In life, Murphy’s law is the adage which states that “Anything that can go wrong will go wrong.”
In technical analysis and charting, Murphy’s Laws help to provide indicators of which way the market is headed. John Murphy, a technical analyst and the chief technical analyst at StockCharts.com, has developed and battle-tested his own laws of technical trading, and investors can learn a lot from this 30-year veteran.
Map Out the Trends
One of Murphy’s first decrees is to map the trend and study long-term charts. You should start with weekly and monthly charts over several years to get an idea of the overall long-term trend. Using a weekly or monthly chart lets you gain a different perspective of a stock, ignoring the noise; thereafter, once you know the long-term view, you could move onto daily and intraday charts.
Plotting the Trend Lines
Trend lines are used widely, and are a simple-yet-effective charting tool. All you need to do is draw a line connecting points on a stock chart. Downtrends are a series of lower highs and lower lows, while uptrends are a series of higher highs and higher lows.
Check out this weekly chart on Amazon.com Inc. (AMZN):
You’ll notice from the trend lines drawn on the chart, AMZN has been in a clear uptrend over this period. Practice drawing trend lines on your own to get an overall idea of how a stock has been performing.
Listen to the Moving Averages
Chartists typically use moving averages to indicate at which points they may buy or sell a stock. Moreover, it gives an idea of the overall existing trend. Using a combination of moving averages can give clues to where a stock is headed, providing trading signals.
Follow the Trend
If you’re able to spot the overall trend in a stock or the market, you should follow that trend. Be sure, however, that you keep the time frames of your charts consistent. For example, you have to decide whether you want to hold over the short-, medium- or long-term. If you’re looking to hold onto a position for the long run, you should look at weekly or monthly charts. That said, make sure you’re not going against the overall trend.
Finding Key Support and Resistance Levels
Support and resistance levels are some of the main building blocks of technical analysis. The support level acts as a bottom for the stock, and a point at which buyers are willing to step in, while resistance levels are the exact opposite. You typically want to buy at support levels and sell at resistance levels.
If, however, a stock breaks above its resistance level, that area could serve as the new support level; if the stock pulls back, it may look to the previous resistance level as an area of support.
Take a look at the daily chart on Puma Biotech Inc. (PBYI).
The area that is outlined by the square is the support area. Consequently, you might be a buyer at these levels; potentially looking to sell if the stock reaches the resistance level.
These laws of technical trading are not so much laws as combat-tested tips that could help you when you’re trading using technicals. As with all trading, these tips outlined are not set in stone, as the markets are dynamic. The real Murphy’s Law — about whatever could go wrong — may still come into play, but following these steps may help you avoid a lot of things that could go wrong while giving you some insight into what might go right.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.