Why Bull Markets Steam Roll Bears

John Murphy’s Ten Laws of Technical Trading

 

Original Source: John Murphy’s Ten Laws of Technical Trading

Charts and information courtesy of www.StockCharts.com

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.

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.

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.”

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 fifty percent 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 Retracements1) of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.

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.

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 they help confirm trend changes. 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. Signals are given when the shorter average line crosses the longer. 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.

7. Learn the Turns

Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and the Stochastics Oscillator. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. 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.

8. Know the Warning Signs

Trade the MACD indicator. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel) combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. An 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.

9. Trend or Not a Trend

Use the ADX indicator. 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.

10. Know the Confirming Signs

Don’t ignore volume. Volume is a very important confirming indicator. Volume precedes price. It’s 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 volume confirms that new money is supporting the prevailing trend. Declining volume is often a warning that the trend is near completion. A solid price uptrend should always be accompanied by rising volume.

“11.”

Keep at it. Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.

– John Murphy

Original Source: John Murphy’s Ten Laws of Technical Trading

Charts and information courtesy of www.StockCharts.com

My 20 Trading Truths

 

I have been fortunate to get the opportunity to participate in some great stock market environments over the past 20 years.

I started in the early nineties building capital and letting it compound. I started as an investor in mutual funds, moved to individual stocks, then high growth stocks and trading price action, swing trading, to trend following, and finally to equity options.

I was fortunate to be blessed with some parabolic bull markets in the late nineties and 2003-2007 that covered up much of my learning curve. I had a huge drawdown in trading capital from 2000-2002 but the lessons I learned there enabled me to sidestep any permanent losses in the 2008-2009 melt down.

I always had a big aversion to losses that really saved me from ever blowing up my first trading accounts like most new traders do because they lack an understanding of the risk of ruin. From the beginning I always cut losses short because I hated to lose money. I also had a natural appreciation for making money and let winning trades go as far as they would.

Much of the first money I made in the stock market was just luck. I was in the right market environment doing the right thing so the profits just happened. Much of the past ten years has been an effort to quantify everything I did to make money and transfer my luck into skill.

 “Patience is power. Patience is not an absence of action; rather it is “timing” it waits on the right time to act, for the right principles and in the right way.” ― Fulton J. Sheen

Here are twenty things that I learned through actual trading that have dramatically helped me to be consistently profitable in my trading through skill.

1.    You have to have passion for learning to trade; passion is the energy that you need to take you to your goals.

2.    You have to have the perseverance to keep going after you want to give up.  90% of new traders quit when they were very frustrated while 100% of successful traders didn’t quit until they reached their goals

3.    New traders spend too much time looking for what to trade instead of focusing on who they are as traders.  You have to know who you are as trader first then you can start building your trading system.

4.    Traders have to be able to manage their stress by trading inside their current comfort zone. Traders have to grow themselves and trade size step by step.

5.    The vast majority of new traders fail simply because they did not do their homework before they started trading.

6.    A trader has to build a trading system that matches their own personality and risk tolerance levels.

7.    A trader that chooses to be master a specific type of trading method or trading vehicles has a much better chance of success than the traders that just dabble in many different things and never make much progress.

8.    A trader has to write a good trading plan while the market is closed to guide their trading while the market is open.

9.    A trading plan has to be followed with discipline to have a chance at success.

10.    A trader has to manage their behavior by acting consistently with their own rules.

11.    “The answer to what’s the trend? Is the question “What’s your timeframe?” – Richard Weissman.  All traders are simply trying to capture trends in their own time frame.

12.    Never risk losing more than 1% of your trading capital on any one trade. Once you lose 1% of your capital you should exit the trade.

13.    Be very aware of how much risk your total account is exposed to at any one time through position sizing and volatility.

14.    Set your stop losses far enough away from your entry point to avoid regular noise and fluctuations. Find your stop level first, and then position size accordingly.

15.    A trading plan has to be followed with discipline to have a chance at success.

16.    The money I have made in the stock market was made through following the chart and the trend not from some prediction or opinion.

17.    My biggest trading losses came from hoping, stubbornness, and bias.

18.    My best trading has happened when I was the most open minded simply trying to answer the question: “What is the chart telling me to do now?”

19.    If you have to ask others for their opinions about your trade you should not be trading you should still be in the process of study and writing your trading plan.

20.    “If you diversify, go with the trend, and manage your risk, then it just has to work.” – Larry Hite

The Trend Commandments

 

The principles that successful trend traders use to make money in the markets is difficult for the average investor or trader to understand.

Readers unfamiliar with systematic trend trading have a hard time grasping the concept of trading for profitability without trying to predict where price will go next. Most successful trend traders have preset planned entries that are triggered by a reaction to a new high or low price being hit. They use quantifiable price levels and indicators like moving averages to know when to enter and exit a trade and do not rely on any attempt to ‘know’ what will happen next. They buy or sell short in the direction of the dominant trend when they get a signal that shows the potential for a trend, they do not predict the trend… they simply attempt to follow it.

Even though many professional trend followers that manage money have had huge long term gains and have compounded managed capital over many years, some critics complain that many trend traders have large draw downs. While 20% drawdowns are unpleasant to trade through, traders of all types do have drawdowns and many traders that trade against trends and do not manage risk carefully blow up eventually. It is very difficult to argue with the many trend followers that have made fortunes with reactive technical systems over the long term.

Anyone who says they can predict the stock market with certainty cannot be trusted. It is delusional thinking to believe they are smarter than all the participants and can see all events that move markets ahead of time without the aid of a working crystal ball or time machine. Trend followers simply use preset price signals to identify trends, they manage their risk on every trade, and they follow their system with great discipline.

As long as markets trend then trend-followers will be winners in the zero sum game over long term.

Here are some of the commandments they trade by:
1.    You shall back test and develop quantify robust trend trading systems that are profitable over the long term.
2.    You shall identify and follow the long term trend in the markets you trade, and have no guru that you bow down to.
3.    You shall not try to predict the future, that is a fool’s game, but follow the current price trend.
4.    You shall remember the stop loss to keep your capital safe from destruction; you shall know your exit level before your entry is taken.
5.    Follow your trend following system all the days that you are trading, so that through discipline you will be profitable.
6.    You shall not give up on your trading system because of a draw down.
7.    You shall not change a winning system because it has had a few losing trades.
8.    You shall trade with the principles that have proven to work for successful traders. Manage risk, go with the trend, and diversify so your days in the market will be long.
9.    You shall keep the faith in your trend following system even in range bound markets; a trend will begin anew eventually.
10.    You shall not covet fundamentalist’s valuations, CNBC talking heads, newsletter predictions, Holy Grails, or the false claims of any of the black box systems.