Technical Analysis
from First Principles

What is Dow Theory?

Charles Dow observed in the early 1900s that markets don't move randomly — they move in trends. Murphy built his entire framework on this insight. Dow Theory identifies three simultaneous trend types:

• Primary trend (months to years) — the dominant bull or bear market. This is the tide.
• Secondary trend (weeks to months) — corrections and rallies within the primary trend. This is the wave.
• Minor trend (days) — daily price fluctuations. This is the ripple.

Murphy's rule of thumb: "Never fight the primary trend." Short-term noise is irrelevant if you know which way the tide is running.

Higher Highs & Higher Lows

An uptrend is defined by a sequence of higher highs (HH) and higher lows (HL). Each rally reaches a new peak; each pullback holds above the previous low. As long as this pattern is intact, buyers are in control.

A downtrend is the mirror: lower highs (LH) and lower lows (LL). Each bounce fails below the prior peak; each dip breaks the prior trough.

The trend is broken — not just paused — when the defining structure fails: an uptrend ends when price makes a lower low for the first time. That's the signal to reassess, not before.

Trendlines & Channels

A trendline connects at least two swing lows (in an uptrend) or two swing highs (in a downtrend). The more touches without a break, the more significant the line. When price decisively penetrates the trendline — especially on high volume — the trend is likely reversing.

A channel adds a parallel return line drawn from the peaks. Price oscillating between support trendline and resistance channel line is a powerful, tradeable structure.

Why Price Levels Have Memory

Support is a price level where buying pressure has historically been strong enough to stop or reverse a decline. Think of it as a floor — the more times price has bounced from this level, the more traders are watching it.

Resistance is the ceiling — a level where selling pressure has historically capped rallies. Prior highs create resistance because investors who bought at the top are relieved to break even and sell; traders who shorted earlier add more supply.

Murphy's Role Reversal

One of Murphy's most powerful and reliable principles: once a support level breaks, it becomes resistance — and vice versa. Why? The psychology flips:

• Former buyers at the old support, now underwater, want to sell when price returns to that level to cut their loss
• Short sellers who sold the breakdown defend the level from above

This role reversal is the basis for many of the best trade entries Murphy describes. Watch for price to return to a broken level — the reaction there confirms whether the break was real.

How Levels Strengthen

A support level tested three times and holding is stronger than one tested once. The logic: each test attracts more traders who've seen the level hold, adding their buy orders just below it. Conversely, a level broken after many tests carries more significance — all those trapped buyers have now become potential sellers.

Volume is also key: a break of support on high volume is far more reliable than a low-volume break, which might just be a temporary shake-out.

Head & Shoulders

Murphy considers this the most reliable of all reversal patterns. It forms at the end of an uptrend with three peaks: a left shoulder, a higher central peak (the head), and a lower right shoulder. The neckline connects the two troughs between the peaks.

• Signal: a decisive close below the neckline confirms the reversal
• Target: measure the height from neckline to the top of the head; project that distance downward from the neckline break
• Volume: should be highest on the left shoulder, lower on the head, even lower on the right shoulder — fading buying pressure
• Inverse H&S is the bullish mirror, forming at the end of a downtrend

Double Tops & Bottoms

A double top forms when price reaches the same resistance level twice, fails both times, and then breaks below the trough between the two peaks (the "neckline" here). It signals that buyers have exhausted the supply at that level — they tried twice and couldn't break through.

Key rule: the two peaks must be roughly equal in price (within ~3%). A break above a prior high, even slightly, disqualifies the pattern as a double top.

A double bottom is the bullish inverse — the "W" pattern. Two tests of support, with a break above the midpoint peak to confirm.

Triple tops and bottoms are rarer but even more powerful — three tests of the same level with increasing conviction, then a clean break.

Flags & Pennants

Flags and pennants form after a sharp, nearly vertical price move (the "flagpole") and represent a brief, orderly consolidation before the trend resumes. They are among the most reliable and consistent patterns in Murphy's toolkit.

• Flag: consolidation in a small rectangular channel, often slanting slightly against the prior trend. Usually lasts 1–3 weeks.
• Pennant: converging trendlines (a small symmetrical triangle) after the flagpole. Similar duration.
• Target: project the length of the flagpole from the breakout of the flag/pennant
• Volume: typically dries up during the consolidation, then surges on breakout

Triangles

Triangles come in three varieties, each with a different implication:

• Symmetrical triangle: converging highs and lows — a neutral coil that typically resolves in the direction of the prior trend. Breakout direction = signal.
• Ascending triangle: flat top resistance, rising lows. Bullish bias — buyers are consistently willing to pay more while sellers are stuck at the same ceiling. Breaks up most often.
• Descending triangle: flat bottom support, declining highs. Bearish bias — sellers are consistently pressing lower while buyers defend the same floor. Breaks down most often.

Target for any triangle: measure the height of the widest part of the triangle, then project that distance from the breakout point.

Rectangles

A rectangle (or trading range) forms when price oscillates between two clearly defined horizontal support and resistance levels. The breakout direction typically continues the prior trend, but the rectangle can also serve as a reversal pattern — watch the volume and broader trend context.

The Three Types of Gaps

A gap occurs when today's opening price is above yesterday's high (gap up) or below yesterday's low (gap down), leaving an empty space on the chart. Not all gaps are equal:

• Breakaway gap: occurs at the beginning of a new trend, often breaking out of a consolidation area on high volume. The most significant — it marks the start of a major move. Gaps of this type rarely fill quickly.
• Runaway gap (measuring gap): occurs in the middle of a strong trend — price gaps in the trend direction with no nearby resistance. Murphy notes it often occurs near the midpoint of the move, making it useful for estimating the target.
• Exhaustion gap: appears near the end of a trend — price gaps far in the direction of the trend on high volume, but momentum is nearly spent. It's often followed within days by a sharp reversal. When an exhaustion gap is followed by a gap in the opposite direction, the combination is called an "island reversal."

Key Reversal Days

A key reversal day signals a potential trend change in a single session. Murphy's criteria:

• Bearish key reversal: price makes a new high for the current move, then reverses to close below the prior day's close — all in the same session. Buying exhaustion.
• Bullish key reversal: price makes a new low for the move, then reverses to close above the prior day's close. Selling exhaustion.

The higher the volume on the reversal day, the more significant the signal. Key reversal days on weekly or monthly charts carry far more weight than daily ones.

Murphy's Core Volume Rule

Murphy states it simply: "Volume should expand in the direction of the price trend." This rule is the foundation for all volume analysis. It asks whether institutional (large, "smart money") participants are behind the move or not.

• Rising price + rising volume = healthy uptrend. Institutional buyers are participating. The move has conviction.
• Rising price + falling volume = warning sign. The rally is losing participation. Distribution (smart money selling to retail buyers) is often occurring.
• Falling price + rising volume = selling pressure is heavy. Bears in control. A breakdown on high volume is a strong bearish signal.
• Falling price + falling volume = selling is drying up. The decline may be near exhaustion — watch for a bounce.

Volume and Breakouts

Volume confirmation is most critical at breakout points. A price breaking above resistance on 2× or more of average volume is a high-confidence signal — it means buyers overwhelmed sellers decisively. A breakout on below-average volume is suspect and often fails (a "false breakout" or "bull trap").

Murphy's checklist for a valid breakout:

• Price closes above (or below for breakdowns) the level
• Volume expands significantly on the breakout day
• Price doesn't immediately pull back through the level (role reversal holds)

How OBV Works

OBV (developed by Joe Granville, popularized by Murphy) is a running cumulative total:

• On up days (close > prior close): add that day's volume to the running total
• On down days (close < prior close): subtract that day's volume

The result is a single line that tracks whether volume is flowing into or out of a stock. The absolute number is meaningless — only the direction and trend of OBV matter.

OBV as a Leading Indicator

Murphy's key insight: OBV often leads price. When institutions start accumulating a stock (buying quietly without moving the price much), volume on up days builds while the price consolidates. OBV rises before the price breakout signals it.

The most important OBV signals are divergences:

• Bullish divergence: price makes a new low but OBV holds above its prior low — selling pressure is weakening. Smart money is absorbing the sell-off. A rally often follows.
• Bearish divergence: price makes a new high but OBV fails to confirm — buying volume is drying up despite the new high. A reversal is likely near.

Moving Averages — Trend Filters

A simple moving average (SMA) is the average closing price over N days, recalculated each day as the oldest price drops off and the newest is added. It smooths out daily noise to reveal the underlying trend direction.

Murphy's two most important SMAs:

• 50-day SMA: intermediate-term trend benchmark. Price consistently above the 50-day = bullish intermediate outlook. Price crossing below = caution. Used by institutional traders to gauge medium-term momentum.
• 200-day SMA: the long-term benchmark — the most closely watched MA on Wall Street. In a healthy bull market, the 200-day slopes upward and price stays above it. A break below the 200-day on a major index is a serious warning.

The Golden Cross & Death Cross

The golden cross occurs when the 50-day SMA crosses above the 200-day SMA. Murphy regards this as one of the most significant long-term bullish signals — it marks the transition from a bear trend to a bull trend in the price structure. MurphyTrend assigns it the highest weight in the outlook score: 2.0.

The death cross is the inverse — 50-day crosses below the 200-day. A major bearish signal. Historically, death crosses have preceded extended bear phases in indices like the S&P 500. Equally weighted at 2.0 due to the structural significance of the transition.

Important nuance: both crosses are lagging by nature — they confirm a trend change that has already begun, not predict one. Their value is in filtering out whipsaws and confirming the direction for longer-term positioning.

How Bollinger Bands Are Built

Bollinger Bands place a volatility envelope around price using three lines:

• Middle band: 20-day simple moving average
• Upper band: middle band + (2 × 20-day standard deviation)
• Lower band: middle band − (2 × 20-day standard deviation)

Statistically, approximately 95% of price action should fall within the bands. When price touches or breaches a band, it represents a statistically extreme price level relative to recent history.

Reading the Bands

%B (percent-B) measures where price is relative to the bands: 1.0 = upper band, 0.0 = lower band, 0.5 = middle.

• %B > 0.8 → price near upper band (MurphyTrend: bearish signal in non-trending markets)
• %B < 0.2 → price near lower band (bullish signal — potential support)
• Band squeeze: when bands narrow to their tightest point in months, volatility is at a low ebb — a large move is imminent. The direction of the first significant breakout is the trade signal.
• In strong trends: price can "ride" the upper (or lower) band for an extended period. Band touches in a strong trend mean continuation, not reversal.

Context is everything with Bollinger Bands — always check whether price is trending or ranging before interpreting an upper/lower band touch.

How RSI Works

RSI(14) measures momentum: it compares the average gain over 14 days to the average loss, normalizing the result to a 0–100 scale. The formula ensures RSI can never actually reach 0 or 100 but approaches those extremes under relentless buying or selling.

• RSI > 70: overbought. Price has moved up faster than the historical norm. In trending markets, this can persist — use as a warning, not an automatic sell signal.
• RSI < 30: oversold. Price has fallen faster than the norm. Again, in strong downtrends, RSI can stay below 30 for weeks.
• RSI = 50: momentum is neutral — neither buyers nor sellers have a clear edge

RSI Divergence — The Most Powerful Signal

Murphy emphasizes divergence as the most reliable RSI signal — more so than the overbought/oversold levels alone:

• Bullish divergence: price makes a lower low, but RSI makes a higher low. Downward momentum is weakening even though price is still falling — a reversal is often near.
• Bearish divergence: price makes a higher high, but RSI makes a lower high. Upward momentum is fading even though price is still rising — the top may be close.

Divergences are most significant when they occur at extreme RSI levels (<30 or >70) and when supported by other indicators (volume, patterns, MA context).

The Three MACD Components

MACD was designed by Gerald Appel to combine trend-following and momentum in a single indicator. Murphy adopted it as one of his primary tools. Three components:

• MACD line: 12-day EMA minus 26-day EMA. Positive when short-term momentum leads long-term (bullish); negative when lagging (bearish).
• Signal line: 9-day EMA of the MACD line — a smoothed version that generates crossover signals
• Histogram: MACD line minus signal line. Growing bars = momentum accelerating in the direction of the MACD; shrinking bars = fading

Reading MACD Signals

• Signal line cross (bullish): MACD line crosses above its signal line — short-term momentum is picking up relative to the smoothed signal. MurphyTrend weight: 1.5.
• Signal line cross (bearish): MACD drops below signal — momentum fading.
• Zero line cross: MACD crossing above zero confirms the 12-day EMA has overtaken the 26-day (bullish trend confirmation). Crossing below = bearish confirmation. Less frequent, but higher significance than signal crosses.
• Histogram divergence: if price makes a new high but the histogram peak is lower than the prior peak, momentum is waning — a bearish divergence. Strongest when combined with an RSI divergence.

Why Fibonacci Works in Markets

The Fibonacci sequence (1, 1, 2, 3, 5, 8, 13, 21…) produces ratios that appear throughout nature — and, Murphy argues, in human crowd behavior. The key ratios are:

• 61.8% — the "golden ratio" (each number is ~61.8% of the next)
• 38.2% — the complement of 61.8% (i.e., 100% − 61.8%)
• 50.0% — not a Fibonacci number, but widely used (Dow Theory's "half-way" rule)

Whether these ratios "work" due to self-fulfilling prophecy or something deeper, enough traders watch them that they become significant price levels where decisions cluster.

Retracements

After a significant price move, markets typically retrace (pull back) a fraction of that move before resuming the trend. Murphy's retracement hierarchy:

• 33% (or 38.2%): shallow pullback — the underlying trend is very strong. Price bouncing here signals the move is far from over.
• 50%: the most common retracement depth. A bounce from 50% is the classic "buy the dip" opportunity in a bull market.
• 61.8%: the deepest normal pullback. A bounce here, in the context of a strong prior trend, is a high-probability entry. A break below 61.8% often signals a trend reversal, not just a retracement.
• 66% (or 2/3): Murphy also uses this simpler approximation — break below 2/3 of the prior move reversal territory.

Extensions for Price Targets

Fibonacci extensions project how far a move may travel beyond its prior high (in an uptrend):

• 100% extension: the minimum measured-move target — the market "expects" the move to be at least equal to the prior swing
• 138.2% / 161.8%: extended targets for strong trending moves

MurphyTrend uses these extension levels as clamps on the 30/60/90-day price target projections, anchoring them to the nearest Fibonacci level to avoid unrealistic projections.

The Weighted Scoring System

MurphyTrend converts every indicator into a direction score (+1 bullish, 0 neutral, −1 bearish) and multiplies by its weight. The final outlook is the weighted average:

The weights by signal:

• Golden/Death Cross — 2.0 (highest; long-term structural shift)
• Price Trend (HH/HL) — 1.5 (Dow Theory primary structure)
• RSI(14) — 1.5 (momentum extremes and divergence)
• MACD Signal Cross — 1.5 (trend + momentum confirmation)
• Price vs. 50-day MA — 1.0
• Price vs. 200-day MA — 1.0
• MACD Histogram — 1.0
• Bollinger %B — 1.0
• Volume Trend — 1.0
• OBV — 1.0
• Chart Patterns — 1.0–1.5 each (when detected)

Reading a Complete Analysis

Murphy's framework synthesized into a reading checklist:

• Step 1 — Check the primary trend. Is price making HH/HL or LH/LL? Is it above or below the 200-day MA? These establish the dominant context.
• Step 2 — Check the golden/death cross. Weight 2.0 — this single signal can dominate a neutral outlook. If it's present, it matters most.
• Step 3 — Count the signal agreement. If 7+ signals point the same direction, the thesis is strong. Mixed signals = uncertain, not "neutral do nothing."
• Step 4 — Check momentum (RSI + MACD). Is momentum confirming or diverging from price? Divergences are early warnings.
• Step 5 — Read the price targets in context. A bullish target with a bearish score = caution. A bearish target near strong support = potential opportunity. Never read targets without the score.