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Dow Theory is named after Charles H Dow, who is considered as the father of Technical
Analysis. Dow Theory is very basic and more than 100 years old but still remains the foundation
of Technical Analysis.
Charles H Dow(1851-1902) ,however neither wrote a book nor published his complete theory
on the market, but several followers and associates have published work based on his theory
from 255 Wall Street Journal editorials written by him. These editorials refl ected his belief on
stock market behavior. Some of the most important contributors to Dow Theory are
a. Samuel A. Nelson- He is the fi rst person to use the term Dow Theory and he selected
fi fteen articles by Charles Dow for his book The ABC of Stock Speculation.
b. William P. Hamilton-He wrote a book titled The Stock Market Barometer which is a
comprehensive summary of the fi ndings that Charles H Dow and Samuel A. Nelson have
c. Robert Rhea- He wrote a book titled The Dow Theory.
d. George E Schaefer- He wrote a book titled How I Helped More than 10000 Investors to
profi t in Stocks.
e. Richard Russell- He wrote a book titled The Dow Theory Today.
Principles of Dow Theory
The Dow Theory is made up of six basic principles. Let’s understand the principles of Dow
First Principle: The Stock Market Discounts All Information
The first principle of Dow Theory suggests that stock price represents sum total of hopes,
fears and expectation of all participants and stock prices discounts all information that is
known about stock i.e. past, current and above all stock price discounts future in advance i.e.
the stock market makes tops and bottoms ahead of the economy.
It suggests stock market discounts all information be it interest rate movement, macroeconomic
data, central bank decision, future earnings announcement by the company etc. The
only information which stock market does not discount is natural calamities like tsunami,
earthquake, cyclone etc.
Second Principle: The Stock Market Have Three Trends
Dow Theory says stock market is made up of three trends
a. Primary Trend
b. Secondary trend
c. Minor Trend
Dow Theory says primary trend is the main trend and trader should trade in direction of this
trend. It says primary trend is trader’s best friend which would never ditch trader in this
volatile stock market. If primary trend is rising then trend is considered rising (bullish) else
trend is considered falling (bearish). The primary trend is the largest trend lasting for more
than a year.
The primary trend is considered rising if each peak in the rally is higher than previous peak
in the rally and each trough in the rally is higher than previous trough in the rally. In other
words as long as each successive top is higher than previous top and each successive bottom
is higher than previous bottom, primary trend is considered rising and we say markets are
bullish. This would be clearer from (Figure 1)
(Figure 1) illustrates that each successive top that is D, F, and H are higher than previous tops
and each successive bottom that is E and G are higher than previous bottoms, hence primary
trend is considered rising.
The primary trend is considered falling if each peak in the rally is lower than previous peak in
the rally and each trough in the rally is lower than previous trough in the rally. In other words
as long as each successive bottom is lower than previous bottom and each successive top is
lower than previous top, primary trend is considered falling and we say markets are bearish.
This would be clearer from (Figure 2)
(Figure 2) illustrates that each successive bottom that is D, F, and H are lower than previous
bottoms and each successive top that is E and G are lower than previous tops, hence primary
trend is considered falling.
Dow Theory says secondary trends are found within the primary trend i.e. corrections when
primary trend is rising and pullback when primary trend is falling. More precisely secondary
trend is the move against the direction of the primary trend .The secondary trend usually lasts
for three weeks to three months. This would be more clearer from (Figure 3) & (Figure 4).
Dow Theory says that secondary trend consist of short term price movements which is known
as minor trends. The minor trend is generally the corrective move within a secondary trend,
more precisely moves against the direction of the secondary trend. The minor trend usually
lasts for one day to three weeks. The Dow Theory says minor trends are unimportant and
needs no attention. If too much focus is placed on minor trends, it can lead to total loss of
capital as trader gets trapped in short term market volatility.
Third Principle: Primary Trend Have Three Phases
The Dow Theory says primary trend have three phases
a. Accumulation Phase
b. Participation Phase
c. Distribution Phase
The Dow Theory says that the accumulation phase is made up of buying by intelligent investor
who thinks stock is undervalued and expects economic recovery and long term growth. During
this phase environment is totally pessimistic and majority of investors are against equities
and above all nobody at this time believes that market could rally from here. This is because
accumulation phase comes after a signifi cant down move in the market and everything appears
at its worst. Practically this is the beginning of the new bull market.
The participation phase is characterized by improving fundamentals, rising corporate profi ts
and improving public sentiment. More and more trader participates in the market, sending
prices higher. This is the longest phase of the primary trend during which largest price
movement takes place. This is the best phase for the technical trader.
The distribution phase is characterized by too much optimism, robust fundamental and above
all nobody at this time believes that market could decline. The general public now feels
comfortable buying more and more in the market. It is during this phase that those investors
who bought during accumulation phase begin to sell in anticipation of a decline in the market.
This is time when Technical Analyst should look for reversal in the trend to initiate sell side
position in the stock market.
Three phases of primary trend would be clearer from (Figure 5)
(Figure 5) illustrates –
• Accumulation phase from April 2003 to June 2003 during which nobody believed that
markets could rally but intelligent investor took buy side positions in the stock market.
• Participation phase from July 2003 to January 2004 during which largest and longest
price movement occurred.
• Distribution phase from February 2004 to May 2004 during which smart money closed
buy side positions in the market.
Fourth Principle: Stock Market Indexes Must Confi rm Each Other
Charles H Dow believed that stock market as a whole refl ected the overall business condition
of the country. In other words stock market as a whole is a benchmark indicator to measure
the economic condition of the country.
Dow fi rst used basis of his theory to create two indexes namely (i) Dow Jones Industrial Index
and (ii) Dow Jones Rail Index (now Transportation Index).Dow created these two indexes
because those days U.S was a growing industrial nation and urban centers and production
centers were apart. Factories have to transport their goods to urban centers by rail road. Hence
these two indexes covered two major economic segments i.e. Industrial and transportation.
Dow felt these two indexes would refl ect true business condition within the economy.
According to Dow
(a) Rise in these two indexes refl ects that overall business condition of the economy is good
.The basic concept behind this is that if production is increasing then transportation of
goods to customer should also increase i.e. performance of companies transporting goods
to consumer should improve. According to Dow Theory, two averages should move in the
same direction and rising Industrial Index is not sustainable as long as Transportation
Index is not rising.
(b) The divergence in these two indexes is a warning signal.
Under Dow Theory, a reversal from a bull market to bear market or vice versa is not signaled
until and unless both indexes i.e. Industrial Index and Transportation Index confi rm the
In simple wors, if one index is confi rming a new primary uptrend but another index remains
in a primary downtrend, then there is no clear trend.
Basically Dow Theory says that stock market will rise if business conditions are good and stock
market would decline if business conditions are poor.
Fifth Principle: Volume Must Confi rm the Trend
Dow Theory says that trend should be confi rmed by the volume. It says volume should
increase in the direction of the primary trend i.e.
• If primary trend is down then volume should increase with the market decline.
• If primary trend is up then volume should increase with the market rally.
Basically volume is used as a secondary indicator to confi rm the price trend and once the
trend is confi rmed by volume, one should always remain in the direction of the trend.
Sixth Principle: Trend Remains Intact Until and Unless Clear Reversal Signals Occur
As we are dealing in stock market which is controlled by only one “M” i.e. Money and this
money fl ows very fast across borders. Hence stock prices do not move smoothly in a single
line, one day it’s up next day it might be down.
Basically Dow Theory suggests that one should never assume reversal of the trend until and
unless clear reversal signals are there and one should always trade in the direction of the
Significance of Dow Theory
It’s Dow Theory which gave birth to concept of higher top-higher bottom formations and lower
top-lower bottom formations which is the basic foundation of Technical Analysis. This helps
investors to improve their understanding on the market so that they could succeed in their
investment/trading decisions. Most of the technical analysts follow this concept and if you go
through any technical write up, you would defi nitely fi nd this concept.
Problems with Dow Theory
a. One misses the large gain due to conservative nature of a trend reversal signal i.e.
uptrend would reverse when stock prices make lower top-lower bottom formation and
downtrend would reverse when stock prices make higher top-higher bottom formation.
b. Charles Dow considered only two indexes namely Industrial and Transportation which
is not major part of the economy today. Technology and fi nancial services i.e. banking
constitutes major part of the economy today. We have seen in 1998-1999, one sided rally
in Nifty led by technology stocks. In this rally none of industrial stock participated and
if one waited for buy confi rmation from Industrial and Transportation indexes then one
must have missed the classic bull run of technology stocks.
Strategies for day trading:
Scalping: Scalping is one of the most popular strategies. Scalping is a trading style focusing
on taking profi ts on small price changes, generally immediately after one enters a trade
becomes profi table. It requires a strict and aggressive exit strategy because one large loss
could wipe out the several small gains realized. Having the right tools such as a live feed, a
direct-access broker and the propensity to execute many trades is required for this strategy
to be successful. A scalper’s main objective is to take as many small profi ts as possible.
Fading: Fading involves shorting stocks after rapid moves upwards. This strategy involves
a considerable amount of risk. But it is also more profi table; and can work well for novice
traders as it does not involve extensive technical analysis. The fading strategy is based on
three assumptions: i) the stock is overbought, ii) early buyers are ready to begin taking profi ts
and iii) existing buyers may be scared out. Although risky, this strategy can be extremely
rewarding. Here the price target is when buyers begin stepping in again.
Daily pivots: This strategy involves profi ting from a stock’s daily volatility. For many years,
traders and market makers have used pivot points to determine critical support and/or
resistance levels. This is done by attempting to buy at the low of the day (LOD) and sell at the
high of the day (HOD). Pivots are extremely useful tool for range-bound traders to identify
points of entry and for trend traders and breakout traders to spot the key levels that need to
be broken for a move to qualify as a breakout.
Momentum trading is when a trader sees a stock price picking up and joins it. This strategy
usually involves trading on news releases or fi nding strong trending moves supported by
high volume. The investor will take a short or long position in the stock anticipating that
the momentum of the stock will continue. Here the price target is when volume begins to
decrease and bearish candles start appearing.
Momentum trading Strategies:
Momentum traders are truly a unique group of individuals. To engage in momentum trading,
you must have the mental focus to remain steadfast when things are going your way and
to wait when targets are yet to be reached. Unlike other traders or analysts who dissect a
company’s fi nancial statements or chart patterns, a momentum trader is only concerned with
stocks in the news. These stocks will be the high percentage and volume movers of the day.
Momentum trading requires a massive display of discipline, a rare personality attribute that
makes short-term momentum trading one of the more diffi cult means of making a profi t. Let’s
look at a few techniques for successful momentum trading.
Techniques for entry
Dr. Alexander Elder had designed an impulse system for momentum trading. To identifying
appropriate entry points the system simultaneously uses two indicators:
i) Exponential moving average - EMA is used to measure market inertia i.e for fi nding
uptrends and downtrends
ii) Moving Average Convergence-Divergence – MACD measures market momentum.
When EMA rises, the inertia favors the bulls, and when EMA falls, inertia favors the bears. To
measure market momentum, the trader uses MACD histogram, which is an oscillator displaying
a slope refl ecting the changes of power among bulls and bears. When the slope of the MACD
histogram rises, bulls are becoming stronger. When it falls, the bears are gaining strength.
The system issues an entry signal when both the EMA and MACD move in the same direction,
and an exit signal is issued when these two indicators diverge. If signals from both the EMA
and the MACD histogram point in the same direction, both inertia and momentum are working
together toward clear uptrends or downtrends. When both the EMA and the MACD histogram
are rising, the bulls have control of the trend, and the uptrend is accelerating. When both EMA
and MACD histogram fall, the bears are in control, and the downtrend is paramount.
Times You trade
The unfavorable time for momentum traders is during lunch (12 - 2pm), where volume dries
up and the moves are choppy to fl at. So momentum traders should limit the times they trade
to the fi rst and last hour of the day trading session. This is because volatility is very high
during these two time slots.
Techniques for exiting positions
The key to being a successful momentum trader is to know when to exit the position. Once
you have identifi ed and entered into a strong momentum trade i.e. when daily EMA and MACD
histogram are both rising, you should exit your position at the very moment either indicator
turns down. Since momentum traders initiate positions during the most volatile times during
the trading day, sharp corrections are commonplace. This is why it is imperative that prior to
plunging into the momentum trade, the traders must become acclimated to the speed of the
Day trading means buying and selling a stock within the same day. The positions are closed
before the market close for the trading day. Day trading is about discipline and training of
mind. It is about waiting in the trenches till the right opportunity appears. The goal of a day
trader is to capitalize on price movement within one trading day. Day traders maximize profi ts
by leveraging large amounts of capital to take advantage of small price movements in highly
liquid stocks or indexes. Because of the nature of fi nancial leverage and the rapid returns
that are possible, day trading can be either extremely profi table or extremely unprofi table,
and high-risk profi le traders can generate either huge percentage returns or huge percentage
losses. Some day traders manage to earn millions per year solely by day trading.
Advantages of day trading:
Zero Overnight risk: One of the best advantages of day trading is ability to close your
position at or before the end of the trading day. Since positions are closed prior to the end
of the trading day, news and events that affect the next trading day’s opening prices do not
effect your portfolio.
When you open and close your position before the trading day ends, the risks of holding a stock
overnight are erased. A traditional trader’s profi ts can disappear overnight with traditional,
long-term trading, but with day trading your profi ts are secure as long as you close your
positions before the end of the trading day. No overnight crises or calamities in the fi nancial
markets can affect your income for that day.
Increased leverage: Unlike positions trading where you would have to have high levels of
investment to put up in the market to gain a profi t, in day trading it is quite the opposite. Day
traders usually need to put up less money to get into day trading and succeed at it. Because of
low margin requirements for day trades you enjoy a greater leverage on your trading capital.
This increased leverage can multiply your profits.
Profi t in any market direction: Unlike long term investors who keep their stocks for long
duration to capitalize only bull market, day traders can take advantage of both rising and
falling market. Day traders can often take advantage of a struggling market by utilizing
short-selling trading strategies to take advantage of falling stock prices. The ability to lock in
profi ts even as markets fall throughout the trading day is extremely useful during bear market
High returns: If successful, the rewards of day trading can far exceed the risks. Of course
if you begin day trading it will not always mean that you get high returns all the time. In
the beginning you have to learn the ins and outs and fl uctuations of the market to keep up.
However, over time, you will hone a certain skill to make day trading profi table for you.
Unlike in ordinary stock market trading or position trading, day trading only requires you to
trade intensely within market hours. Day trading requires discipline and time management,
but it also affords an individual to make their own hours without a manager or boss standing
over their back. And, in addition to the amount of money an individual can make form the
comfort of their own home, day trading offers individuals many advantages they will not
encounter in the more traditional forms of trading stocks and other fi nancial instruments.
Risks associated with day trading:
Day trading can be very risky. Not being able to manage losses, or letting them run, is biggest
reason why day traders lose money. Day traders should not risk the money that they cannot
afford to lose. It is essential that you have the discipline and proper knowledge to succeed
in day trading. You need to have an internal system of checks and balance to make sure you
don’t take too many risks or begin to overtrade. You need to learn how to take a loss, because
losses will occur, especially at the beginning stages. The rewards of day trading are high, but
so are the risks.
Possibility of large losses
Depending on the decisions made during the day, a trader could either make or lose huge
amount of money. You should be prepared to suffer severe fi nancial losses; this is part of
the process. Losses are inevitable. Nobody makes money everyday. Many novice day traders
suffer severe monetary losses in their fi rst months of trading, and couldn’t stay in the game
long enough to see a profit.
Demands of day trading
Day trading requires a lot of time and attention paid to the markets, trends, technical indicators
and national and international news regarding capital markets. A lot of time has to be put
to focus the market hours. In addition to the time commitment, day trading requires a lot of
study outside of your trading hours. An intensive amount of knowledge is needed in order to
be successful at this highly demanding profession.
Stress is a routine part of every day trading job. Stress and anxiety arises while tracking various
movements within few minutes. In addition to this, the job requires that you make quick
decisions concerning the acquisition or selling of securities, with intensive time constraints.
Overtrading means taking highly risky trades or/and trading too large shares. Novice day
traders generally get overwhelmed with the fast pace of day trading and let their emotions,
instead of their knowledge and analysis, make the decisions for them.
Day traders rely heavily on exposure provided by broker or buying stocks on margin. Borrowing
money to trade stocks always holds some risks. Day traders utilize the leveraged money to
increase returns. If not successful, this could lead to the trader losing large sums of money,
and possibly an accruement of debt. This is why it is very important to have knowledge of the
basics of day trading before venturing into the fi eld.
Understanding market trends
The focus of a day trader is on watching the stocks movement on regular basis. They tend to
follow a stock’s momentum and make a quick transaction before it changes course. Since day
traders intend to make profi ts on all major and minor stock movements, it is very important
that they have knowledge of market trends, technical analysis and investment charts. If this
knowledge is absent form a day trader’s skill base, then in spite of making profi ts, he may run
into huge losses.
Starting out as a day trader can cost a lot of money out of pocket. These expenses can include:
software (and hardware), commissions, manuals, and other resources. It is very important to
develop a budget for these out-o-pocket expenses before entering the arena of day trading.
Operational problems like power outages, software/hardware issues, disrupted internet
connections etc. could hamper your day trading.
Moving Averages — Gives the general trend of price based on its recent be havior and tells
when the trend has been broken.
Relative Strength — Measures the strength left in a price trend by comparing number of up
and down days over a recent timeframe.
Percentage R — This compares a day’s closing price to a recent range of prices to determine
if a market is overbought or oversold.
Oscillators — Measure the momentum of a price trend based on recent price behavior.
Stochastic — Combines indicators like moving average and relative strength to measure
overbought and oversold tendencies.
Point-and-Figure/ kagi — Plots trends and reversals in price movement and then gives buy/
sell signals based on recognizable patterns.
Basic Charting — Techniques for recognizing common price movement pat terns and gauging
Swing Charting — Provides rigid entry and exit signals based on recent price history.
Tic Volume — This is similar to On-Balance Volume, but looks at the volume and directions of
On-Balance Volume — Discovers “smart money’s” moves by balancing the volume of days
with rising prices against falling days.
Elliott Waive — Uses rules of cyclic market behavior and pattern formations to predict future
price levels, trends, and reversal points.
How to use the tool kit of trading techniques
Moving Averages — Gives very good signals in a trending market, but can reduce profi ts in a
Relative Strength — This confi rms other methods in trading markets. Users have to keep
adjusting the scale in trending markets.
Oscillators — Can confi rm other techniques and indicate whether market is overbought or
oversold and should be sold or bought.
Stochastic — Accurate for predicting trading market lows and highs.
Point-and-Figure — Gives acceptable results most of the time, but can be un reliable in strongly
Basic Charting — Gives general framework for interpreting most other tech niques. Volume
analysis is an offshoot of basic charting.
Swing Charting — Works in trending markets. Combine longer and shorter period charts to
avoid choppiness in trading markets.
Tic Volume — Same observations apply as for On-Balance Volume. Does not work well in a
market with no big players.
On-Balance Volume — Gives good advance warning of when the market will move off the
bottom, but is late on tops.
Elliott Wave — Predicts major market moves. Use other techniques to confi rm the times and
Trading market tool kit application
1) Moving Averages — Fade breakouts
2) RSI, and Oscillators — Sell overbought, buy oversold
3) Stochastic — Sell crossovers to downside and buy crossovers to upside
4) On-Balance Volume and Tic Volume — Useless as forecasting indicators but can be viable
as confi rming indicators
5) Elliott Wave — Verifi es the existence of trading market via fl at-type cor rections classifi cation
and shows possible end of trading range
Bull market tool kit application
1) Moving Averages — Buy the upside crossovers
2) RSI, and Oscillators—Buy oversold indicators and ignore the over bought indicators
3) Stochastics—Buy the crossovers to the upside; do not sell crossovers to the downside
4) On-Balance Volume and Tic Volume—Useless as forecasting indicators, but viable as
confi rming indicators, since OBV curves would continual ly display new breakout highs
5) Elliott Wave — Buy breakouts of previous highs
Bear market toolkit application
1) Moving Averages — Sell the downside crossovers
2) RSI, and Oscillators—Sell the overbought indicators and ignore the oversold indicators
3) Stochastics — Sell the crossovers to the downside; do not buy crossovers to the upside
4) On-Balance Volume and Tic Volume — Too late for forecasting, and non- effective as
5) Elliott Wave — Sell the breakdowns of previous lows
Trading market changing to bull market toolkit application
1) Moving Averages — If traders are fading the false breakouts in the trading market, one
trade will fi nally go against them for a greater than normal loss (short in a bull market).
This will signal to them that the markets are about to change.
2) RSI, and Oscillators — If traders have been selling overbought and buying oversold, they
will fi nd a trade which will show a loss even though they sold the overbought signal (short
in bull market). This will signal to them that the markets are changing.
3) Stochastics — Traders must buy all crossovers from the oversold condi tions and not
execute trades on overbought signals.
4) On-Balance Volume and Tic Volume — Accumulation can be observed and hence eventual
upside price breakouts can be forecasted with high ac curacy.
5) Elliott Wave — The theory will show a possible breakout to the upside. Cautiously buy
at the trading range for an impending move and ag gressively buy when the price breaks
into new highs moving above the trading range high.
Trading market changing to bear market toolkit application
1) Moving Averages — If traders had been fading the false breakouts to the upside and false
breakdowns to the downside in a trading market, they would fi nd their last trade to be a
disproportionate loss (long in a bear market). There really isn’t much chance to recoup
this loss because the breakdown is fast and severe. It is best not to fade the markets on
the buy side using moving averages after the markets have had a severe run up going
into a trading range market.
2) RSI, %R and Oscillators — If traders had been selling overbought and buying oversold
indicators in a trading market, they would suffer a large loss on the last trade. Traders
would also fi nd a growing number of oversold indicators and a diminishing number of
overbought signals using standard parameters. This signals an impending change in the
state of the market condition.
3) Stochastic — Crossovers from the overbought side to the downside are more valid than
crossovers to the upside from the oversold level.
4) On-Balance Volume and Tic Volume — These two indicators are unreliable for forewarning
traders of impending weakness. The best that traders can expect from these indicators
is a fl attening of the OBV pattern, im plying a possible, but not certain, breakdown. The
prices would drop dramatically and then the volume indicators would indicate a breakdown.
5) Elliott Wave — In Elliott Wave corrections, traders have a one-in-two chance that
the correction could possibly turn into a bear market sell-off (a zigzag instead of a
flat correction). However, in the formation of this correction traders cannot tell until
they approach the forecasted event that the correction could turn into a bear market
correction instead of a fl at correction. If the market turns into a bear market correction
they only have to sell into new lows and maintain a short position to profi t from the move
downwards. If, however, it turns into a fl at correction, they will fi nd themselves selling
the bottom. Elliott Wave analysis does offer inkling about what type of correction traders
can expect, based on the existence of alternative patterns prior to the one currently
Bull market changing to trading market toolkit application
1) Moving Averages — Price fi nally crosses the moving averages to the downside after
leading the averages from above. If traders didn’t buy the price breakout to the upside,
traders mustn’t do it now but, instead, start to fade the upside breakouts carefully and
fade the downside breakdowns.
2) RSI, and Oscillators — After a solid series of bad overbought signals in the bull market,
traders fi nally fi nd more oversold indicators appear ing. As the trading market continues,
oversold and overbought in dicators become equal in number. The fact that the numbers
even out indicates the complexion of the market is changing from uptrend to trading.
3) Stochastics — In the bull trend, the crossovers from overbought were more often than
not false signals and the crossovers from over sold, if they did happen, were valid buy
signals. Now, as the market fl at tens out, traders will fi nd the crossovers from either side
to be valid and can also initiate positions with profi tability.
4) On-Balance Volume and Tic Volume — This technique fails when you try to use it to
forecast imminent price breakdowns. These cumulative volume indicators would not begin
to signal distribution until price deterioration was well underway. The best signal that could
be emitted would be a fl attening of the price trend signal.
5) Elliott Wave — According to strict Elliott Wave tenets, this application does not exist per
se: A bull market turns to a bear market upon its completion. Elliott Wave would not
consider the existence of trading to bear market designation, but bull to bear immediately.
Yet, traders can observe that the two types of corrective markets alternate with each
other: if a previous correction was one of two types (fl at or zigzag) then the second of
the set will be the alternate type to the fi rst. In this way, traders can predict something
about the nature of this market phase.
Bear market changing to trading market tool kit application
1) Moving Averages — When the market changes to a trading market from a bear market
the moving averages will no longer lag as far behind the actual price or shorter moving
average as was the case in the preceding bear market. Traders can now expect a
fl attening out of the moving average curve to correspond with the fl attening of market
prices. If they continued to sell the breakdowns and defer from buying as before, they
would be continually whipsawed (instead, they should sell the breakouts and buy the
2) RSI, and Oscillators — In the bear down trend traders would have an overwhelming
number of oversold signals and a dearth of over bought signals. They could have adjusted
the overbought parameter to the downside to give themselves, in effect, “overbought”
signals to in itiate short positions on. At the changing point, the number of oversold and
overbought signals begins to equal each other in numbers. They could sell the overbought
and buy the oversold with confi dence at this point.
3) Stochastics — During the bear market, crossovers from the oversold side were less valid
as buy signals than crossovers from the overbought side were as sell signals. They will
now appear equally valid as the trading market appears.
4) On-Balance Volume and Tic Volume — The OBV curve and Tic Volume fl atten out after
the bottom price is made, thereby giving traders an after-the-fact confi rmation of the
end of the down move, but not a reli able anticipatory signal.
5) Elliott Wave — The ‘bear move down’ would have been an impulse wave down and the
trading market would have been a corrective wave to this. Once traders have determined
which of the three impulse waves (1,3, or 5 of an impulse 1-2-3-4-5, or even in a larger
dimension or c of an a-b-c correction) they were in the process of completing they would
have a better idea of what type of correction was beginning
Relative Strength Index (RSI)
The RSI is part of a class of indicators called momentum oscillators.
There are a number of indicators that fall in this category, the most common being Relative
Strength Index, Stochastic, Rate of Change, Williams %R. Although these indicators are all
calculated differently, there are a number of common elements to their use which shall be
discussed in the context of the RSI.
What is momentum?
Momentum is simply the rate of change – the speed or slope at which a stock or commodity
ascends or declines. Measuring speed is a useful gage of impending change. For example,
assume that you were riding in a friends’ car, not looking at what was happening ahead
but instead just at the speedometer. You can see when the car starts to slow down and if it
continues to do so you can reasonably assume it’s going to stop very shortly. You may not
know the reason for it coming to a stop…it could be the end of the journey, approaching and
intersection or because the road is a little rougher ahead. In this manner watching the speed
provides a guide for what may happen in the future.
An oscillator is an indicator that moves back and forth across a reference line or between
prescribed upper and lower limits. When an oscillator reaches a new high, it shows that an
uptrend is gaining speed and is likely to continue. When an oscillator traces a lower peak, it
means that the trend has stopped accelerating and a reversal can be expected from there,
much like a car slowing down to make a U-Turn.
In the same way watching a stock for impending momentum change can provide a glimpse of
what may happen in the future – momentum oscillators, such as RSI are referred to as trend
The chart below illustrates the typical construction of the RSI which oscillates between 0%
and 100%. You will notice there is a pair of horizontal reference lines: 70% ‘overbought’ and
30% ‘oversold’ lines. The overbought region refers to the case where the RSI oscillator has
moved into a region of signifi cant buying pressure relative to the recent past and is often an
indication that an upward trend is about to end. Similarly the oversold region refers to the
lower part of the momentum oscillator where there is a signifi cant amount of selling pressure
relative to the recent past and is indicative of an end to a down swing.
Nifty Chart with RSI
Application of RSI
RSI is a momentum oscillator generally used in sideways or ranging markets where the price
moves between support and resistance levels. It is one of the most useful technical tool
employed by many traders to measure the velocity of directional price movement.
Overbought and Oversold
The RSI is a price-following oscillator that ranges between 0 and 100. Generally, technical
analysts use 30% oversold and 70% overbought lines to generate the buy and sell signals.
• Go long when the indicator moves from below to above the oversold line.
• Go short when the indicator moves from above to below the overbought line.
Note here that the direction of crossing is important; the indicator needs to fi rst go past the
overbought/oversold lines and then cross back through them.
Silver Chart showing buy and sell points and also the failure in trending market
The other means of using RSI is to look at divergences between price peaks/troughs and
indicator peaks/ troughs.
If the price makes a new higher peak but the momentum does not make a corresponding
higher peak this indicates there is less power driving the new price high. Since there is less
power or support for the new higher price a reversal could be expected.
Similarly if the price makes a new lower trough but the momentum indicator does not make a
corresponding lower trough, then it can be surmised that the downward movement is running
out of strength and a reversal upward could soon be expected. This is illustrated in the
chart below. A bullish divergence represents upward price pressure and a bearish divergence
represents downward price pressure.
Wipro Chart showing Negative and Positive Divergence
• The fi rst divergence shows a new lower trough forming at point ‘A’ but the RSI oscillator
does not reach a new lower trough. This indicates the downward movement is exhausting
and an upward move is imminent.
• The second and third are a bearish divergence with a new sharply higher peak formed at
‘B’ but it is not supported by at least an equal high in the RSI, hence a downward move
Natural Gas Chart showing Strong Bullish Divergence
The Stochastic indicator was developed by George Lane. It compares where a security’s price
closes over a selected number of period. The most commonly 14 periods stochastic is used.
The Stochastic indicator is designated by “%K” which is just a mathematical representation
of a ratio.
%K=(today’s Close)-(Lowest low over a selected period)/(Highest over a selected period)- (Lowest low over a selected period)
For example, if today’s close is 50 and high and low over last 14 days is 40 and 55 respectively
%K= 50-40 / 55-40 = 0.666
Finally these values are multiplied by 100 to change decimal value into percentage for better
This 0.666 signifi es that today’s close was at 66.6% level relative to its trading range over
last 14 days.
A moving average of %K is then calculated which is designated by %D. The most commonly
3 period’s %D is used.
The stochastic indicator always moves between zero and hundred, hence it is also known as
stochastic oscillator. The value of stochastic oscillator near to zero signifi es that today’s close
is near to lowest price security traded over a selected period and similarly value of stochastic
oscillator near to hundred signifi es that today’s close is near to highest price security traded
over a selected period.
Interpretation of Stochastic Indicator
Most popularly stochastic indicator is used in three ways
a. To defi ne overbought and oversold zone- Generally stochastic oscillator reading above
80 is considered overbought and stochastic oscillator reading below 20 is considered oversold.
It basically suggests that
• One should book profi t in buy side positions and should avoid new buy side positions in
an overbought zone.
• One should book profi t in sell side positions and should avoid new sell side positions in
an oversold zone
This would be clearer from figure
Figure illustrates overbought and oversold zones for spot Nifty. It is clearly visible that in most
of the cases prices have corrected from overbought zone and similarly prices have rallied from
b. Buy when %K line crosses % D line(dotted line) to the upside in oversold zone and sell
when %K line crosses % D line(dotted line) to the downside in overbought zone-
This would be clearer from fi gure below
Figure illustrates buying signals being generated by %K upside crossover in an oversold zone
and selling signals being generated by %K downside crossover in an overbought zone on a
Nifty spot price chart.
c. Look for Divergences- Divergences are of two types i.e. positive and negative.
Positive Divergence-are formed when price makes new low, but stochastic oscillator fails to
make new low. This divergence suggests a reversal of trend from down to up. This would be
clearer from fi gure below.
Figure illustrates Nifty spot making new lows whereas stochastic oscillator fails to make new
low, fi nally Nifty trend reversed from down to up.
Negative Divergence-are formed when price makes new high, but stochastic oscillator fails
to make new high. This divergence suggests a reversal of trend from up to down. This would
be clearer from fi gure below.
Figure illustrates Nifty spot making new highs whereas stochastic oscillator fails to make new
high, fi nally Nifty trend reversed from up to down.
The William %R indicator was developed by Larry Williams. This is almost similar to stochastic
oscillator except for a negative scale. The William %R indicator always moves between zero
and minus hundred (-100)
Interpretation of William %R Indicator
Most popularly stochastic indicator is used in two ways
a. To defi ne overbought and oversold zone- Generally William % R reading between 0 and
-20 are considered overbought and William % R reading between -80 to -100 are considered
oversold. It basically suggests that
• One should book profi t in buy side positions and should avoid new buy side positions in
an overbought zone.
• One should book profi t in sell side positions and should avoid new sell side positions in
an oversold zone
This would be clearer from fi gure 138 below.
Figure illustrates overbought and oversold zones for spot Nifty. It is clearly visible that in most
of the cases prices have corrected from overbought zone and similarly prices have rallied from
b. Look for Divergences- Divergences are of two types i.e. positive and negative.
Positive Divergence-are formed when price makes new low, but William % R fails to make
new low. This divergence suggests a reversal of trend from down to up. This would be clearer
from fi gure below.
Figure illustrates Nifty spot making new lows whereas William % R fails to make new low,
fi nally Nifty trend reversed from down to up.
Negative Divergence-are formed when price makes new high, but William % R fails to make
new high. This divergence suggests a reversal of trend from up to down. This would be clearer
from fi gure below.
Figure illustrates Nifty spot making new highs whereas William % R fails to make new high,
fi nally Nifty trend reversed from up to down.
The RSI belong to a class of indicators called trend leading indicators. These are usually used
in ranging markets and are not suitable for trending markets. We have discussed the basic
concept of momentum, being a measure of speed of price movement. The RSI has oversold and
overbought lines or zones at a predefi ned level. For the RSI, oversold and overbought levels
are defi ned by lines that pass through the signifi cant peaks and troughs of the indicator.
There are two basic methods of using these oscillators in ranging markets; using the
overbought/oversold regions and divergence between the price and oscillator.
When the indicator fi rst moves into the overbought zone and then crosses back through
the overbought line this is a signal to go short. Similarly when the indicator moves into the
oversold region and then crosses back across the oversold line this is a signal to go long.
There are two main types of divergence, a strong and moderate divergence. A strong
divergence occurs when the price makes a new higher peak but the momentum indicator
makes a corresponding lower peak indicating a loss of momentum in the current up trend.
When this occurs it is a signal to go short. Lower price troughs and higher momentum troughs
indicate a bullish move and is a signal to go long.
Real-life Problems in use of RSI
• RSI in overbought levels does not always signify an overbought Market.
• RSI in oversold levels does not always signify an oversold Market.
• The RSI can remain in overbought / oversold zones for long periods of time.
• A bullish divergence may not always lead to a rally.
• A bearish divergence may not always lead to a decline.
In Bull Markets the level is 70 and 40.
Gold Chart in Uptrend showing RSI Oversold levels below 40
IN Bear Markets the level is 60 and 30.
Infosys in Downtrend showing Overbought level above 60
RSI moves into overbought and oversold zones
• Overbought and oversold levels cannot be used to buy and sell under all circumstances.
When the RSI goes above 70, we say that it is overbought. This leads to the erroneous
conclusion that we should be selling the security. IF the RSI goes below 30, we say
that it is oversold. This leads to the erroneous conclusion that we should be buying the
• We should consider the upper and lower boundaries of 70 and 30 as ‘extreme zones’.
When the RSI moves inside an extreme zone, we receive an alert that the security may
be ready for a buy or sell trade. But, the trade may or may not actually happen.
Low risk trades when RSI is in extreme zones
• The level of extreme zones changes in bull and bear markets. In general, in a bull market,
the extreme zones are located at 70 and 40. In a bear market, the extreme zones are
located at 60 and 30.
• A zone shift in an indication of a change in trend. When the RSI shifts zones, this is one
of the fi rst indications that a change in trend is taking place.
• In a bear market, the RSI moves up during periods of bear allies. It usually fi nds resistance
around 60. Now, in one such rally, the RSI crosses 60 and fi nds resistance around 70. A
zone shift has taken place. This is one of the fi rst signs that the market may be shifting
from a bearish to bullish environment.
In a bear market, look for these signs
• The RSI moves up during periods of bear rallies. It usually fi nds resistance around 60.
Now, in one such rally, the RSI crosses 60 and fi nds resistance around 70. A zone shift
has taken place. This is one of the fi rst signs that the market may be shifting from a
bearish to bullish environment.
• The RSI falls and fi nds support between 20 to 30. During a decline, the RSI falls but
fi nds support around 40. This may be a sign that the market is changing from bearish to
bullish. This is also an example of zone shift.
Shift from Bear to Bull
Reliance Chart showing Upward Shift in RSI
In a bull market, look for these signs
• The RSI moves down during periods of declines decline. It usually fi nds support around
40. Now, in one such decline, the RSI crosses 40 and fi nds support around 30. A zone
shift has taken place. This is one of the fi rst signs that the market may be shifting from
a bullish to bearish environment.
• The RSI rallies and fi nds resistance around 70. During a rally, the RSI rises but fi nds
resistance around 60. This may be a sign that the market is changing from bullish to
bearish. This is also an example of zone shift.
Shift from bull to bear
When a zone shift is detected, look for a signal to trade in the direction of the new trend. If
possible, step down to a lower time frame to take the trade.
If a zone shift from Up to Down is detected on a daily chart, move to a 60-minute chart. Sell
when the trend indicators on this 60 minute chart give a sell signal.
• Use the ADX to determine a strong trend. When the ADX is above 30 and rising, assume
that a strong trend is in place. The direction of the trend, up or down should be available
by simple chart examination. When the market is trending use the extreme levels to
identify trades only in the direction of the trend.
IF the market is in an up trend, then a dip to 40 should be considered as an opportunity to
buy. But a rally to 70 is NOT an opportunity to short sell.
Moving Average Convergence/Divergence (MACD)
MACD stands for Moving Average Convergence / Divergence. It is a technical analysis indicator
created by Gerald Appel in the late 1970s. The MACD indicator is basically a refi nement of the
two moving averages system and measures the distance between the two moving average
What is the MACD and how is it calculated?
The MACD does not completely fall into either the trend-leading indicator or trend following
indicator; it is in fact a hybrid with elements of both. The MACD comprises two lines, the
fast line and the slow or signal line. These are easy to identify as the slow line will be the
smoother of the two.
NIFTY chart below illustrates the basic MACD lines
The procedure for calculating the MACD lines is as follows:
Step1. Calculate a 12 period exponential moving average of the close price.
Step2. Calculate a 26 period exponential moving average of the close price.
Step3. Subtract the 26 period moving average from the 12 period moving average. This is
the fast MACD line.
Step4. Calculate a 9 period exponential moving average of the fast MACD line calculated
above. This is the slow or signal MACD line.
The importance of MACD lies in the fact that it takes into account the aspects of both momentum
and trend in one indicator. As a trend-following indicator, it will not be wrong for very long. The
use of moving averages ensures that the indicator will eventually follow the movements of
the underlying security. By using exponential moving averages, as opposed to simple moving
averages, some of the lag has been taken out. As a momentum indicator, MACD has the
ability to foreshadow moves in the underlying security. MACD divergences can be key factors
in predicting a trend change. A negative divergence signals that bullish momentum is going to
end and there could be a potential change in trend from bullish to bearish. This can serve as
an alert for traders to take some profi ts in long positions, or for aggressive traders to consider
initiating a short position.
MACD can be applied to daily, weekly or monthly charts. The MACD indicator is basically a
refi nement of the two moving averages system and measures the distance between the two
moving average. The standard setting for MACD is the difference between the 12 and 26-
period EMA. However, any combination of moving averages can be used. The set of moving
averages used in MACD can be tailored for each individual security. For weekly charts, a faster
set of moving averages may be appropriate. For volatile stocks, slower moving averages may
be needed to help smooth the data. No matter what the characteristics of the underlying
security, each individual can set MACD to suit his or her own trading style, objectives and risk
Use of MACD lines
MACD generates signals from three main sources:
• Moving average crossover
• Centerline crossover
Crossover of fast and slow lines
The MACD proves most effective in wide-swinging trading markets. We will fi rst consider the
use of the two MACD lines. The signals to go long or short are provided by a crossing of the
fast and slow lines. The basic MACD trading rules are as follows:
• Go long when the fast line crosses above the slow line.
• Go short when the fast line crosses below the slow line.
These signals are best when they occur some distance above or below the reference line. If
the lines remain near the reference line for an extended period as usually occurs in a sideways
market, then the signals should be ignored.
INFOSYS chart showing MACD crossovers
Center line crossover
A bullish centerline crossover occurs when MACD moves above the zero line and into positive
territory. This is a clear indication that momentum has changed from negative to positive or
from bearish to bullish. After a positive divergence and bullish moving average crossover, the
centerline crossover can act as a confi rmation signal. Of the three signals, moving average
crossover are probably the second most common signals.
A bearish centerline crossover occurs when MACD moves below zero and into negative
territory. This is a clear indication that momentum has changed from positive to negative or
from bullish to bearish. The centerline crossover can act as an independent signal, or confi rm
a prior signal such as a moving average crossover or negative divergence. Once MACD crosses
into negative territory, momentum, at least for the short term, has turned bearish.
Tata Steel Chart showing Centerline crossover
An indication that an end to the current trend may be near occurs when the MACD diverges
from the security. A positive divergence occurs when MACD begins to advance and the security
is still in a downtrend and makes a lower reaction low. MACD can either form as a series of
higher lows or a second low that is higher than the previous low. Positive divergences are
probably the least common of the three signals, but are usually the most reliable and lead to
the biggest moves.
A negative divergence forms when the security advances or moves sideways and MACD
declines. The negative divergence in MACD can take the form of either a lower high or a
straight decline. Negative divergences are probably the least common of the three signals,
but are usually the most reliable and can warn of an impending peak.
INFOSYS chart showing MACD Positive Divergence
NIFTY chart showing MACD Negative Divergence
• The MACD is a hybrid trend following and trend leading indicator.
• The MACD consists of two lines; a fast line and a slow ‘signal’ line
• A long position is indicated by a cross of the fast line from below to above the slow line.
• A short position is indicated by a cross of the fast line from above to below the slow
• MACD should be avoided in trading markets
• The MACD is useful for determining the presence of divergences with the price data.
Money Flow Index
Money fl ow index takes into account volume action and on the basis of volume action; it
attempts to measure the strength of money fl owing in and out the security which now a days
is also known as smart money fl ow indicator.
To understand calculation aspect of MFI, one should fi rst understand positive money fl ow
and negative money fl ow which is the basis of MFI. When day’s average price is greater than
previous day’s average price, it’s said to be positive money fl ow and similarly when day’s
average price is less than previous day’s average price; it’s said to be negative money fl ow.
Money fl ow for a specifi c day is calculated by multiplying the average price by the volume.
Positive money fl ow is calculated by summing the positive money fl ow over a specifi ed number
of periods. Negative money fl ow is calculated by summing the negative money fl ow over a
specifi ed number of periods.
When one divides positive money fl ow by negative money fl ow, one gets money ratio.
Finally MFI = 100-100/(1+money ratio)
Interpretation of MFI
Most popularly MFI indicator is used in two ways
a. To defi ne overbought and oversold zone- Generally MFI reading above 80 is considered
overbought and MFI reading below 20 is considered oversold. It basically suggests that
• One should book profi t in buy side positions and should avoid new buy side positions in
an overbought zone.
• One should book profi t in sell side positions and should avoid new sell side positions in
an oversold zone
This would be clearer from fi gure below.
Figure illustrates overbought and oversold zones for spot Nifty. It is clearly visible that in most
of the cases prices have corrected from overbought zone and similarly prices have rallied from
b. Look for Divergences- Divergences are of two types i.e. positive and negative.
Positive Divergence-are formed when price is making new lows, but MFI fails to break
previous lows. This divergence suggests a reversal of trend from down to up.
Figure illustrates Nifty making new lows, where as MFI fails to break previous lows.
Figure illustrates Nifty making new lows whereas MFI fails to make new low, fi nally Nifty trend
reversed from down to up.
Negative Divergence-are formed when price is making new highs, but MFI fails to make
new high. This divergence suggests a reversal of trend from up to down.
Figure below illustrates Nifty making new highs, where as MFI fails to make new high.
Figure illustrates Nifty making new highs whereas MFI fails to make new high, fi nally Nifty
Future trend reversed from up to down.
Bollinger bands are trading bands developed by John Bollinger.
It consists of a 20 period simple moving average with upper and lower bands. The upper band
is 2 standard deviation above the moving average and similarly lower band is 2 standard
deviation below the moving average. This makes these bands more dynamic and adaptive to
This would be clearer from fi gure below
Figure illustrates Bollinger band plotted on Nifty price chart.
Interpretation of Bollinger Bands
Mr. John Bollinger described following important interpretation of Bollinger bands in projecting
1. Big move in price is witnessed on either side when bands tightens/contracts as volatility
2. The upper band act as area of resistance and lower band act as area of support.
3. When prices move outside the band, it signifi es breakout, hence continuation of the
4. Bottoms and tops made outside the band, followed by tops and bottoms made inside the
band suggests reversal of the trend.
Moving averages are used to determine the direction of trend and are basis of many trendfollowing
systems. Moving averages smooth out a data series and make it easier to identify
the direction of the trend. Instead of predicting a change in trend, moving averages follow
behind the current trend because past price data is used to form moving averages, they are
considered lagging or trend following. Therefore, you can use moving averages for trend
identifi cation and trend following purposes, not for prediction.
When to use?
Because moving average is a trend following indicator, you should use it when a security is
trending. Application of moving averages would be ineffective when a security moves in a
trading range. With this in mind, investors and traders should fi rst identify securities that
display some trending characteristics before attempting to analyze with moving averages.
With a simple visual assessment of the price chart you can determine if a security exhibits
characteristics of trend.
Using price chart you can analyse whether a stock is trending up, trending down or trading
in a range. When a security forms a series of higher highs and higher lows it is said to be in
uptrend. A downtrend is established when a security forms a series of lower lows and lower
highs. A trading range is established if a security cannot establish an uptrend or downtrend. If
a security is in a trading range, an uptrend is started when the upper boundary of the range
is broken and a downtrend begins when the lower boundary is broken.
It is sometimes diffi cult to determine when a trend will stop and a trading range will begin or
when a trading range will stop and a trend will begin. The basic rules for trends and trading
ranges laid out above can be applied.
Moving average settings
Once the security exhibiting the above characteristics is selected the next task is to select the
number of moving average periods and type of moving average. The number of periods in
a moving average will depend upon the security’s volatility, trend and personal preferences.
Shorter length moving averages are more sensitive and identify new trends earlier, but also
give more false alarms. Longer moving averages are more reliable but less responsive, only
picking up the big trends. There is no predetermined or fi xed length of moving averages, but
some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30
and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day
moving average, while longer-term investors may look for evidence of 3-4 month trends with
a 40-week moving average. You should examine how the moving average fi ts with the price
data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If
the moving average is slow to react, shorten the moving average to increase its sensitivity. In
addition, you may want to try using both simple and exponential moving averages. Exponential
moving averages are usually best for short-term situations that require a responsive moving
average. Simple moving averages work well for longer-term situations that do not require a
lot of sensitivity.
Uses of moving averages
There are many uses for moving averages, but three basic uses stand out:
• Trend identifi cation/confi rmation
• Support and resistance level identifi cation/confi rmation
• Trading systems
Trend identifi cation/ Confirmation
Moving averages are helpful in keeping you in line with the price trend by providing buy
signals shortly after the market bottoms out and sell signals shortly after it tops, rather than
trying to catch the exact bottom or top.
There are three ways to identify the trend with moving averages: direction, location and
The fi rst trend identifi cation technique uses the direction of the moving average to determine
the trend. The trend is considered up when moving average is continuously rising. If the
moving average is declining, the trend is considered down. The direction of a moving average
can be determined simply by looking at a plot of the moving average or by applying an
indicator to the moving average. In either case, we would not want to act on every subtle
change, but rather look at general directional movement and changes.
The second technique for trend identifi cation is price location. The basic trend can be determined
through location of the price relative to the moving average. If the price is located below the
moving average then there is a downward trend in place and visa versa for the price being
located above the moving average.
The third technique for trend identifi cation is the location of the shorter moving average
relative to the longer moving average. The trend will go up is going up if the shorter moving
average is above the longer moving average. If the shorter moving average is below the
longer moving average, the trend is considered down.
Moving averages - key points
The Moving Average (MA) is the simplest and most widely used technical analysis tool. The
MA attempts to tone down the fl uctuations of market prices to a smoothed trend, so that
distortions are reduced to a minimum. MAs help in tracking trends and signaling reversals.
The most important merit of moving average system is that you will always be on “right” side
of the market.
Signals to buy or sell are generated when the price crosses the MA or when one MA crosses
another, in the case of multiple MAs. Buy when prices move above the moving average line on
the chart and sell when prices drop below the moving average line
Another method used by technical analysts is using the two moving averages on the same
chart with different time periods. Since the MA is a lagging indicator, a crossover will usually
signal a trend reversal well after a new trend has begun and is used largely for confi rmation.
Generally speaking, the longer the time span covered by an MA, the greater the signifi cance
of a crossover signal. For example, the crossover of a 100 or 200-day MA is signifi cantly more
important then the crossover of a 20-day MA.
Moving averages differ according to the weight assigned to the most recent data. Simple
moving averages apply equal weight to all prices. More weight is applied to recent prices
in the case of exponential and weighted averages. Variable moving averages change the
weighting based on the volatility of prices.
When prices fl uctuate up and down in a broad sideways pattern for an extended period
(trading-range market), longer term MAs are slow to react to reversals in trend, and when
prices move sideways in a narrow range shorter term MAs often produce false signals. Flat
and confl icting MAs generally indicate a trading-range market and one to avoid, unless there
is pronounced rounding that suggests a possible new trend.
A variable moving average is an exponential moving average that automatically adjusts
the smoothing percentage based on the volatility of the data series. Such moving average
compensates for trading-range versus trending markets. This MA automatically adjusts the
smoothing constant to adjust its sensitivity, often allowing it to outperform the other moving
averages in these diffi cult markets.
Because of the potential for false signals MAs should always be used in conjunction with
the other indicators. For example Bollinger bands adjust in distance from a moving average
based on volatility, using standard deviation above and below the moving average rather than
Indicators which are especially well-suited for being used with moving averages include MACD,
Price ROC, Momentum, and Stochastic. A moving average of another moving average is also
Signals - moving average price crossover
A price break upwards through an MA is generally a buy signal, and a price break downwards
through an MA is generally a sell signal. As we have seen, the longer the time span or period
covered by an MA, the greater the signifi cance of a crossover signal.
If the MA is fl at or has already changed direction, its violation is fairly conclusive proof that
the previous trend has reversed.
False signals can be avoided by using a fi ltering mechanism. Many traders, for example,
recommend waiting for one period - that is one day for daily data and one week for weekly
Whenever possible try to use a combination of signals. MA crossovers that take place at the
same time as trend line violations or price pattern signals often provide strong confirmation.
Signals - multiple moving averages
It is usually advantageous to employ more than one moving average. Double and triple MAs
often provide useful signals.
With two MAs the double crossover is used. When the short term moving average crosses
the long term moving average to the downside, then a sell signal would be triggered and visa
versa. For example, two popular combinations are the 5 and 20-day averages and the 20 and
100-day averages. The technique of using two averages together lags the market a bit more
than a single moving average but produces fewer whipsaws.
Many investors use the triple moving average crossover system to buy and sell stock. The
most widely used triple crossover system is the popular 4-9-18-day MA combination. A buy
signal is generated when the shortest (and most sensitive) average - the 4 day - crosses fi rst
the 9-day and then the 18-day averages, each crossover confi rming the change in trend.
• The 200-day MA (or 40-week MA), should be carefully watched as a pivotal level of
support or resistance for the long-term trend. Many people watch carefully when the
200-day MA is approached by the price. The relationship between the price and its 200-
day MA can often provide excellent buy or sell signals.
• The 200-day MA is also particularly signifi cant for the various indexes, such as the Nifty,
Sensex or NASDAQ. A crossover of this MA has often signaled a correction or period of
• Moving averages can also be calculated and plotted for other indicators, not just the
price. A continued upward movement by the indicator is signifi ed by the indicator rising
above its moving average. A continued downward movement is signifi ed by the indicator
falling below its moving average.
What Does a Technical indicator offer?
Technical analysts use indicators to look into a different perspective from which stock prices
can be analyzed. Technical indicators provide unique outlook on the strength and direction of
the underlying price action for a given timeframe.
Why use indicators?
Technical Indicators broadly serve three functions: to alert, to confi rm and to predict. Indicator
acts as an alert to study price action, sometimes it also gives a signal to watch for a break of
support. A large positive divergence can act as an alert to watch for a resistance breakout.
Indicators can be used to confi rm other technical analysis tools. Some investors and traders
use indicators to predict the direction of future prices.
Tips for using indicators
There are a large number of Technical Indicators that can be used to assist you in selection
of stocks and in tracking the right entry and exit points. In short, indicators indicate. But it
doesn’t mean that traders should ignore the price action of a stock and focus solely on the
indicator. Indicators just fi lter price action with formulas. As such, they are derivatives and
not direct refl ections of the price action. While applying the indicators, the analyst should
consider: What is the indicator saying about the price action of a security? Is the price action
getting stronger? Is it getting weaker?
The buy and sell signals generated by the indicators, should be read in context with other
technical analysis tools like candlesticks, trends, patterns etc. For example, an indicator may
fl ash a buy signal, but if the chart pattern shows a descending triangle with a series of
declining peaks, it may be a false signal.
An indicator should be selected with due care and attention. It would be a futile exercise to
cover more than fi ve indicators. It is best to focus on two or three indicators and learn their
intricacies inside and out. One should always choose indicators that complement each other,
instead of those that move in unison and generate the same signals. For example, it would
be redundant to use two indicators that are good for showing overbought and oversold levels,
such as Stochastic and RSI. Both of these indicators measure momentum and both have
Types of indicators
Indicators can broadly be divided into two types “LEADING” and “LAGGING”.
Leading indicators are designed to lead price movements. Benefi ts of leading indicators are
early signaling for entry and exit, generating more signals and allow more opportunities to
trade. They represent a form of price momentum over a fi xed look-back period, which is
the number of periods used to calculate the indicator. Some of the wellmore popular leading
indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index
(RSI), Stochastic Oscillator and Williams %R.
Lagging Indicators are the indicators that would follow a trend rather then predicting a
reversal. A lagging indicator follows an event. These indicators work well when prices move
in relatively long trends. They don’t warn you of upcoming changes in prices, they simply tell
you what prices are doing (i.e., rising or falling) so that you can invest accordingly. These
trend following indicators makes you buy and sell late and, in exchange for missing the early
opportunities, they greatly reduce your risk by keeping you on the right side of the market.
Moving averages and the MACD are examples of trend following, or “lagging,” indicators.
One of the most common and familiar trend-following indicators is the moving averages. They
smooth a data series and make it easier to spot trends, something that is especially helpful in
volatile markets. They also form the building blocks for many other technical indicators and
The two most popular types of moving averages are the Simple Moving Average (SMA) and
the Exponential Moving Average (EMA). They are described in more detail below.
Simple moving average (SMA)
A simple moving average is formed by computing the average (mean) price of a security
over a specifi ed number of periods. It places equal value on every price for the time span
selected. While it is possible to create moving averages from the Open, the High, and the
Low data points, most moving averages are created using the closing price. For example: a
5-day simple moving average is calculated by adding the closing prices for the last 5 days and
dividing the total by 5.
The calculation is repeated for each price bar on the chart. The averages are then joined to
form a smooth curving line - the moving average line. Continuing our example, if the next
closing price in the average is 15, then this new period would be added and the oldest day,
which is 10, would be dropped.
The new 5-day simple moving average would be calculated as follows:
Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will
be subtracted and the moving average will continue to move over time.
Exponential moving average (EMA)
Exponential moving average also called as exponentially weighted moving average is calculated
by applying more weight to recent prices relative to older prices. In order to reduce the lag in
simple moving averages, technicians often use exponential moving averages. The weighting
applied to the most recent price depends on the specifi ed period of the moving average. The
shorter the EMA’s period, weight is applied to the most recent price. For example: a 10-period
exponential moving average weighs the most recent price 18.18% while a 20-period EMA
weighs the most recent price 9.52%. As we’ll see, the calculating and EMA is much harder
than calculating an SMA. The important thing to remember is that the exponential moving
average puts more weight on recent prices. As such, it will react quicker to recent price
changes than a simple moving average. Here’s the calculation formula.
Exponential moving average calculation
Exponential Moving Averages can be specifi ed in two ways - as a percent-based EMA or as
a period-based EMA. A percent-based EMA has a percentage as its single parameter while a
period-based EMA has a parameter that represents the duration of the EMA. The formula for
an exponential moving average is:
EMA (current) = ((Price (current) - EMA (prev)) x (Multiplier) + EMA (prev)
For a percentage-based EMA, “Multiplier” is equal to the EMA’s specifi ed percentage. For a
period-based EMA, “Multiplier” is equal to 2 / (1 + N) where N is the specifi ed number of
For example, a 10-period EMA’s Multiplier is calculated like this:
This means that a 10-period EMA is equivalent to an 18.18% EMA.
The 10-period simple moving average is used for the fi rst calculation only. After that the
previous period’s EMA is used.
Note that, in exponential moving average, every previous closing price in the data set is used
in the calculation. The impact of the older data never disappears though it diminishes over a
period of time. This is true regardless of the EMA’s specifi ed period. The effects of older data
diminish rapidly for shorter EMA’s than for longer ones but, again, they never completely
Simple versus exponential
Generally you will fi nd very little difference between an exponential moving average and a
simple moving average. Consider this example which uses only 21 trading days, the difference
is minimal but a difference nonetheless. The exponential moving average is consistently closer
to the actual price. On average, the EMA is 3/8 of a point closer to the actual price than the
Which is better?
A question about moving averages that seems to weigh heavily on traders’ minds is whether
to use the “simple” or “exponential” moving average. Regardless of the type you choose, the
basic principle is that if there is more buying pressure than selling pressure, prices will move
above the average and the market will be in an uptrend. On the other hand heavy selling
pressure will make the prices drop below the moving average, indicating a downtrend.
The choice of moving average depends on various factors like your trading frequency, investing
style and the stock which has been traded by you. The simple moving average obviously has a
lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer
to use exponential moving averages for shorter time periods to capture changes quicker.
Some investors prefer simple moving averages over long time periods to identify long-term
trend changes. In addition, much will depend on the individual security in question. A 50-
day SMA might work great for identifying support levels in INFOSYS but a 100-day EMA may
work better for the ACC. Moving average type and length of time will depend greatly on the
individual security and how it has reacted in the past.
The dilemma of an investor whether to select exponential moving average or simple moving
average can be solved only by obtaining an optimum trade off between sensitivity and reliability.
The more sensitive an indicator is the more signals that will be given. Although these signals
may prove timely, but they are highly sensitive and may generate false signals. The less
sensitive an indicator is the fewer signals that will be given by it. However, less sensitivity
leads to fewer and more reliable signals. Sometimes these signals can be late as well.
Shorter moving averages are very sensitive and generate more signals. The EMA, which is
generally more sensitive than the SMA, will also be likely to generate more signals. But along
with it numbers of false signals are also high. Longer moving averages will move slower and
generate fewer signals. These signals will likely prove more reliable, but they also may come
late. Thus it requires every investor to experiment on different moving averages –lengths and
their types to examine the trade-off between sensitivity and signal reliability.
A gap is an area on a price chart in which there were no trades. Normally this occurs after the
close of the market on one day and the next day’s open. Lot’s of things can cause this, such
as an earnings report coming out after the stock market had closed for the day. If the earnings
were signifi cantly higher than expected, this could result in the price opening higher than the
previous day’s close. If the trading that day continues to trade above that point, a gap will
exist in the price chart. Gaps can offer evidence that something important has happened to
the fundamentals or the psychology of the crowd that accompanies this market movement.
Gaps appear more frequently on daily charts, where every day is an opportunity to create an
opening gap. Gaps can be subdivided into four basic categories:
• Common gap
• Breakaway gap
• Runaway/ Continuation gap
• Exhaustion gap
Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful.
This gap occurs characteristically in nervous markets and is generally closed within few days.
In fact, they can be caused by a stock going ex-dividend when the trading volume is low.
Getting closed means that the price action at a later time (few days to a few weeks) usually
retraces to at the least the last day before the gap. This is also known as fi lling the gap.
A common gap usually appears in a trading range or congestion area and reinforces the
apparent lack of interest in the stock at that time. Many times this is further exacerbated by
low trading volume. Being aware of these types of gaps is good, but doubtful that they will
produce trading opportunities.
Breakaway gaps are the exciting ones. They occur when the price action is breaking out of
their trading range or congestion area. To understand gaps, one has to understand the nature
of congestion areas in the market. A congestion area is just a price range in which the market
has traded for some period of time, usually a few weeks or so. The area near the top of the
congestion area is usually resistance when approached from below. Likewise, the area near
the bottom of the congestion area is support when approached from above. To break out of
these areas requires market enthusiasm and either many more buyers than sellers for upside
breakouts or more sellers than buyers for downside breakouts.
Volume will (should) pick up signifi cantly, for not only the increased enthusiasm, but many
are holding positions on the wrong side of the breakout and need to cover or sell them. It is
better if the volume does not happen until the gap occurs. This means that the new change
in market direction has a chance of continuing. The point of breakout now becomes the new
support (if an upside breakout) or resistance (if a downside breakout). Don’t fall into the trap
of thinking this type of gap, if associated with good volume, will be fi lled soon. It might take a
long time. Go with the fact that a new trend in the direction of the stock has taken place and
A good confi rmation for trading gaps is if they are associated with classic chart patterns. For
example, if an ascending triangle all of a sudden has a breakout gap to the upside, this can be
a much better trade than a breakaway gap without a good chart pattern associated with it.
Runaway gaps are also called measuring gaps and are best described as gaps that are caused
by increased interest in the stock. For runaway gaps to the upside, it usually represents
traders who did not get in during the initial move of the up trend and while waiting for a
retracement in price, decided it was not going to happen. Increased buying interest happens
all of a sudden and the price gaps above the previous day’s close. This type of runaway gap
represents an almost panic state in traders. Also, a good uptrend can have runaway gaps
caused by signifi cant news events that cause new interest in the stock.
Runaway gaps can also happen in down trends. This usually represents increased liquidation
of that stock by traders and buyers who are standing on the sidelines. These can become
very serious as those who are holding onto the stock will eventually panic and sell, but sell to
whom? The price has to continue to drop and gap down to fi nd buyers. Not a good situation.
The futures market at times will have runaway gaps that are caused by trading limits imposed
by the exchanges. Getting caught on the wrong side of the trend when you have these limit
moves in futures can be horrifying. The good news is that you can also be on the right side
of them. These are not common occurrences in the futures market despite all the wrong
information being touted by those who do not understand it and are only repeating something
they read from an uninformed reporter.
Exhaustion gaps are those that happen near the end of a good up or down trend. They are
many times the fi rst signal of the end of that move. They are identifi ed by high volume and
large price difference between the previous day’s close and the new opening price. They can
easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.
It is almost a state of panic if during a long down move pessimism has set in. Selling all
positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly
fi lled as prices reverse their trend. Likewise if they happen during a bull move, some bullish
euphoria overcomes trades and they cannot get enough of that stock. The prices gap up with
huge volume, then there is great profi t taking and the demand for the stock totally dries up.
Prices drop and a signifi cant change in trend occurs.
Exhaustion gaps are probably the easiest to trade and profi t from. In the chart, notice that
there was one more day of trading to the upside before the stock plunged. The high volume
was the giveaway that this was going to be either an exhaustion gap or a runaway gap.
Because of the size of the gap and an almost doubling of volume, an exhaustion gap was in
the making here.
Island clusters are identifi ed by an exhaustion gap followed by a breakaway gap in opposite
direction. They are powerful reversal signals
There is an old saying that the market abhors a vacuum and all gaps will eventually be fi lled.
While this may have some merit for common and exhaustion gaps, holding positions waiting
for breakout or runaway gaps to be fi lled can be devastating to your portfolio. Likewise if
waiting to get on board a trend by waiting for prices to fi ll a gap just might mean you never
participate in the move. Gaps are a signifi cant technical development in price action and in
chart analysis, and should not be ignored. Japanese candlestick analysis is fi lled with patterns
that rely on gaps to fulfi ll their objectives.
Double tops and bottoms
These are considered to be among the most familiar of all chart patterns and often signal
turning points, or reversals. The double top resembles the letter “M”. Conversely, the double
bottom resembles a “W” formation; in reverse of the double top.
It is a term used in technical analysis to describe the rise of a stock, a drop and another rise
roughly of the same level as the previous top and fi nally followed by another drop.
A double top is a reversal pattern which occurs following an extended uptrend. This name
is given to the pair of peaks which is formed when price is unable to reach a new high. It is
desirable to sell when the price breaks below the reaction low that is formed between the two
Context: The double top must be followed by an extended price rise or uptrend. The two
peaks formed need not be equal in price, but should be same in the area with a minor reaction
low between them. This is a reliable indicator of a potential reversal to the downside.
Appearance: Price moves higher and forms a new high. This is followed by a downside
retracement, which forms a reaction low before one fi nal low-volume assault is made on the
area of the recent high. In some cases the previous high is never reached, and sometimes it
is briefl y but does not hold. This pattern is said to be complete once price makes the second
peak and then penetrates the lowest point between the highs, called the reaction low. The
sell indication from this topping pattern occurs when price breaks the reaction low to the
Breakout expectation: When the reaction low is penetrated to the downside, accompanied by
expanding volume the double top pattern becomes offi cial. Downside price target is calculated
by subtracting the distance from the reaction low to the peak from the reaction low. Often
times a double top will mark a lasting top and lead to a signifi cant decline which exceeds the
price target to the downside.
Although there can be variations but if the trend is from bullish to bearish, the classic double
top will mark at least an intermediate change, if not long-term change. Many potential double
tops can form along the way up, but until key support is broken, a reversal cannot be confi rmed.
Let’s look at the key points in the formation.
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In
the case of the double top, a signifi cant uptrend of several months should be in place.
2. First peak: The fi rst peak marks the highest point of the current trend.
3. Trough: Once the fi rst peak is reached, a decline takes place that typically ranges from
10-20%. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid
4. Second peak: The advance off the lows usually occurs with low volume and meets
resistance from the previous high. Resistance from the previous high should be expected and
after the resistance is met, only the possibility of a double top exists. The pattern still needs
to be confi rmed. The time period between peaks can vary from a few weeks to many months,
with the norm being 1-3 months. While exact peaks are preferable, there is some leeway.
Usually a peak within 3% of the previous high is adequate.
5. Decline from peak: Decline in the second peak is witnessed by an expanding volume
and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that
the forces of supply are stronger than the forces of demand and a support test is imminent.
6. Support break: The double top and trend reversal are not complete even when the
trading till the support is done. The double top pattern is said to be complete when the support
breaks from the lowest point between the peaks. This too should occur with an increase in
volume and/or an accelerated descent.
7. Support turned resistance: Broken support becomes potential resistance and there is
sometimes a test of this newfound resistance level with a reaction rally
8. Price target: Price target is calculated by subtracting the distance from the support
break to peak from the support break. The larger the potential decline the bigger will be the
ALEMBIC LTD Chart Showing Double Top
BHEL Chart showing Double Top
• This stock formed a double top after a big price advance. But it fails to breach the
resistance and results in price falls.
Points to be kept in mind:
• Technicians should take proper steps to avoid deceptive double tops. The peaks should
be separated by a time period of at least a month. If the peaks are too close, they could
just represent normal resistance rather than a lasting change in the supply/demand
picture. Ensure that the low between the peaks declines at least 10%. Declines less than
10% may not be indicative of a signifi cant increase in selling pressure. After the decline,
analyze the trough for clues on the strength of demand. If the trough drags on a bit
and has trouble moving back up, demand could be drying up. When the security does
advance, look for a contraction in volume as a further indication of weakening demand.
• The most important aspect of a double top is to avoid jumping the gun. The support should
be broken in a convincing manner and with an expansion of volume. A price or time fi lter
can be applied to differentiate between valid and false support breaks. A price fi lter might
require a 3% support break before validation. A time fi lter might require the support break
to hold for 3 days before considering it valid. The trend is in force until proven otherwise.
This applies to the double top as well. Until support is broken in a convincing manner, the
trend remains up.
Double bottom is a charting technique used in technical analysis. It is used to describe a drop
in the value of a stock (index), bounces back and then another drop to the similar level as the
previous low and fi nally rebounds again. A double bottom is a reversal pattern which occurs
following an extended downtrend. The buy signal is when price breaks above the reaction high
which is formed between the two lows.
Context: The double bottom must be followed by an extended decline in prices. The two lows
formed have to be equal in areas with a minor reaction high between them, though they need
not to be equal in price. This is a reliable indicator of a potential reversal to the upside.
Appearance: Price reduces further to form a new low. This is followed by upside retracement or
minor bounce, which forms a reaction high before one fi nal low-volume downward push is made
to the area of the recent low. In some cases the previous low is never reached, while in others it is
briefl y penetrated to the downside, but price does not remain below it. This pattern is considered
complete once price makes the second low and then penetrates the highest point between the
lows, called the reaction high. The buy indication from this bottom pattern occurs when price
breaks the reaction high to the upside.
Breakout expectation: A double bottom pattern becomes offi cial when the reaction high is
penetrated to the upside, ideally accompanied by expanding volume. Upside price target is
calculated adding the distance from the reaction high to the low to that of reaction high. Often
times a double bottom will mark a lasting low and lead to a signifi cant price advance which
exceeds the price target to the upside.
There can be many variations that can occur in the double bottom, but the classic double
bottom usually marks an intermediate or a long-term change in trend. Many potential double
bottoms can be formed along the way down, but a reversal cannot be confi rmed until key
resistance is broken. The key points in the formation are as follows:
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In
the case of the double bottom, a signifi cant downtrend of several months should be in place.
2. First trough: It marks the lowest point of the current trend. Though it is fairly normal
in appearance and the downtrend remains fi rmly in place.
3. Peak: After the fi rst trough is reached, an advance ranging from 10-20% usually takes
place. An increase in the volume from the fi rst trough signals an early accumulation. The
peaks high is sometimes rounded or drawn out a bit because of the hesitation in going back.
This hesitation is an indication of an increase in demand, but this increase is not strong
enough for a breakout.
4. Second trough: The decline off the reaction high usually occurs with low volume and
meets support from the previous low. Support from the previous low should be expected.
Even after establishing support, only the possibility of a double bottom exists, it still needs to
be confi rmed. The time period between troughs can vary from a few weeks to many months,
with the norm being 1-3 months. While exact troughs are preferable, there is some room to
maneuver and usually a trough within 3% of the previous is considered valid.
5. Advance from trough: Volume gains more importance in the double bottom than in the
double top. The advance of the second trough should be clearly evidenced by the increasing
volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also
indicates a potential change in sentiment.
6. Resistance break: The double top and trend reversal are considered incomplete, even
after they trade up to resistance. Breaking resistance from the highest point between the
troughs completes the double bottom. This too should occur with an increase in volume and/
or an accelerated ascent.
7. Resistance turned support: Broken resistance becomes potential support and there is
sometimes a test of this newfound support level with the fi rst correction. Such a test can offer
a second chance to close a short position or initiate a long.
8. Price target: Target is estimated by adding the distance from the resistance breakout
to trough lows on top of the resistance break. This would imply that the bigger the formation
is, the larger the potential advance.
Crude oil chart showing Double Bottom
Points to be kept In Mind
• The double bottom is an intermediate to long-term reversal pattern that will not form in
a few days. Though it can be formed in a time span of few weeks, but it is preferable to
have at least a time of 4 weeks between the two lows. Bottoms usually take more time
than the top. This pattern should be given proper time to develop.
• The advance off of the fi rst trough should be 10-20%. The second trough should
form a low within 3% of the previous low and volume on the ensuing advance should
increase. Signs of buying pressure can be checked by the volume indicators such
as Chaikin Money Flow, OBV and Accumulation/Distribution. The formation is not
complete until the previous reaction high is taken out.
Rounded top and bottom
Another shape which a top and bottom can take is one in which the reversal is “rounded”. The
rounded bottom formation forms when the market gradually yet steadily shifts from a bearish
to bullish outlook while in the case of a rounded top, from bullish to bearish. The Rounded
Top formation consists of a gradual change in trend from up to down. The Rounded Bottom
formation consists of a gradual change in trend from down to up. This formation is the exact
opposite of a Rounded Top Formation. The prices take on a bowl shaped pattern as the market
slowly and casually changes from an upward to a downward trend
OMAXE Chart showing Rounded Top
It is very (remove) considered very diffi cult to separate a rounded bottom, where the price
continues to decrease from a consolidation pattern and where price stays at a level, but the
clue, as always, is in volume. In a true Rounded Bottom, the volume decreases as the
price decreases, this signifi es a decrease in the selling pressure. A very little trading activity
can be seen when the price movement becomes neutral and goes sideways and the volumes
are also low. Then, as prices start to increase, the volume increases.
Head and Shoulders
The head and shoulders pattern can be either head and shoulders, top or head and shoulders
bottom. The Charts are a picture of a head and shoulders movement, which portrays three
successive rallies and reactions with the second one making the highest/lowest point.
Head and Shoulders (Top reversal)
A Head and Shoulders (Top) is a reversal pattern which occurs following an extended uptrend
forms and its completion marks a trend reversal. The pattern contains three successive peaks
with the middle peak (head) being the highest and the two outside peaks (shoulders) being
low and roughly equal. The reaction lows of each peak can be connected to form support, or
As its name implies, the head and shoulders reversal pattern is made up of a left shoulder,
head, right shoulder, and neckline. Other parts playing a role in the pattern are volume, the
breakout, price target and support turned resistance. Lets look at each part individually, and
then put them together with some example
1. Prior trend: It is important to establish the existence of a prior uptrend for this to be a
reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders
reversal pattern, or any reversal pattern for that matter.
2. Left shoulder: While in an uptrend, the left shoulder forms a peak that marks the high
point of the current trend. It is formed usually at the end of an extensive advance during
which volume is quite heavy. At the end of the left shoulder there is usually a dip or recession
which typically occurs on low volume.
3. Head: From the low of the left shoulder, an advance begins that exceeds the previous
high and marks the top of the head. At this point, in order conform to proper form, prices
must come down somewhere near the low of the left shoulder –somewhat lower perhaps or
somewhat higher but in any case, below the top of the left shoulder.
4. Right shoulder: The right shoulder is formed when the low of the head advances again.
The peak of the right shoulder is almost equal in height to that of the left shoulder but lower
than the head. While symmetry is preferred, sometimes the shoulders can be out of whack.
The decline from the peak of the right shoulder should break the neckline.
5. Neckline: A neckline can be drawn across the bottoms of the left shoulder, the head and
the right shoulder. A breaking of this neckline on a decline from the right shoulder is the fi nal
confi rmation and completes the head and shoulder formation.
6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in
confi rmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply
by analyzing volume levels. Ideally, but not always, volume during the advance of the left
shoulder should be higher than during the advance of the head. These decreases in volume
along with new highs that form the head serve as a warning sign. The next warning sign
comes when volume increases on the decline from the peak of the head. Final confi rmation
comes when volume further increases during the decline of the right shoulder.
7. Neckline break: The head and shoulders pattern is said to be complete only when the
neckline support is broken. Ideally, this should also occur in a convincing manner with an
expansion in volume.
8. Support turned resistance: Once support is broken, it is common for this same support
level to turn into resistance. Sometimes, but certainly not always, the price will return to the
support break, and offer a second chance to sell.
9. Price target: After breaking neckline support, the projected price decline is found by
measuring the distance from the neckline to the top of the head. Price target is calculated by
subtracting the above distance from the neckline. Any price target should serve as a rough
guide, and other factors such as previous support levels should be considered as well.
ABHISHEK IND chart showing the Head and Shoulders pattern
Potato futures (MCX) showing H&S Pattern
Signals generated by head and shoulder pattern
• The support line is based on points B and C.
• The resistance line. After giving in at point D, the market may retest the neckline at
• The price direction. If the neckline holds the buying pressure at point E, then the formation
provides information regarding the price direction: diametrically opposed to the direction
of the head-and-shoulders (bearish).
• The price target D to F. This is provided by the confi rmation of the formation (by breaking
through the neckline under heavy trading volume). This is equal to the range from top of
the head to neckline.
Some important points to remember
• The head and shoulders pattern is one of the most common reversal formations. It
occurs after an uptrend and usually marks a major trend reversal when complete.
• It is preferable that the left and right shoulders be symmetrical, it is not an absolute
requirement. They can be different widths as well as different heights.
• Volume support and neckline support identifi cation are considered to be the most critical
factors. The support break indicates a new willingness to sell at lower prices. There is an
increase in supply combined with lower prices and increasing volume .The combination
can be lethal, and sometimes, there is no second chance return to the support break.
• Measuring the expected length of the decline after the breakout can be helpful, but it
is not always necessary target. As the pattern unfolds over time, other aspects of the
technical picture are likely to take precedence.
Inverted head and shoulders
The head and shoulders bottom is the inverse of the H&S Top. In the chart below, after a
period, the downward trend reaches a climax, which is followed by a rally that tends to carry
the share back approximately to the neckline. After a decline below the previous low followed
by a rally, the head is formed. This is followed by the third decline which fails to reach the
previous low. The advance from this point continues across the neckline and constitutes the
The main difference between this and the Head and Shoulders Top is in the volume pattern
associated with the share price movements.
The volume should increase with the increase in the price from the bottom of the head and
then it should start increasing even more on the rally which is followed by the right shoulder.
If the neckline is broken but volume is low, you should be skeptical about the validity of the
As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its
completion marks a change in trend. The pattern contains three troughs in successive manner
with the two outside troughs namely the right and the shoulder being lower in height than the
middle trough (head) which is the deepest. Ideally, the two shoulders i.e. the right and the left
shoulder should be equal in height and width. The reaction highs in the middle of the pattern
can be connected to form resistance, or a neckline.
Head and shoulders bottom
The price action remains roughly the same for both the head and shoulders top and bottom, but
in a reversed manner. The biggest difference between the two is played by the volume. While
an increase in volume on the neckline breakout for a head and shoulders top is welcomed, it
is absolutely required for a bottom. Lets look at each part of the pattern individually, keeping
volume in mind:
1. Prior trend: For this to be a reversal pattern it is important to establish the existence
of a prior downtrend for this to be a reversal pattern. There cannot be a head and shoulders
bottom formation, without a prior downtrend to reverse.
2. Left shoulder: It is formed after an extensive increase in price, usually supported by high
volume. While in a downtrend, the left shoulder forms a trough that marks a new reaction low
in the current trend. After forming this trough, an advance ensues to complete the formation
of the left shoulder. The high of the decline usually remains below any longer trend line, thus
keeping the downtrend intact.
3. Head: After the formation of the left shoulder, a decline begins that exceeds the previous
low and forms a point at an even lower point. After making a bottom, the high of the subsequent
advance forms the second point of the neckline.
4. Right shoulder: Right shoulder is formed when the high of the head begins to decline.
The height of the right shoulder is always less than the head and is usually in line with the
left shoulder, though it can be narrower or wider. When the advance from the low of the right
shoulder breaks the neckline, the head and shoulders reversal is complete.
5. Neckline: The neckline is drawn through the highest points of the two intervening
troughs and may slope upward or downward. The neckline forms by connecting two reaction
highs. The fi rst reaction marks the end of the left shoulder and the beginning of the head. The
second reaction marks the end of the head and the beginning of the right shoulder. Depending
on the relationship between the two reaction highs, the neckline can slope up, slope down,
or be horizontal. The slope of the neckline will affect the pattern’s degree of bullishness: an
upward slope is more bullish than downward slope.
6. Volume: Volume plays a very important role in head and shoulders bottom.
Without the proper expansion of volume, the validity of any breakout becomes suspect.
Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing
the absolute levels associated with each peak and trough.
Volume levels during the second half of the pattern are more important than the fi rst half.
The decline of the volume of the left shoulder is usually heavy and selling pressure is also
very intense. The selling continues to be intense even during the decline that forms the low of
the head. After this low, subsequent volume patterns should be watched carefully to look for
expansion during the advances.
The advance from the low of the head should be accompanied by an increase in volume
and/or better indicator readings (e.g. CMF > 0 or strength in OBV). After the formation the
second neckline point by the reaction high, there should be a decline in the right shoulder
accompanied with light volume. It is normal to experience profi t-taking after an advance.
Volume analysis helps distinguish between normal profi t-taking and heavy selling pressure.
With light volume on the pullback, indicators like CMF and OBV should remain strong. The
most important moment for volume occurs on the advance from the low of the right shoulder.
For a breakout to be considered valid there needs to be an expansion of volume on the
advance and during the breakout.
1. Neckline break: The head and shoulders pattern is said to be complete only when
neckline resistance is broken. For a head and shoulders bottom, this must occur in a convincing
manner with an expansion of volume.
2. Resistance turned support: The same resistance level can turn into support, if the
resistance is broken. Price will return to the resistance break and provide a second chance to
3. Price target: Once the neckline resistance is broken, the projected advance is calculated
by measuring the distance from the neckline to the bottom of the head. This distance is
then added to the neckline to reach a price target. Any price target should serve as a rough
guide and other factors should be considered as well. These factors might include previous
resistance levels, Fibonacci retracements or long-term moving averages.
CNX IT INDEX Chart Showing Inverse Head and Shoulders Pattern
Once the neckline breaches the prices of index starts rising
Once the resistance is broken at point D the price target will be equal to the bottom of the
head from neckline. It may test the line again at point E therefore the stop should be below
Some important points to remember:
• Head and shoulder bottom is one of the most common and reliable reversal formations.
They occur after a downtrend and usually mark a major trend reversal when complete.
• It is preferable but not a necessary requirement that the left and right shoulders be
symmetrical. Shoulders can be of different widths as well as different heights. If you are
looking for the perfect pattern, then it will take a long time to come.
• The major focus of the analysis of the head and shoulders bottom should be the correct
identifi cation of neckline resistance and volume patterns. These are two of the most
important aspects to a successful trade. The neckline resistance breakout combined with
an increase in volume indicates an increase in demand at higher prices. Buyers are
exerting greater force and the price is being affected.
• As seen from the examples, traders do not always have to choose a stock after the
neckline breakout. Many times, the price will return to this new support level and offer a
second chance to buy. Measuring the expected length of the advance after the breakout
can be helpful, but it is not always necessary to achieve the fi nal target. As the pattern
unfolds over time, other aspects of the technical picture are likely to take precedent.
What are support and resistance lines?
Support and resistance represent key junctures where the forces of supply and demand meet.
These lines appear as thresholds to price patterns. They are the respective lines which stops
the prices from decreasing or increasing.
A support line refers to that level beyond which a stock’s price will not fall. It denotes that
price level at which there is a suffi cient amount of demand to stop and possibly, for a time,
turn a downtrend higher. Similarly a resistance line refers to that line beyond which a stock’s
price will not increase. It indicates that price level at which a suffi cient supply of stock is
available to stop and possibly, for a time, head off an uptrend in prices. Trend lines are often
referred to as support and resistance lines on an angle.
A support is a horizontal fl oor where interest in buying a commodity is strong enough to
overcome the pressure to sell. Support level is the price level at which suffi cient demand
exists to, at least temporarily, halt a downward movement in prices. Logically as the price
declines towards support and gets cheaper, buyers become more inclined to buy and sellers
become less inclined to sell. By the time the price reaches the support level, it is believed that
demand will overcome supply and prevent the price from falling below support.
Support does not always hold true and a break below support signals that the bulls have
lost over the bears. A fall below support level indicates more willingness to sell and a lack of
willingness to buy. A break in the levels of support indicates that the expectations of sellers
are reducing and they are ready to sell at even lower prices. In addition, buyers could not
be coerced into buying until prices declined below support or below the previous low. Once
support is broken, another support level will have to be established at a lower level
ACC chart showing the support level at 720
A resistance is a horizontal ceiling where the pressure to sell is greater than the pressure to
buy. Thus a Resistance level is a price at which suffi cient supply exists to; at least temporarily,
halt an upward movement. Logically as the price advances towards resistance, sellers become
more inclined to sell and buyers become less inclined to buy. By the time the price reaches the
resistance level, it is believed that supply will overcome demand and prevent the price from
rising above resistance.
Resistance does not always hold true and a break above resistance signals that the bears
have lost over the bulls. A break in the resistance level shows more willingness to buy or
lack of incentive to sell. Resistance breaks and new highs indicate that buyer’s expectations
have increased and are ready to buy at even higher prices. In addition, sellers could not
be coerced into selling until prices rose above resistance or above the previous high. Once
resistance is broken, another resistance level will have to be established at a higher level.
Euro showing resistance around 1.4930 and then 1.5896
Why do support and resistance lines occur?
A stock’s price is determined by supply and demand. Bulls buy when the stock’s is prices
are too low and bears sell when the price reaches its maximum. Bulls increase the prices by
increasing the demand and bears decrease it by increasing the supply. The market reaches a
balance when bulls and bears agree on a price.
When prices are increasing upward, there exists a point at which the bears become more
aggressive the bulls begin to pull back - the market balances along the resistance line.
When prices are going downwards, the market balances along the support line. As prices
starts to decline toward the support line, buyers become more inclined to buy and sellers start
holding on to their stocks. The support line marks the point where demand takes precedence
over supply and prices will not decrease below that support line. The reverse holds true for a
Prices often break through support and resistance lines. A break through a resistance line
shows that the buyers have won out over the sellers. The price of the stock is bid higher than
the previous levels by the Bulls. Once the resistance line is broken, another will be created at
a higher level. The reverse holds true for a support line.
Support and resistance zones
Support and resistance is often thought of as a price level. For example, analysts and traders
might discuss support for Nifty futures contract is at 4850. As a trader, if you are looking for
a place to go long would you wait for the market to actually trade at 4850 before taking a
position? Should you buy one, two or maybe fi ve ticks above the low and stop yourself out one
tick through the low to manage your risk in the long position. If you wait for a test of support,
you could miss a trading opportunity. The problem is thinking about support and resistance
as a precise price level and this is where most traders err. It is very common for most people
to think of support and resistance levels in terms of absolute price levels. For instance, if they
are looking at Rs 50 as a resistance levels, they mean exactly Rs 50.
In reality, support and resistance levels are not exact prices, but rather price zones. So, if the
resistance level is Rs50, then it is actually the zone around that 50 level that is the resistance.
The stock may hit only 49.87 or it may hit 50.25 and still hold the Rs 50 as price resistance.
One solution is to use price zones for support and resistance instead of price levels. Support
and resistance zones give you a better trading opportunity. A risk taking investor may buy at
top of support zone whereas a cautious investor may want to wait till the bottom of support
The main factor in determining exactly how much the exact prices are tested by is how quickly
or slowly the prices move into that resistance zone. For instance, if the zone hits very quickly
on a large momentum surge, then it is more likely to hit that 50.25 level. This is also the case
if the stock is a rather volatile one with a wide price range intraday. If the security spikes
higher and does not quite hit the price resistance, such as a spike into 49.70, then it may
round off into 50 with slightly higher highs and never exactly touch the Rs 50 price resistance
zone before turning over due to the slowdown in momentum into that resistance. The larger
the time frame, the greater the price zone is as well. A resistance zone at 50 on a weekly time
frame may have a range of 1 Rs on each side of 50. Where traders tend to run into trouble
is in thinking that because the stock has traded over 50 therefore the Rs 50 resistance has
been broken, so we often hear of people “buying the highs” or “shorting the lows” in the case
Resistance levels can transform into support levels and vice versa. After prices break through
a support level, investors may try to limit their losses by selling the stock, pushing prices back
up to the line which now becomes a resistance level.
Change of support to resistance and vice versa
Another principle of technical analysis stipulates that support can turn into resistance and visa
versa. Once the price penetrates below the support level, the earlier or the broken support
level can turn into resistance. The break of support level signals that the forces of supply have
overcome the forces of demand. Therefore, if the price returns to this level, there is likely to
be an increase in supply, and hence resistance
Wipro chart showing change of support around 440 to resistance
Another aspect of technical analysis is resistance turning into support. As the price increases
above resistance, it signals changes in demand and supply. The breakout above resistance
proves that the forces of demand have overcome the forces of supply. If the price returns to
this level, there is likely to be an increase in demand and support can be established at this
Crude oil chart showing change of resistance to support around 100$
Why are support and resistance lines important?
Technical analysts often say that the market has a memory. Support and resistance lines are
a key component of that memory.
Investors “tend” to remember previous area levels and thus make them important. When a
price of a stock is changing rapidly each day the buying and selling will be done at a divergent
level and there will not exist any unanimity or pattern in price changing. But when prices trade
within a narrow range for a period of time an area is formed and investors begin to remember
that specifi c price.
If the prices stay in an area for a longer period than the volume of that spot increases and that
level becomes more important because investors remember it exceptionally well. Therefore,
that level becomes more signifi cant for the technical analyst. According to experts, previous
support and resistance levels can be used as “target” or “limit” prices when the market have
traded away from them. Assume that a year ago a rally ended with a top price of 120. That
price of 120 then becomes a resistance level for the rally occurring in today’s market.
Two candles pattern
A “bullish engulfi ng pattern” consists of a large white real body that engulfs a small black
real body during a downtrend. It signifi es that the buyers are overwhelming the sellers
The Engulfi ng pattern is a major reversal pattern comprised of two opposite colored bodies.
This Bullish Pattern is formed after a downtrend. It is formed when a small black candlestick
is followed by a large white candlestick that completely eclipses the previous day candlestick.
It opens lower that the previous day’s close and closes higher than the previous day’s open.
1. The candlestick body of the previous day is completely overshadowed by the next day’s
2. Prices have been declining defi nitely, even if it has been in short term.
3. The color of the fi rst candle is similar to that of the previous one and the body of the
second candle is opposite in color to that fi rst candle. The only exception being an engulfed
body which is a doji.
1. A small body being covered by the larger one. The previous day shows the trend was
running out of steam. The large body shows that the new direction has started with good
2. Large volume on the engulfi ng day increases the chances that a blow off day has
3. The engulfi ng body engulfs absorbs the body and the shadows of the previous day; the
reversal has a greater probability of working.
4. The probability of a strong reversal increases as the open gaps between the previous and
the current day increases.
After a decline has taken place, the price opens at a lower level than its previous day closing
price. Before the close of the day, the buyers have taken over and have led to an increase in
the price above the opening price of the previous day. The emotional psychology of the trend
has now been altered.
When investors are learning the stock market they should utilize information that has worked
with high probability in the past.
Bullish Engulfi ng signal if used after proper training and at proper locations, can lead to highly
profi table trades and consistent results. This pattern allows an investor to improve their
probabilities of been in a correct trade. The common sense elements conveyed in candlestick
signals makes for a clear and concise trading technique for beginning investors as well as
A “bearish engulfing pattern,” on the other hand, occurs when the sellers are overwhelming
the buyers. This pattern consists of a small white candlestick with short shadows or tails
followed by a large black candlestick that eclipses or “engulfs” the small white one.
The bullish counterpart to the dark cloud cover is the “piercing pattern.” The fi rst thing to
look for is to spot the piercing pattern in an existing downtrend, which consists of a long black
candlestick followed by a gap lower open during the next session, but which closes at least
halfway into the prior black candlestick’s real body.
The Piercing Pattern is composed of a two-candle formation in a down trending market. With
daily candles, the piercing pattern will often end a minor downtrend (a downtrend that lasts
between six and fi fteen trading days). The day before the piercing candle appears, the
daily candle should have a fairly large dark real body, signifying a strong down day.
1. The downtrend has been evident for a good period.
2. The body of the fi rst candle is black; the body of the second candle is white.
3. A long black candle occurs at the end of the trend.
4. The white candle closes more than halfway up the black candle.
5. The second day opens lower than the trading of the prior day.
1. The reversal will be more pronounced, if the gap down the previous day close is more.
2. The longer the black candle and the white candle, the more forceful the reversal.
3. The higher the white candle closes into the black candle, the stronger the reversal.
4. Large volume during these two trading days is a signifi cant confi rmation.
The atmosphere becomes bearish once a strong downtrend has been in effect. The price goes
down. Bears may move the price even further but before the day ends the bulls enters and
bring a dramatic change in price in the opposite direction. They fi nish near the high of the day.
The move has almost negated the price decline of the previous day. This now has the bears
concerned. More buying the next day will confi rm the move. Being able to utilize information
that has been used successfully in the past is a much more viable investment strategy than
taking shots in the dark. Keep in mind, when you are given privileged information about stock
market tips, where you are in the food chain. Are you one of those privileged few that get
top-notch pertinent information on a timely manner, or are you one of the masses that feed
into a frenzy and allow the smart money to make the profi ts?
In up trends, the harami consists of a large white candle followed by a small white or black
candle (usually black) that is within the previous session’s large real body.
Bearish Harami is a two candlestick pattern composed of small black real body contained
within a prior relatively long white real body. The body of the fi rst candle is the same color
as that of the current trend. The open and the close occur inside the open and the close of
the previous day. Its presence indicates that the trend is over.
1. The fi rst candle is white in color; the body of the second candle is black.
2. The second day opens lower than the close of the previous day and closes higher than
the open of the prior day.
3. For a reversal signal, confi rmation is needed. The next day should show weakness.
4. The uptrend has been apparent. A long white candle occurs at the end of the trend.
1. The reversal will be more forceful, if the white and the black candle are longer.
2. The lower the black candle closes down on the white candle, the more convincing that a
reversal has occurred, despite the size of the black candle.
The bears open the price lower than the previous close, after a strong uptrend has been in
effect and after a long white candle day. The longs get concerned and start profi t taking. The
price for the day ends at a lower level. The bulls are now concerned as the price closes lower.
It is becoming evident that the trend has been violated. A weak day after that would convince
everybody that the trend was reversing. Volume increases due to the profi t taking and the
addition of short sales.
A candlestick chart pattern in which a large candlestick is followed by a smaller candlestick
whose body is located within the vertical range of the larger body. In downtrends, the harami
consists of a large black candle followed by a small white or black candle (usually white) that
is within the previous session’s large real body. This pattern signifi es that the immediately
preceding trend may be concluding, and that the bulls and bears have called a truce.
The Harami is a commonly observed phenomenon. The pattern is composed of a two candle
formation in a down-trending market. The color fi rst candle is the same as that of current
trend. The fi rst body in the pattern is longer than the second one. The open and the close
occur inside the open and the close of the previous day. Its presence indicates that the trend
The Harami (meaning “pregnant” in Japanese) Candlestick Pattern is a reversal pattern. The
pattern consists of two Candlesticks. The fi rst candle is black in color and a continuation of
the existing trend. The second candle, the little belly sticking out, is usually white in color but
that is not always the case. Magnitude of the reversal is affected by the location and size of
1. The fi rst candle is black in body; the body of the second candle is white.
2. The downtrend has been evident for a good period. A long black candle occurs at the end
of the trend.
3. The second day opens higher than the close of the previous day and closes lower than
the open of the prior day.
4. Unlike the Western “Inside Day”, just the body needs to remain in the previous day’s
body, where as the “Inside Day” requires both the body and the shadows to remain inside
the previous day’s body.
5. For a reversal signal, further confi rmation is required to indicate that the trend is now
1. The reversal will be more forceful if the black candle and the white candle are longer.
2. If the white candle closes up on the black candle then the reversal has occurred in a
convincing manner despite the size of the white candle.
After a strong down-trend has been in effect and after a selling day, the bulls open at a price
higher than the previous close. The short’s get concerned and start covering. The price for
the day fi nishes at a higher level. This gives enough notice to the short sellers that trend
has been violated. A strong day i.e. the next day would convince everybody that the trend
was reversing. Usually the volume is above the recent norm due to the unwinding of short
When the second candle is a doji, which is a candle with an almost non-existent real body,
these patterns are called “harami crosses.” They are however less reliable as reversal patterns
as more indecision is indicated.
Three candle pattern
The Evening Star is a top reversal pattern that occurs at the top of an uptrend. It is formed
by a tall white body candle, a second candle with a small real body that gaps above the fi rst
real body to form a “star” and a third black candle that closes well into the fi rst session’s white
The Evening Star pattern is a bearish reversal signal. Like the planet Venus, the evening star
represents that darkness is about to set or prices are going to decline. An uptrend has been in
place which is assisted by a long white candlestick. The following day gaps up, yet the trading
range remain small for the day. Again, this is the star of the formation. The third day is a
black candle day and represents the fact that the bears have now seized control. That candle
should consist of a closing that is at least halfway down the white candle of two days prior. The
optimal Evening Star signal would have a gap before and after the star day.
1. The uptrend should be apparent.
2. The body of the fi rst candle is white, continuing the current trend. The second candle has
small trading range showing indecision formation.
3. The third day shows evidence that the bears have stepped in. That candle should close
at least halfway down the white candle.
1. Long length of the white candle and the black candle indicates more forceful reversal.
2. The more indecision the middle day portrays, the better probabilities that a reversal will
3. A gap between the fi rst day and the second day adds to the probability of occurrence of
4. A gap before and after the star day is even more desirable. The magnitude, that the
third day comes down into the white candle of the fi rst day, indicates the strength of the
The psychology behind this pattern is that a strong uptrend has been in effect. Buyers have
been piling up the stock. However, it is the level where sellers start taking profi ts or think the
price is fairly valued. The next day all the buying is being met with the selling, causing for a
small trading range. The bulls get concerned and the bears start taking over. The third day is
a large sell off day. If there is big volume during these days, it shows that the ownership has
dramatically changed hands. The change of direction is immediately seen in the color of the
Morning star is the reverse of evening star. It is a bullish reversal pattern formed by a tall
black body candle, a second candle with a small real body that gaps below the fi rst real body
to form a star, and a third white candle that closes well into the fi rst session’s black real body.
Its name indicates that it foresees higher prices.
The Morning Star is a bottom reversal signal. Like the planet Mercury, the morning star,
signifi es brighter things – that is sunrise is about to occur, or the prices are going to go higher.
A downtrend has been in place which is assisted by a long black candlestick. There is little
about the downtrend continuing with this type of action. The next day prices gap lower on
the open, trade within a small range and close near their open. This small body shows the
beginning of indecision. The next day prices gap higher on the open and then close much
higher. A signifi cant reversal of trend has occurred.
The make up of the star, an indecision formation, can consist of a number of candle formations.
The important factor is to witness the confi rmation of the bulls taking over the next day. That
candle should consist of a closing that is at least halfway up the black candle of two days
1. Downtrend should be there.
2. The body of the fi rst candle is black, continuing the current trend. The second candle is
an indecision formation.
3. The third day is the opposite color of the fi rst day. It shows evidence that the bulls have
stepped in. That candle should close at least halfway up the black candle.
1. Long length of the black candle and the white candle indicates more forceful reversal.
2. The more indecision that the star day illustrates, the better probabilities that a reversal
3. A Gap between the fi rst day and the second day adds to the probability of occurrence of
4. A gap before and after the star day is even more desirable.
5. The magnitude, that the third day comes up into the black candle of the fi rst day, indicates
the strength of the reversal.
While a strong downtrend has been in effect, there is a large sell-off day. The selling continues
and bulls continue to step in at low prices. Big volume on this day shows that the ownership
has dramatically changed. The second day does not have a large trading range. The third
day, the bears start to lose conviction as the bull increase their buying. When the price starts
moving back into the trading range of the fi rst day, the sellers diminish and the buyers seize
Doji lines are patterns with the same open and close price. It’s a signifi cant reversal
The Importance of the Doji
The perfect doji session has the same opening and closing price, yet there is some fl exibility
to this rule. If the opening and closing price are within a few ticks of each other, the line could
still be viewed as a doji.
How do you decide whether a near-doji day (that is, where the open and close are very close,
but not exact) should be considered a doji? This is subjective and there are no rigid rules but
one way is to look at a near-doji day in relation to recent action. If there are a series of very
small real bodies, the near-doji day would not be viewed as signifi cant since so many other
recent periods had small real bodies. One technique is based on recent market activity. If the
market is at an important mar ket junction, or is at the mature part of a bull or bear move,
or there are other technical signals sending out an alert, the appearance of a near-doji is
treated as a doji. The philosophy is that a doji can be a signifi cant warning and that it is better
to attend to a false warning than to ignore a real one. To ignore a doji, with all its inherent
implications, could be dangerous.
The doji is a distinct trend change signal. However, the likelihood of a reversal increases if
subsequent candlesticks confi rm the doji’s reversal potential. Doji sessions are important
only in markets where there are not many doji. If there are many doji on a particular chart,
one should not view the emergence of a new doji in that particular market as a meaningful
development. That is why candlestick analysis usually should not use intra-day charts of less
than 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or near
Doji at tops
A Doji star at the top is a warning that the uptrend is about to change. This is especially true
after a long white candlestick in an uptrend. The reason for the doji’s negative implications in
uptrend is because a doji repre sents indecision. Indecision among bulls will not maintain the
uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an extended
rally, or is overbought, then formation of a doji could mean the scaffolding of buy ers’ support
will give way.
Doji are also valued for their ability to show reversal potential in downtrends. The reason may
be that a doji refl ects a balance between buying and selling forces. With ambiva lent market
participants, the market could fall due to its own weight. Thus, an uptrend should reverse but
a falling market may continue its descent. Because of this, doji need more confi rmation to
signal a bottom than they do a top.
Bull: An investor who thinks the market, a specifi c security or an industry will rise.
Bear: An investor who believes that a particular security or market is headed downward
is indicative of a bearish trend. Bears attempt to profi t from a decline in prices. Bears are
generally pessimistic about the state of a given market.
Bull market: A fi nancial market of a group of securities in which prices are rising or are
expected to rise. The term “bull market” is most often used to refer to the stock market, but
can be applied to anything that is traded, such as bonds, currencies and commodities.
Bull markets are characterized by optimism, investor confi dence and expectations that strong
results will continue. It’s diffi cult to predict consistently when the trends in the market will
change. Part of the diffi culty is that psychological effects and speculation may sometimes play
a large role in the markets
The use of “bull” and “bear” to describe markets comes from the way the animals attack their
opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These
actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If
the trend is down, it’s a bear market.
A market condition in which the prices of securities are falling, and widespread pessimism
causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear
market, selling continues, which then creates further pessimism.
This is not to be confused with a correction which is a short-term trend that has duration
shorter than two months. While corrections are often a great place for a value investor to
fi nd an entry point, bear markets rarely provide great entry points as timing the bottom is
very diffi cult to do. Fighting back can be extremely dangerous because it is quite diffi cult for
an investor to make stellar gains during a bear market unless he or she is a short seller.
Fundamental Analysis: A method of evaluating securities by analyzing statistics generated
by market activity such as past prices and volume is defi ned as ‘Fundamental Analysis’.
Technical analysts do not attempt to measure a security’s intrinsic value, but instead use
charts and other tools to identify patterns that can suggest future activity.
Morning star: A bullish candlestick pattern that consists of three candles that have
demonstrated the following characteristics:
• The fi rst bar is a large black candlestick located within a defi ned downtrend.
• The second bar is a small-bodied candle (either black or white) that closes below the
fi rst black bar.
• The last bar is a large white candle that opens above the middle candle and closes near
the center of the fi rst bar’s body.
This pattern is used by traders as an early indication that the downtrend is about to reverse.
Technical Analysis: This is a method of evaluating securities by analyzing statistics generated
by market activity, such as past prices and volume. Technical analysts do not attempt to
measure a security’s intrinsic value, but instead use charts and other tools to identify patterns
that can suggest future activity
One cannot ignore that investor’s psychologically driven forces of fear; greed and hope greatly
infl uence the stock prices. The overall market psychology can be tracked through candlestick
analysis. More than just a method of pattern recognition, candlestick analysis shows the
interaction between buyers and sellers. A white candlestick indicates opening price of the
session being below the closing price; and a black candlestick shows opening price of the
session being above the closing price. The shadow at top and bottom indicates the high and
low for the session.
Japanese candlesticks offer a quick picture into the psychology of short term trading, studying
the effect, not the cause. Therefore if you combine candlestick analysis with other technical
analysis tools, candlestick pattern analysis can be a very useful way to select entry and exit
One candle patterns
In the terminology of Japanese candlesticks, one candle patterns are known as “Umbrella
lines”. There are two types of umbrella lines - the hanging man and the hammer. They have
long lower shadows and small real bodies that are at top of the trading range for the session.
They are the simplest lines because they do not necessarily have to be spotted in combination
with other candles to have some validity.
Hammer and Hanging Man Hammer Hanging Man Candlesticks
Hammer is a one candle pattern that occurs in a downtrend when bulls make a start to
step into the rally. It is so named because it hammers out the bottom. The lower shadow of
hammer is minimum of twice the length of body. Although, the color of the body is not of
much signifi cance but a white candle shows slightly more bullish implications than the black
body. A positive day i.e. a white candle is required the next day to confi rm this signal.
1. The lower shadow should be at least two times the length of the body.
2. There should be no upper shadow or a very small upper shadow.
3. The real body is at the upper end of the trading range. The color of the body is not
important although a white body should have slightly more bullish implications.
4. The following day needs to confi rm the Hammer signal with a strong bullish day.
1. The longer the lower shadow, the higher the potential of a reversal occurring.
2. Large volume on the Hammer day increases the chances that a blow off day has
3. A gap down from the previous day’s close sets up for a stronger reversal move provided
the day after the Hammer signal opens higher.
The market has been in a downtrend, so there is an air of bearishness. The price opens and
starts to trade lower. However the sell-off is abated and market returns to high for the day as
the bulls have stepped in. They start bringing the price back up towards the top of the trading
range. This creates a small body with a large lower shadow. This represents that the bears
could not maintain control. The long lower shadow now has the bears questioning whether
the decline is still intact. Confi rmation would be a higher open with yet a still higher close on
the next trading day.
The hanging man appears during an uptrend, and its real body can be either black or white.
While it signifi es a potential top reversal, it requires confi rmation during the next trading
session. The hanging man usually has little or no upper shadow.
Soybean Oil-December, 1990, Daily (Hanging Man and Hammer)
Dow Jones Industrials-1990, Daily (Hanging Man and Hammer)
Shooting star and inverted hammer
Other candles similar to the hanging man and hammer are the “shooting star,” and the
“inverted hammer.” Both have small real bodies and can be either black or white but they
both have long upper shadows, and have very little or no lower shadows.
Inverted hammer is one candle pattern with a shadow at least two times greater than the
body. This pattern is identifi ed by the small body. They are found at the bottom of the decline
which is evidence that bulls are stepping in but still selling is going on. The color of the small
body is not important but the white body has more bullish indications than a black body. A
positive day is required the following day to confi rm this signal.
1. The longer the upper shadow, the higher the potential of a reversal occurring.
2. A gap down from the previous day’s close sets up for a stronger reversal move.
3. Large volume on the day of the inverted hammer signal increases the chances that a
blow off day has occurred
4. The day after the inverted hammer signal opens higher.
After a downtrend has been in effect, the atmosphere is bearish. The price opens and starts to
trade higher. The Bulls have stepped in, but they cannot maintain the strength. The existing
sellers knock the price back down to the lower end of the trading range. The Bears are still in
control. But the next day, the Bulls step in and take the price back up without major resistance
from the Bears. If the price maintains strong after the Inverted Hammer day, the signal is
A small real body that gaps away from the large real body preceding it is known as star. It’s
still a star as long as the small real body does not overlap the preceding real body. The color
of the star is not important. Stars can occur at tops or bottoms.
The Shooting Star is a single line pattern that indicates an end to the uptrend. It is easily
identifi ed by the presence of a small body with a shadow at least two times greater than the
body. It is found at the top of an uptrend. The Japanese named this pattern because it looks
like a shooting star falling from the sky with the tail trailing it.
1. The upper shadow should be at least two times the length of the body.
2. Prices gap open after an uptrend.
3. A small real body is formed near the lower part of the price range. The color of the body
is not important although a black body should have slightly more bearish implications.
4. The lower shadow is virtually non-existent.
5. The following day needs to confi rm the Shooting Star signal with a black candle or better
yet, a gap down with a lower close.
1. The longer the upper shadow, the higher the potential of a reversal occurring.
2. A gap up from the previous day’s close sets up for a stronger reversal move provided.
3. The day after the Shooting Star signal opens lower.
4. Large volume on the Shooting Star day increases the chances that a blow-off day has
occurred although it is not a necessity.
During an uptrend, the market gaps open and rallies to a new high. The price opens and trades
higher. The bulls are in control. But before the close of the day, the bears step in and take
the price back down to the lower end of the trading range, creating a small body for the day.
This could indicate that the bulls still have control if analyzing a Western bar chart. However,
the long upper shadow represents that sellers had started stepping in at these levels. Even
though the bulls may have been able to keep the price positive by the end of the day, the
evidence of the selling was apparent. A lower open or a black candle the next day reinforces
the fact that selling is going on.
What is a chart?
Charts are the working tools of technical analysts. They use charts to plot the price movements
of a stock over specifi c time frames. It’s a graphical method of showing where stock prices
have been in the past.
A chart gives us a complete picture of a stock’s price history over a period of an hour, day,
week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical). Typically, the
x-axis represents time; the y-axis represents price. By plotting a stock’s price over a period of
time, we end up with a pictorial representation of any stock’s trading history.
A chart can also depict the history of the volume of trading in a stock. That is, a chart can
illustrate the number of shares that change hands over a certain time period.
Types of price charts:
1. Line charts
“Line charts” are formed by connecting the closing prices of a specifi c stock or market over
a given period of time. Line chart is particularly useful for providing a clear visual illustration
of the trend of a stock’s price or a market’s movement. It is an extremely valuable analytical
tool which has been used by traders for past many years.
2. Bar chart
Bar chart is the most popular method traders use to see price action in a stock over a
given period of time. Such visual representation of price activity helps in spotting trends and
Although daily bar charts are best known, bar charts can be created for any time period -
weekly and monthly, for example. A bar shows the high price for the period at the top and
the lowest price at the bottom of the bar. Small lines on either side of the vertical bar serve
to mark the opening and closing prices. The opening price is marked by a small tick to the left
of the bar; the closing price is shown by a similar tick to the right of the bar. Many investors
work with bar charts created over a matter of minutes during a day’s trading.
Candlestick charts provide visual insight to current market psychology. A candlestick displays
the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a
manner that extenuates the relationship between the opening and closing prices. Candlesticks
don’t involve any calculations. Each candlestick represents one period (e.g., day) of data. The
fi gure given below displays the elements of a candle.
A candlestick chart can be created using the data of high, low, open and closing prices for
each time period that you want to display. The hollow or fi lled portion of the candlestick is
called “the body” (also referred to as “the real body”). The long thin lines above and below
the body represent the high/low range and are called “shadows” (also referred to as “wicks”
and “tails”). The high is marked by the top of the upper shadow and the low by the bottom of
the lower shadow. If the stock closes higher than its opening price, a hollow candlestick
is drawn with the bottom of the body representing the opening price and the top of the body
representing the closing price. If the stock closes lower than its opening price, a fi lled
candlestick is drawn with the top of the body representing the opening price and the bottom
of the body representing the closing price.
Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader
can see and compare the relationship between the open and close as well as the high and
low. The relationship between the open and close is considered vital information and forms
the essence of candlesticks. Hollow candlesticks, where the close is greater than the open,
indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate
selling pressure. Thus, compared to traditional bar charts, many traders consider candlestick
charts more visually appealing and easier to interpret.
Why candlestick charts?
What does candlestick charting offer that typical Western high-low bar charts do not? Instead
of vertical line having horizontal ticks to identify open and close, candlesticks represent two
dimensional bodies to depict open to close range and shadows to mark day’s high and low.
For several years, the Japanese traders have been using candlestick charts to track market
activity. Eastern analysts have identifi ed a number of patterns to determine the continuation
and reversal of trend.
These patterns are the basis for Japanese candlestick chart analysis. This places candlesticks
rightly as a part of technical analysis. Japanese candlesticks offer a quick picture into the
psychology of short term trading, studying the effect, not the cause. Applying candlesticks
means that for short-term, an investor can make confi dent decisions about buying, selling, or
holding an investment.
Importance of Technical Analysis
Not Just for stocks
Technical analysis has universal applicability. It can be applied to any fi nancial instrument -
stocks, futures and commodities, fi xed-income securities, forex, etc
Focus on price
Fundamental developments are followed by price movements. By focusing only on price action,
technicians focus on the future. The price pattern is considered as a leading indicator and
generally leads the economy by 6 to 9 months. To track the market, it makes sense to look
directly at the price movements. More often than not, change is a subtle beast. Even though
the market is prone to sudden unexpected reactions, hints usually develop before signifi cant
movements. You should refer to periods of accumulation as evidence of an impending advance
and periods of distribution as evidence of an impending decline.
Supply, demand, and price action
Technicians make use of high, low and closing prices to analyze the price action of a stock. A
good analysis can be made only when all the above information is present
Separately, these will not be able to tell much. However, taken together, the open, high, low
and close refl ect forces of supply and demand.
Support and resistance
Charting is a technique used in analysis of support and resistance level. These are trading
range in which the prices move for an extended period of time, saying that forces of demand
and supply are deadlocked. When prices move out of the trading range, it signals that either
supply or demand has started to get the upper hand. If prices move above the upper band of
the trading range, then demand is winning. If prices move below the lower band, then supply
Pictorial price history
A price chart offers most valuable information that facilitates reading historical account of
a security’s price movement over a period of time. Charts are much easier to read than a
table of numbers. On most stock charts, volume bars are displayed at the bottom. With this
historical picture, it is easy to identify the following:
• Market reactions before and after important events
• Past and present volatility
• Historical volume or trading levels
• Relative strength of the stock versus the index.
Assist with entry point
Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to
decide what to buy and technical analysis is used to decide when to buy. Timings in this
context play a very important role in performance. Technical analysis can help spot demand
(support) and supply (resistance) levels as well as breakouts. Checking out for a breakout
above resistance or buying near support levels can improve returns.
First of all you should analyze stock’s price history. If a stock selected by you was great for
the last three years has traded fl at for those three years, it would appear that market has a
different opinion. If a stock has already advanced signifi cantly, it may be prudent to wait for a
pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend
Weaknesses of Technical Analysis
Technical analysis is not hard core science. It is subjective in nature and your personal biases
can be refl ected in the analysis. It is important to be aware of these biases when analyzing
a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis.
On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably
have a bearish tilt.
Open to interpretation
Technical analysis is a combination of science and art and is always open to interpretation.
Even though there are standards, many times two technicians will look at the same chart
and paint two different scenarios or see different patterns. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify their position. Is the cup
half-empty or half-full? It is in the eye of the beholder.
You can criticize the technical analysis for being too late. By the time the trend is identifi ed, a
substantial move has already taken place. After such a large move, the reward to risk ratio is
not great. Lateness is a particular criticism of Dow Theory.
Always another level
Technical analysts always wait for another new level. Even after a new trend has been identifi ed,
there is always another “important” level close at hand. Technicians have been accused of
sitting on the fence and never taking an unqualifi ed stance. Even if they are bullish, there is
always some indicator or some level that will qualify their opinion.
An array of pattern and indicators arises while studying technical analysis. Not all the signals
work. For instance: A sell signal is given when the neckline of a head and shoulders pattern is
broken. Even though this is a rule, it is not steadfast and can be subject to other factors such
as volume and momentum. In that same vein, what works for one particular stock may not
work for another. A 50-day moving average may work great to identify support and resistance
for Infosys, but a 70-day moving average may work better for Reliance. Even though many
principles of technical analysis are universal, each security will have its own idiosyncrasies.
TA is also useful in controlling risk
It is Technical Analysis only that can provide you the discipline to get out when you’re on the
wrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a
trade and to get stubborn. That is also potentially the worst thing you can do. You think that
if you ride it out you’ll be okay. However, there will also be occasions when you won’t be okay.
The stock will move against you in ways and to an extent that you previously found virtually
It is more important to control risk than to maximize profi ts!
There is asymmetry between zero and infi nity. What does that mean? Most of us have very
fi nite capital but infi nite opportunities because of thousands of stocks. If we lose an opportunity,
we will have thousands more tomorrow. If we lose our capital, will we get thousands more
tomorrow? It is likely that we will not. We will also lose our opportunities. Our capital holds
more worth to us than our opportunities because we must have capital in order to take
advantage of tomorrow’s opportunities.
It is more important to control risk than to maximize profi ts! Technical Analysis, if practiced
with discipline, gives you specifi c parameters for managing risk. It’s simply supply and demand.
Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your capital is
your opportunity. You can be right a thousand times, become very wealthy and then get wiped
out completely if you manage your risk poorly just once. One last time: That is why it is more
important to control risk than to maximize profi ts!
How to know what to look for? How to organize your thinking in a market of thousands of
stock trading millions of shares per day? How to learn your way around? Technical Analysis
answers all these questions.
Technical analysis works on Pareto principle. It considers the market to be 80% psychological
and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80%
logical. Psychological or logical may be open for debate, but there is no questioning the current
price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The
price set by the market refl ects the sum knowledge of all participants, and we are not dealing
with lightweights here. These participants have considered (discounted) everything under the
sun and settled on a price to buy or sell. These are the forces of supply and demand at work.
By examining price action to determine which force is prevailing, technical analysis focuses
directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though some principles and rules of technical analysis are universally applicable, it must
be remembered that technical analysis is more an art form than a science. As an art form, it
is subject to interpretation. However, it is also fl exible in its approach and each investor should
use only that which suits his or her style. Developing a style takes time, effort and dedication,
but the rewards can be signifi cant.
What is Technical Analysis?
Technical Analysis can be defi ned as an art and science of forecasting future prices based on
an examination of the past price movements. Technical analysis is not astrology for predicting
prices. Technical analysis is based on analyzing current demand-supply of commodities,
stocks, indices, futures or any tradable instrument.
Technical analysis involve putting stock information like prices, volumes and open interest
on a chart and applying various patterns and indicators to it in order to assess the future
price movements. The time frame in which technical analysis is applied may range from
intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly
or monthly price data to many years.
There are essentially two methods of analyzing investment opportunities in the security
market viz fundamental analysis and technical analysis. You can use fundamental information
like fi nancial and non-fi nancial aspects of the company or technical information which ignores
fundamentals and focuses on actual price movements.
The basis of Technical Analysis
What makes Technical Analysis an effective tool to analyze price behavior is explained by
following theories given by Charles Dow:
• Price discounts everything
• Price movements are not totally random
• What is more important than why
Price discounts everything
“Each price represents a momentary consensus of value of all market participants – large
commercial interests and small speculators, fundamental researchers, technicians and
gamblers- at the moment of transaction” – Dr Alexander Elder
Technical analysts believe that the current price fully refl ects all the possible material
information which could affect the price. The market price refl ects the sum knowledge of
all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side
analysts, market strategist, technical analysts, fundamental analysts and many others. It
would be folly to disagree with the price set by such an impressive array of people with
impeccable credentials. Technical analysis looks at the price and what it has done in the past
and assumes it will perform similarly in future under similar circumstances. Technical analysis
looks at the price and assumes that it will perform in the same way as done in the past under
similar circumstances in future.
Price movements are not totally random
Technical analysis is a trend following system. Most technicians acknowledge that hundreds
of years of price charts have shown us one basic truth – prices move in trends. If prices were
always random, it would be extremely diffi cult to make money using technical analysis. A
technician believes that it is possible to identify a trend, invest or trade based on the trend
and make money as the trend unfolds. Because technical analysis can be applied to many
different time frames, it is possible to spot both short-term and long-term trends.
“What” is more important than “Why”
It is said that “A technical analyst knows the price of everything, but the value of nothing”.
Technical analysts are mainly concerned with two things:
1. The current price
2. The history of the price movement
All of you will agree that the value of any asset is only what someone is willing to pay for
it. Who needs to know why? By focusing just on price and nothing else, technical analysis
represents a direct approach. The price is the fi nal result of the fi ght between the forces of
supply and demand for any tradable instrument. The objective of analysis is to forecast the
direction of the future price. Fundamentalists are concerned with why the price is what it is.
For technicians, the why portion of the equation is too broad and many times the fundamental
reasons given are highly suspect. Technicians believe it is best to concentrate on what and
never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers
The principles of technical analysis are universally applicable. The principles of support,
resistance, trend, trading range and other aspects can be applied to any chart. Technical
analysis can be used for any time horizon; for any marketable instrument like stocks, futures
and commodities, fi xed-income securities, forex, etc
Top-down Technical Analysis
Technical analysis uses top-down approach for investing. For each stock, an investor would
analyze long-term and short-term charts. First of all you will consider the overall market, most
probably the index. If the broader market were considered to be in bullish mode, analysis
would proceed to a selection of sector charts. Those sectors that show the most promise
would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry
groups, individual stock selection can begin. With a selection of 10-20 stock charts from each
industry, a selection of 3-5 most promising stocks in each group can be made. How many
stocks or industry groups make the fi nal cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These
stocks could even be broken down further to fi nd 3-4 best amongst the rest in the lot.
Technical Analysis: The basic assumptions
The field of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The market discounts everything
Technical analysis is criticized for considering only prices and ignoring the fundamental analysis
of the company, economy etc. Technical analysis assumes that, at any given time, a stock’s
price refl ects everything that has or could affect the company - including fundamental factors.
The market is driven by mass psychology and pulses with the fl ow of human emotions.
Emotions may respond rapidly to extreme events, but normally change gradually over time.
It is believed that the company’s fundamentals, along with broader economic factors and
market psychology, are all priced into the stock, removing the need to actually consider these
factors separately. This only leaves the analysis of price movement, which technical theory
views as a product of the supply and demand for a particular stock in the market.
2. Price moves in trends
“Trade with the trend” is the basic logic behind technical analysis. Once a trend has been
established, the future price movement is more likely to be in the same direction as the trend
than to be against it. Technical analysts frame strategies based on this assumption only.
3. History tends to repeat itself
People have been using charts and patterns for several decades to demonstrate patterns in
price movements that often repeat themselves. The repetitive nature of price movements
is attributed to market psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns
to analyze market movements and understand trends.
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