a “histogram”.

9. Trend or Not a Trend:

The line that helps determine whether a forex trading market is in a trending phase is called ADX. ADX line measures the magnitude of the trend. The presence of a strong trend is indicated by a rising ADX line. However, the absence of a forex trading trend is indicated by a falling ADX line. Moving averages favour a rising ADX line, oscillators favour a falling ADX line. 

10. Be acquainted with the Confirming Signs:

Volume is a validating indicator. Volume paves the way for market price action sentiment. When we see a larger body for a candlestick that indicates a larger volume during a particular session.

When trading the markets technical analysis is a useful skill that nourishes knowledge and experience. Many successful traders only utilise and believe technical analysis can alone give you success if it’s formulated into a strategy. For example, some individuals trade only by RSI and others may incorporate RSI & MACD as an additional signal to their overall trend line and Fibonacci strategy etc. Trading the markets is purely subjective; create a strategy, own it and stick to it!