10 rules of technical trading

January 13, 2014 05:16 AM

There are two major types of analysis normally used to forecast the performance of commodity futures: fundamental and technical. Fundamental analysis examines the supply and demand factors that influence price, while technical analysis is the study of price and price behavior. The world of technical analysis is complex, but with a working knowledge can be applied to virtually any market. There are literally hundreds of different patterns and indicators that technical analysts look at, but you should find early on what works for you and what doesn’t. Here we set out to introduce you to 10 important rules of technical trading as first described by technical trading legend John J. Murphy.

Anyone who has ever looked into technical analysis will have heard of Murphy; a technical analyst with more than 35 years of market experience.  His book, “Technical Analysis of the Financial Markets,” should be part of every trader’s library.  Murphy wrote “The 10 Important Rules of Technical Trading,” and these principles remain relevant today. We can learn from and build on them.

Adding to their appeal, Murphy’s rules are designed to explain the concept of technical trading to the beginner and to streamline the trading methodology of the more experienced market participant. They are meant to equip traders with a meaningful framework on which to pin their own technical analysis, and assist with answering some of the following questions: Which way is the market moving? How far up or down will it go? And when will it go the other way? These are the basic concerns of the technical analyst.

Even if you have read Murphy’s rules before, it is always a good idea to re-visit them. Below are Murphy's 10 Most Important Rules of Technical Trading, followed by my commentary (in italics) on specific aspects of the rules:

1. Map the Trends Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale “map of the market” provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you’re trading in the same direction as the intermediate and longer term trends.

Matt Bradbard: When establishing a position trade, look at the monthly, weekly, and then daily chart in that order. My best trades have said the same thing on all three time frames; buy or sell.

2. Spot the Trend and Go With It Determine the trend and follow it. Market trends come in many sizes: long-term, intermediate-term and short-term. First, determine which one you’re going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing.

Matt Bradbard: You’ve heard “the trend is your friend”, now apply it.

3. Find the Low and High of It Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new "low." In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies -- the old "low" can become the new "high."

Matt Bradbard: This helps a lot with stop placement and buying or selling breakouts.

4. Know How Far to Backtrack Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A 50% retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38.2% and 61.8% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.

Matt Bradbard: If you’re not already watching Fibonacci retracements as part of your trading…start.  In fact, go back and look at past trades and insert Fibonacci levels and see how much easier the trades could have been had you used this type of analysis.

5. Draw the Line Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes.

Matt Bradbard: Knowing whether or not you are above/ below support and resistance levels helps with stop placement.   

6. Follow that Average Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if the existing trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4- and 9-day moving averages, 9- and 18-day, 5- and 20-day. The shorter average line crossing the longer is a key signal. Price crossings above and below a 40-day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market.

Matt Bradbard: Some averages work better depending on the market and time frame but for position trades, the 40-, 100-, and 200-day moving averages are critical as those are usually what the “big boys” follow.

7. Learn the Turns Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators help warn us of markets that have rallied/ fallen too far and that may soon turn. Two of the most popular are the Relative Strength Index (RSI) and Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are indicative of a market that is overbought while readings below 30 point to an oversold market. The overbought and oversold values for Stochastics are 80 and 20 respectively. Most traders use 14 days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used as filters for intra-day charts.

Matt Bradbard: Many a time RSI and Stochastics have kept me from taking on a loss-making position in the first place, or helped with making a timely exit. Knowing when markets are either overbought or oversold is important because it is generally an early warning sign of a trend reversal.

8. Know the Warning Signs Trade MACD. The Moving Average Convergence Divergence (MACD) indicator combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal may be justified when the faster line crosses above the slower and both lines are below zero. A sell signal may be appropriate when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. A MACD histogram plots the difference between the two lines and gives even earlier warnings of trend changes. It's called a “histogram” because vertical bars are used to show the difference between the two lines on the chart.

Matt Bradbard: MACD helps with identifying when a trend reversal is likely. I like to use MACD on longer term charts but have not found it too effective a method on shorter time frames.

9. Trend or Not a Trend Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX favors oscillators. By plotting the direction of the ADX line, the trader is able to determine which trading style and which set of indicators are most suitable for the current market environment.

Matt Bradbard: Quite obviously, when looking at a price chart, almost everyone can see if a trend is up or down. The ADX allows traders to be more specific by quantifying the strength of a trend. It also sheds light on whether a trend is likely to continue.

10. Know the Confirming Signs Volume and open interest are important confirming indicators in futures markets. Volume precedes price. It is important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising open interest confirms that new money is supporting the prevailing trend. Declining open interest is often a warning sign that the trend is near completion. A solid price uptrend should be accompanied by rising volume and rising open interest.

Matt Bradbard: Generally speaking, when you see a significant increase in volume coincide with other technical indicators, you should see new highs and lows followed by a trend reversal. 

But perhaps most importantly, as Murphy said: “Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.”    

One final note of caution: Do not try to incorporate every technical tool out there in every single one of your trades. They all have value and some work well in concert with others, but when you try and deploy them all at once, you stand the risk of suffering “paralysis by analysis.”

Technical Analysis is a vital part of my trading and helps me make key decisions with almost every transaction. But I do not take lightly the fact that traders should not ignore fundamental factors. I’m simply a little more partial towards technicals.

About the Author

Vice President of Managed Futures & Alternatives at RCM Asset Management, brings hands-on analysis and trading experience to RCM Asset Management clients. Mr. Bradbard has been creating and executing trading strategies for over 10 years, and he is a respected commentator on a number of futures and options markets. Mr. Bradbard regularly publishes market commentary and trading ideas, and he is frequently cited in articles covering the futures and options space, and the role played by commodities in a diversified portfolio.