Based on John J. Murphy, Technical Analysis of the Futures Markets (1999)
Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. "Market action" encompasses three principal sources of information: price, volume, and open interest (in futures). Murphy argues that these three data streams, properly interpreted, contain everything the analyst needs to know.
Market action discounts everything. Anything that can possibly affect the price — fundamentals, politics, psychology, weather — is already reflected in the price. The technician need not know why prices move; the chart already contains the answer.
Prices move in trends. The entire purpose of charting is to identify trends in their early stages so the trader can ride them. A trend in motion is more likely to continue than to reverse. This is the single most important concept in technical analysis, and all pattern recognition and indicator analysis flows from it.
History repeats itself. Chart patterns that have worked for over a hundred years continue to work because they reflect human psychology, which does not change. The patterns are pictures of bullish or bearish psychology — and the same collective emotions produce the same price footprints generation after generation.
Murphy does not dismiss fundamental analysis. He argues they answer different questions: fundamentals address what to buy, technicals address when to buy. The technician enjoys flexibility — the same methods apply to any market, any time frame, with no need for industry- specific domain knowledge. A single set of chart-reading skills transfers from soybeans to Treasury bonds to the S&P 500.
Futures markets bring unique characteristics: leverage, margin, expiration dates, and open interest data not available in equities. Technical analysis is arguably more important in futures because the leveraged nature of these markets demands precise timing, which is the technician's core strength.
Charles Dow never wrote a formal treatise. His ideas, published in Wall Street Journal editorials (1900-1902), were assembled by William Hamilton, Robert Rhea, and later Richard Russell. Dow Theory remains the cornerstone of technical analysis — most techniques in Murphy's book are extensions or elaborations of Dow's original principles.
Tenet 1: The Averages Discount Everything. The sum total of market knowledge — supply, demand, crop reports, Fed policy, war risk — is reflected in the price. No new information escapes the market's processing mechanism.
Tenet 2: The Market Has Three Trends.
The primary trend is what the position trader cares about. Secondary trends provide entry opportunities. Minor trends are largely noise.
Tenet 3: Major Trends Have Three Phases.
Tenet 4: The Averages Must Confirm Each Other. A buy signal in the Industrials is only valid if the Transports confirm. In futures, Murphy extends this to related markets: a breakout in gold should be confirmed by silver; a trend in crude oil should align with heating oil.
Tenet 5: Volume Must Confirm the Trend. Volume should expand in the direction of the primary trend. In an uptrend, volume increases on rallies and decreases on pullbacks. Shrinking volume on a rally is an early warning.
Tenet 6: A Trend Is Assumed in Effect Until Definite Signals of Reversal. This is the principle of inertia. The burden of proof lies with the analyst claiming the trend has ended. Until trendlines break, moving averages cross, or confirmed reversal patterns form, the existing trend is given the benefit of the doubt.
Critics call Dow Theory late (missing 20-25% of a move on entry and exit). Murphy counters that catching 50-60% of a major trend is highly profitable, and that no system catches tops and bottoms. The real value is discipline: Dow Theory keeps traders on the right side of the primary trend.
The bar chart is Murphy's primary vehicle. Each bar represents one time period:
The relationship of close to range reveals sentiment: a close near the high is bullish; near the low, bearish. The range expansion (wide bars after narrow bars) signals the onset of momentum.
Murphy covers Japanese candlestick charts as a visual enhancement to bar charts. The body (open-to-close range) is filled or hollow depending on direction. Key single-bar patterns:
Candlesticks add nuance but do not replace classical pattern analysis. Murphy treats them as an overlay, not a stand-alone system.
Close-only charts. Useful for simplicity and for spotting trendline breaks when bar noise obscures the picture. Also essential for long-term monthly charts where the close is the most meaningful data point.
(See Section 10 for full treatment.) P&F charts strip out time entirely, recording only significant price changes. They reduce noise and produce clear support/resistance levels.
Murphy stresses multiple time frame analysis: long-term (weekly/monthly) charts establish the primary trend; intermediate (daily) charts time entries; short-term (intraday) charts fine-tune execution. The trader should always start with the longest time frame and work inward.
The failure to make a new high (in an uptrend) or a new low (in a downtrend) is the first warning of trend change. When followed by a violation of the most recent trough (or peak), the reversal is confirmed.
Key principles:
An up trendline is drawn beneath successive reaction lows. A down trendline is drawn above successive rally peaks. Validity requires a minimum of two touch points; three or more increase reliability.
Rules for trendline breaks:
A channel line is drawn parallel to the trendline on the opposite side. In an uptrend, the channel line connects rally peaks above the up trendline. Channels provide profit targets: when price fails to reach the channel line, it signals a weakening trend. When price exceeds the channel line, it signals acceleration.
After a trendline break, a new (flatter) trendline is drawn from the same origin to the first reaction point. If this too is broken, a third line is drawn. The break of the third fan line is a reliable reversal signal. Three fan lines being broken signals a definitive trend change.
Prices typically retrace a portion of the prior move before resuming. Murphy's key levels:
These align with Dow Theory secondary corrections and with Fibonacci ratios (38.2%, 50%, 61.8%) that Murphy introduces later.
Divide the prior move into thirds. Draw lines from the beginning of the move through the one-third and two-thirds points. In an uptrend correction, the first line to break is the one-third line; if the two-thirds line also breaks, a full retracement is likely.
Mirror image with one critical difference: volume is absolutely essential on the breakout above the neckline. Without heavy volume on the upside break, the pattern is suspect.
Three peaks or troughs at similar levels. Similar to head and shoulders but without a prominent middle peak. The breakout and measuring rules are the same.
Gradual, arc-shaped reversal over an extended period. Volume contracts as the pattern forms and expands on the breakout. No clear measuring rule; the duration suggests the magnitude.
Sudden, violent reversals with no warning pattern. A key reversal day (outside day with close opposite to the prior trend) or an island reversal (gap followed by a gap in the opposite direction) is the only signal. These are hardest to trade and call for immediate stop-loss protection.
Symmetrical triangle — Converging trendlines with lower highs and higher lows. A rest pattern that typically resolves in the direction of the prior trend. Breakout should occur between one-half and three-quarters of the distance from the base to the apex. A break too close to the apex is unreliable. Volume should contract during formation and expand on breakout.
Ascending triangle — Flat upper boundary (resistance) with rising lower trendline. Bullish bias regardless of the prior trend. The flat top provides a clear breakout level.
Descending triangle — Flat lower boundary (support) with declining upper trendline. Bearish bias. Mirror of the ascending triangle.
Measuring rule for all triangles: Height of the base (widest part) projected from the breakout point.
Brief pauses in a sharp, near-vertical move. Flags are small parallelograms that slope against the prevailing trend. Pennants are small symmetrical triangles. Both should complete within one to three weeks and are among the most reliable continuation patterns. Volume dries up during the pattern and explodes on the breakout.
Measuring rule: The flag or pennant is said to "fly at half-mast." The prior sharp move (the flagpole) is projected from the breakout point.
Converging trendlines that both slope in the same direction. A rising wedge is bearish; a falling wedge is bullish. Wedges take longer to form than flags (typically more than three weeks). Volume should decrease noticeably as the wedge develops.
Price oscillates between horizontal support and resistance. A rectangle is a pause in the trend, and the breakout direction usually follows the prior trend, though rectangles can also function as reversal patterns. Volume sometimes gives a clue: higher volume on rallies within the rectangle favors an upside break.
Volume measures the intensity of a price move. Murphy's rules:
| Price | Volume | Interpretation |
|---|---|---|
| Rising | Increasing | Bullish — strong trend |
| Rising | Decreasing | Suspect rally |
| Falling | Increasing | Bearish — strong trend |
| Falling | Decreasing | Selling pressure waning |
Volume leads price. A divergence between price making new highs and volume declining is one of the earliest warnings of trend exhaustion.
Developed by Joe Granville. A cumulative running total: add the day's volume if the close is up, subtract it if the close is down. The absolute number does not matter — only the direction of the OBV line matters. If OBV is making new highs ahead of price, accumulation is occurring. If OBV is diverging (failing to confirm new price highs), distribution is under way.
Open interest is the total number of outstanding contracts that have not been offset or delivered. It reflects the flow of money into or out of a futures market.
| Price | Open Interest | Interpretation |
|---|---|---|
| Rising | Rising | New money entering — bullish |
| Rising | Falling | Short covering rally — bearish signal |
| Falling | Rising | New shorts entering — bearish |
| Falling | Falling | Liquidation of longs — bear market weakening |
Murphy highlights the CFTC's weekly COT report, which breaks open interest into three categories: commercials (hedgers), large speculators, and small speculators. Commercials are the "smart money" — when their net position diverges sharply from price, pay attention. Small speculators are typically wrong at extremes.
Blow-off tops are often accompanied by a spike in both volume and open interest, followed by a sharp decline in both as the move reverses. These climaxes mark emotional extremes and signal potential trend exhaustion.
Moving averages smooth price data to reveal the underlying trend. They are followers, not leaders. They never anticipate — they react. Their value lies in identifying and confirming trends, not in calling turning points.
The arithmetic mean of the last N closing prices. Each data point carries equal weight. The most common periods: 10-day (short-term), 50-day (intermediate), 200-day (long-term).
Limitation: A single outlier price falling out of the window can shift the average even if current prices have not changed meaningfully.
Applies greater weight to recent prices. Responds more quickly to price changes than an SMA of the same period. The smoothing factor is 2 / (N + 1). Murphy notes that EMAs reduce lag but increase whipsaw risk — there is no free lunch.
Each day's price is multiplied by a weight factor (most recent day gets the highest weight). Less common than EMA in practice but conceptually similar in purpose.
Single moving average system:
Double moving average crossover:
Triple moving average system (4-9-18):
Murphy briefly covers Bollinger's concept: an SMA with bands set two standard deviations above and below. Prices touching the upper band are not necessarily overbought — in a strong trend, prices "walk the band." A squeeze (narrowing bands) precedes a volatility expansion. The direction of the breakout determines the trade.
A fixed percentage above and below a moving average. Murphy uses 3% envelopes around a 21-day MA as a common configuration. Penetration of the envelope signals an overextended condition.
Oscillators are most useful when the market is in a trading range, where trend-following methods produce whipsaws. They identify overbought and oversold conditions, and their divergences with price provide the most powerful signals in technical analysis.
Three primary oscillator signals:
The simplest oscillator: today's close minus the close N days ago (momentum), or today's close divided by the close N days ago, times 100 (rate of change). A 10-day momentum above zero is bullish; below zero, bearish. The rate of change of the momentum line matters — a decelerating momentum even while positive warns of an impending decline.
Developed by J. Welles Wilder. Formula:
RS = Average gain over N periods / Average loss over N periods
RSI = 100 - (100 / (1 + RS))
Standard period: 14. Overbought above 70, oversold below 30. Murphy emphasizes:
Developed by George Lane. Measures where the close lies relative to the high-low range over N periods.
%K = 100 * (Close - Lowest Low(N)) / (Highest High(N) - Lowest Low(N))
%D = 3-period SMA of %K
Standard period: 14 for %K, 3 for %D. Overbought above 80, oversold below 20.
Signals:
Developed by Gerald Appel. Uses three EMAs:
MACD Line = EMA(12) - EMA(26)
Signal Line = EMA(9) of MACD Line
Histogram = MACD Line - Signal Line
Signals:
Similar to the stochastic but inverted and unsmoothed:
%R = -100 * (Highest High(N) - Close) / (Highest High(N) - Lowest Low(N))
Scale runs from 0 to -100. Overbought above -20, oversold below -80. Standard period: 14. Murphy notes it is essentially the inverse of the fast stochastic %K.
Developed by Donald Lambert. Measures the deviation of price from its statistical mean:
Typical Price = (H + L + C) / 3
CCI = (Typical Price - SMA(Typical Price, 20)) / (0.015 * Mean Deviation)
Readings above +100 indicate the market is "unusually strong" (potential overbought); below -100, unusually weak. Originally designed for identifying cyclical turns in commodities.
Murphy devotes a section to sentiment analysis. When the majority of market participants are bullish, who is left to buy? Contrary opinion uses surveys of advisors, newsletter writers, and traders to gauge extremes. The Bullish Consensus (published by Market Vane) is the primary tool: readings above 75% suggest a market top; below 25%, a bottom. Contrary opinion works best at extremes and is useless in the middle ground.
P&F charts use Xs for rising prices and Os for falling prices. They eliminate time and focus solely on price movement. Two parameters define the chart:
Horizontal count: Count the number of columns in the congestion area, multiply by box size and reversal amount, and project from the breakout point. This gives a price target.
Vertical count: Count the number of boxes in the first column after a breakout, multiply by the reversal amount, and project from the base of that column.
P&F trendlines are drawn at 45-degree angles from significant lows (bullish support) or highs (bearish resistance). Prices above the up trendline confirm a bull market. A break below the 45-degree line signals a sell.
Ralph Nelson Elliott (1930s) discovered that market prices unfold in recognizable patterns linked to the Fibonacci number sequence. The basic pattern is a five-wave advance followed by a three-wave correction (5-3 cycle):
Murphy treats Elliott Wave as a supplementary framework rather than a stand-alone method. The wave count is useful for estimating how far along a trend is (e.g., recognizing that a fifth wave is underway suggests the trend is mature). Combining wave analysis with traditional pattern recognition and oscillator readings improves confidence.
Wave counting is subjective. Multiple valid counts often exist simultaneously. Murphy warns against becoming "paralyzed by the wave count" and recommends using it as one tool among many.
Murphy devotes a chapter to the concept that markets exhibit repetitive cyclical behavior. The four principles of cycles:
Murphy catalogs several widely observed cycles:
Cycle analysis is used to adjust other tools. If a 20-day cycle is dominant, then a 10-day (half-cycle) moving average is optimal. Oscillator periods should be set to half the dominant cycle length. When cycles suggest a trough is due, a buy signal from an oversold oscillator carries more weight.
Murphy pioneered the concept of intermarket technical analysis, arguing that no market exists in isolation. The four major groups are interrelated:
Bonds and Commodities — Inverse relationship. Rising commodity prices (inflation) lead to falling bond prices (rising interest rates). The CRB Index (Commodity Research Bureau) and Treasury bond prices move in opposite directions. Commodity prices often lead bond prices at turning points.
Bonds and Stocks — Positive relationship (with a lead). Bonds typically turn before stocks. Falling interest rates (rising bond prices) are bullish for equities because they reduce the cost of capital and make stock dividends more attractive relative to bond yields. A bond market peak is a warning for the stock market.
Dollar and Commodities — Inverse relationship. A falling dollar makes dollar-denominated commodities more expensive, driving commodity prices higher. A rising dollar depresses commodity prices. Gold is the most sensitive commodity to dollar movements.
Dollar and Bonds — Complex relationship. A falling dollar can initially boost bonds (flight to quality by foreign investors is offset by inflation expectations). Over time, however, a weak dollar raises inflation expectations, which is bearish for bonds.
The deflationary sequence is the reverse. Murphy stresses that these relationships shift and the analyst must verify rather than blindly assume them.
Within the stock market, sectors rotate based on the business cycle:
The intermarket analyst checks whether a trade in one market is confirmed or contradicted by action in related markets. A buy signal in the S&P 500 is more reliable if bonds are rising and the CRB Index is stable. A gold buy signal is more credible if the dollar is weakening.
Murphy insists that money management is more important than the entry method. A mediocre system with excellent money management will outperform a brilliant system with poor money management.
Murphy does not present a formal formula (no Kelly criterion or fixed fractional), but his framework implies a fixed-percentage-risk model:
Position Size = (Account Equity * Max Risk %) / (Entry Price - Stop Price)
Adding to a winning position should follow decreasing increments (e.g., 4 contracts, then 2, then 1). Never add to a losing position. Each new addition should have its own stop placed at breakeven for the prior tranche.
Every trade should have three elements determined before entry:
If any of the three is missing, the trade is not ready.
Murphy covers automated trading systems as a discipline enforcer. A mechanical system removes emotion by generating objective signals. The trader must decide in advance whether to follow every signal or use discretion to override.
Murphy's meta-advice: use trend-following methods (moving averages, trendlines) in trending markets and oscillators in trading ranges. The challenge is identifying which regime the market is in. One heuristic: if the ADX (Average Directional Index) is above 25 and rising, the market is trending — use moving averages. If ADX is below 20, the market is range-bound — use oscillators.
Trading against the trend. Trying to pick tops and bottoms instead of following confirmed trends. Murphy's first commandment: the trend is your friend.
Not using stops. Hoping that a losing position will recover. "Hope is not a strategy."
Moving stops in the wrong direction. Widening a stop to avoid being stopped out destroys the purpose of the stop.
Over-trading. Taking too many positions, trading too large, or trading on every signal without filtering. Selectivity is a virtue.
Ignoring the larger time frame. A bullish daily signal against a bearish weekly trend is a low-probability trade.
Over-reliance on a single indicator. No indicator works all the time. Murphy stresses using a basket of tools in confirmation.
Curve-fitting in backtests. Optimizing system parameters until the historical equity curve looks perfect guarantees poor future performance.
Ignoring volume. A breakout without volume confirmation is suspect. Volume is the fuel that powers price moves.
Emotional trading. Revenge trades after a loss, premature profit-taking out of fear, doubling down out of ego. The cure is a written trading plan followed mechanically.
Neglecting intermarket analysis. Trading gold without watching the dollar, or trading bonds without watching commodities, is trading with one eye closed.
Using too short a time frame. Short time frames have more noise. Murphy advises starting with weekly charts for direction and daily charts for timing.
Confusing precision with accuracy. A system that signals to the tick is not necessarily better than one that identifies zones. Seek to be approximately right rather than precisely wrong.
Step 1 — Top-down context (weekly chart). The weekly crude oil chart shows a series of higher lows and higher highs. The 40-week MA is rising and price is above it. The weekly MACD is above its signal line and above zero. Primary trend: UP. Proceed to look for buy opportunities.
Step 2 — Intermarket check. The U.S. Dollar Index is declining (bullish for commodities). Treasury bonds are stable (no imminent rate-hike pressure). The CRB Index is trending higher. Intermarket alignment: bullish.
Step 3 — Daily chart pattern. Price has corrected from $78 to $72, a 38.2% Fibonacci retracement of the $62 to $78 rally. A symmetrical triangle has formed over three weeks at the $72 level. Volume is contracting within the triangle. This is a textbook continuation pattern in a confirmed uptrend.
Step 4 — Oscillator confirmation. Daily RSI(14) has pulled back to 45 (neutral, not oversold) and is turning up. Daily stochastic is crossing up from below 30. MACD histogram has stopped declining and shows its first positive bar. All oscillators are aligned for a resumption of the uptrend.
Step 5 — Entry. Buy two contracts on a close above the upper boundary of the triangle at $73.50. The breakout bar shows volume 40% above the 20-day average — confirmation.
Step 6 — Stop-loss. Place initial stop at $71.00, below the triangle's lower boundary and below the 50-day SMA. Risk per contract: $73.50 - $71.00 = $2.50. Total risk: $2.50 * 2 contracts * 1,000 barrels = $5,000. Account equity is $100,000. Risk: 5.0% — at Murphy's maximum threshold.
Step 7 — Profit target. The triangle's height is $3.00 (from $75 to $72 at the widest point). Projected from breakout at $73.50, target is $76.50. The prior swing high was $78.00. Use $76.50 as T1 (close one contract) and $78.00 as T2.
Step 8 — Trade management. Price rallies to $75.00. Move stop on remaining contracts to $73.00 (breakeven minus small cushion). Price reaches $76.50 — close one contract for $3.00 profit. Trail the stop on the remaining contract using the 10-day EMA, currently at $74.80.
Step 9 — Exit. Price reaches $78.50, slightly above the prior high. RSI(14) reaches 75 — overbought. The weekly chart shows price at the upper channel line. MACD histogram begins declining. Close final contract at $78.00 on the stochastic crossover sell signal.
Step 10 — Post-trade review. Contract 1: +$3.00 ($3,000). Contract 2: +$4.50 ($4,500). Total profit: $7,500. Reward-to-risk: $7,500 / $5,000 = 1.5:1 realized (the plan was 3:1 at minimum; the partial exit strategy reduced the realized ratio but locked in guaranteed profit). Document the trade in the journal. Note: the intermarket alignment and the weekly trend confirmation were the primary reasons for confidence.
"The technician believes that anything that can possibly affect the price — fundamentally, politically, psychologically, or otherwise — is actually reflected in the price of that market."
"The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends."
"One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension."
"Volume is the fuel that drives the market. A breakout on heavy volume is far more likely to be genuine than one on light volume."
"A trend in motion is more likely to continue than to reverse."
"The most important rule in money management is to limit each loss to a small percentage of total equity."
"Oscillators are most useful during periods when the market is moving sideways. They warn the trader of short-term extremes — commonly called overbought and oversold conditions."
"No market exists in a vacuum. Every financial market is affected by what is happening in other markets."
"The most dependable oscillator signal is divergence — when the oscillator fails to confirm a new high or new low in the price."
"The key to long-term success in trading lies in the development and implementation of a sound money management plan."
"The three sources of information available to the technician — price, volume, and open interest — are all the raw material that is needed."
"Keep it simple. The most successful trading systems are not the most complex."