Chapter 1 

Introduction to Technical Analysis

Technical Analysis
Technical Analysis is the art of forecasting future price movement based on past price action,
volume on a chart and applying various studies and indicators to it. Technical Analysis works across
all timeframes i.e. intraday – daily – weekly or even yearly data and is applicable to stocks, indices,
commodities, futures or any tradable instrument where the price is governed by the forces of supply
and demand.

Use of Technical Analysis

It is a very effective tool to time the markets, i.e. determine the entry levels, the stop-losses, as well
as the target levels. It takes into account everything (barring the ACTS of GOD) that is likely to
impact the prices, including fundamental reasons, stock specific news, results, events affecting
same sector’s stocks, political happenings and so on.

Bases of Technical Analysis

The three most important bases of Technical Analysis are:
 Price Discounts Everything
 Price Moves in Trend
 History Tends to Repeat Itself

Price Discounts Everything

Technical Analysis assumes 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.

Price Moves in Trend

“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
against it.

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.

Dow Theory
The Dow Theory is the oldest and by far the most publicized method of identifying major trends in
the market. The goal of the theory is determine changes in the primary or major movement of the
market. Once a trend has been established, it is assumed that it will exist until a reversal is proved.
Dow Theory is concerned with the direction of a trend and has no forecasting value in terms of the
trend’s ultimate direction or size.

Interpreting the Theory

The market discounts everything
The Dow Theory states that asset prices take into consideration all available information. Earnings
potential, competitive advantage of a firm, management competence – all of these factors and more
are priced into the market. The closing price reflects the aggregate judgment and emotions of all the
market participants.

There are three kinds of market trends

Markets experience primary trends which last a year or more, such as a bull or bear market. Within
these broader trends, markets experience secondary trends, often seen as a retracement against
the primary trend, such as a pullback within a bull market or a rally within a bear market; these
secondary trends last from three weeks to three months. Finally, there are minor trends that last less
than three weeks, and are generally seen as noise.

Primary trends have three phases

A primary trend consists of three phases, according to the Dow Theory. In a bull market, these are
the accumulation phase, the public participation phase and the excess phase. In a bear market, they
are called the distribution phase, the public participation phase and the panic phase. 

Indices must confirm each other

In order to establish a trend, Dow Theory states that indices or market averages must confirm each
other. Dow made use of two indices: the Dow Jones Industrial and Rail (now Transportation). A rise
in Dow Jones Industrial would only be confirmed if the transportation average also confirmed the
same, else there was no clear trend and we could witness a correction. The converse of this would
also hold true.

Volume must confirm the trend

Volume should increase if price is moving in the direction of the primary trend, and should be light
during a pullback. If volume picks up during a pullback, it could indicate trend reversal as more
participants have turned bearish.

Trends persist until a clear reversal occurs.

Reversals in primary trends can be confused with secondary trends. Identifying whether a bull
market is a reversal – the beginning of a bear market – or a short-lived correction to be followed by
higher highs is difficult, and the Dow Theory advocates caution, insisting that reversal be confirmed.

Difference between technical and fundamental analysis

Fundamental Analysis is the method of evaluating a security by analyzing balance sheet, income
statement, profit/loss, cash-flows and other financial/non-financial data about the company.
Technical Analysis does not attempt to measure a security's intrinsic value, but instead uses charts
and other tools to identify patterns that can suggest future price trend. It is a tool for timing the
market i.e. entry and exit levels.

Technical or Fundamental
Techno fundamental approach is the one you should go by. It means you should use both.
 Which security to trade – use Fundamental Analysis
 When to trade – use Technical Analysis

Key Takeaways
 Technical Analysis helps in identifying entry and exit points.
 Technical Analysis basis a) Price Discounts Everything b) Price Moves in Trend c) History
Tends to Repeat Itself.
 Dow Theory is based on 6 basic tenants
 Technical Analysis is best used to identify short terms trades

Chapter 2 Stock Market Charts

Charts
Charts capture price movements of a stock over specific time frames. These are graphical
representations of how stock prices moved in the past. Typically, the x-axis represents time and the
y-axis represents price. 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.
Three of the most commonly used Chart types are:
 Line Chart
 Bar Chart
 Candlestick
Line Chart
When you draw a line connecting the closing prices of a specific stock or index over a given period
of time you get a Line Chart. It is particularly useful for providing a clear visual illustration of the trend
of a stock’s price or a market’s movement. Line Chart is widely used by beginners to draw trend-
lines.
Line Chart of Nifty

Bar Chart
A Bar Chart tracks four price points for each trading day - open, high, low and close. Bar Chart is
one of the most popular charting techniques to see price action in a stock over a given period of
time. Although daily Bar Charts are best known, Bar Charts can be created for any time period that
can range from 1 minute, 5 minutes, 1 day, 1 week, etc.

Candlestick
Candlestick adds visibility to Bar Chart. Notations used in Candlestick are symmetric unlike the
notations used in Bar Chart. 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 visually represents the fight between
the bulls and bears. Each Candlestick represents one period (e.g. a day) of data.
Logarithmic (Ratio) Vs. Arithmetic Scales
Scaling is an issue that is often overlooked in Technical Analysis. There are two axes on any market
chart. The x-axis along the bottom, registers the timeframe and the y-axis, the price. There are two
methods of plotting the y-axis: arithmetic and logarithmic.

Arithmetic
Arithmetic charts allocate a specific point or Rs amount to a given vertical distance. The arithmetic
scale suppresses price fluctuations at low levels and exaggerates them at high points.

Logarithmic
A logarithmic scale allocates a given percentage price move to a specific vertical distance. There is
very little difference between the scaling methods when charts are plotted over short periods of time.
However, for analysis of charts over a long time frame, it is better to make use of logarithmic scale.

Key Takeaways
 Chart depicts the historical price, volume action of scrip.
 Line Chart, Bar Chart and Candlestick are the most commonly used charts in Technical
Analysis.
 Candlestick provides the most price information to a trader in one go compared to the rest
two charts.
 Over a short term time frame, there is very little difference between the two scaling methods.
For longer time frames, it is better to use logarithmic scale.

Chapter 3 Stock Market Trend Lines

Trend line
The popular saying in the market on Trend-line is “The trend is your friend, until the end when it
bends.” A Trend line is a straight line that connects two or more price points and then extends into
the future to act as a line of support or resistance.
An uptrend line has a positive slope and is formed by connecting 2 or more swing lows (blue arrow -
below). A downtrend line, on the other hand, has a negative slope and is formed by connecting 2 or
more swing highs (red arrow - below).

Using Trend lines

Trend lines are useful because:
 They provide support or resistance level
 They act as an early warning signal of trend change

Uptrend
“Uptrend” is defined as a series of higher highs and higher lows. In this process, the share prices
move in the upward direction touching new highs. For example, in the following diagram, note that
H4 > H3 > H2 > H1 and L4 > L3 > L2 > L1. Here, H4, H3, H2 are known as swing highs and L4, L3,
L2 are known as swing lows.
Downtrend
“Downtrend” is defined as a series of lower highs and lower lows. The share price moves in the
downward direction making new lows in the process. Hence, the best indication of a downtrend is
the price making a lower top and lower bottom.
Flat or Sideways trend
“Flat” or “Sideways” trend is a situation where prices move in a range, neither going upward nor
downward. They move in a horizontal direction for a long period of time.

Catching the trend

Markets trade in a range or stay flat most of the time. However, when the price breaks out (trades
above the range) or breaks down (trades below the range) - the price extends by at least the same
amount as that of the range.
Key Takeaways
 Trend lines are amongst the easiest technical tool to understand, but considerable practice is
required before we can successfully interpret trend lines.
 Markets tend to move in three trends - uptrend, downtrend and sideways trend
(consolidation).
 Trend line violations signal either a temporary interruption or a reversal in the prevailing
trend. It is necessary to refer to other pieces of technical evidence to determine what is being
signaled.
 A good Trend line reflects the underlying trend and represents an important support and
resistance zone.
 The relevance of Trend lines is a function of their length, the number of times they touch and
the steepness of ascent or decent.

Chapter 4 Support and Resistance

The concept of Support and Resistance

Support and resistance represent key junctures where the forces of demand and supply meet. Just
as a ball bounces when it hits the floor or drops after being thrown to the ceiling, support and
resistance define natural boundaries for rising and falling prices.
 Supply is synonymous with bearish, bears and selling.
 Demand is synonymous with bullish, bulls and buying.
As demand increases, prices move up and when supply increases, prices decline. When supply and
demand are equal, prices move sideways.

Support
Support is the price level at which demand is thought to be strong enough to prevent the price from
declining further. By the time the price reaches the support level, it is believed that demand will be
stronger than supply and prevent the price from falling below support. As the price declines towards
support, buyers become more inclined to buy and sellers become less inclined to sell.

Resistance
Resistance is the price level at which selling is thought to be strong enough to prevent the price from
rising further. As the price reaches the resistance level, it is assumed that supply will be stronger,
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 be stronger than demand and prevent the
price from crossing the resistance.

Determining the strength of Support and Resistance levels

The strength or weakness determines how much buying or selling interest will be required to break
the level. The length of time that a support or resistance level exists determines the strength or
weakness of that level. Also, the greater volume traded at any level, the stronger that level will be.
Please note
 Support becomes Resistance and Resistance becomes Support on a breakdown / breakout
of a Trend-line.
 Old Support becomes new Resistance and old Resistance becomes new Support.

Reason for Support and Resistance to Exist

Support and Resistance exist because people/traders have memories. Each price point has certain
memories associated with it. Please refer to the diagram below and check for the price point marked
by the red arrow. Investors got trapped and remember this price point as a sheer pain and wait
patiently to exit once the price point is reached in future. The price point marked by the green arrow
is a sigh of relief for those investors who got trapped at the red arrow point earlier. Desperation
shown by the previous buyers drags the price down in short term. Hence, the price level acts as a
resistance for near future.
Break-down
It is the phenomenon where the prices move downwards breaking an important Support level in the
process. Normally, a breakdown is supported by high volumes and it indicates a further downtrend in
that stock.

Break-out
It is the phenomenon where the prices move upwards out of range breaking an important Resistance
level in the process. Normally, a breakout is supported by high volumes and it indicates a further up
move in the stock.

Key Takeaways
 Support or Resistance represents a concentration of demand and supply sufficient to halt a
price move, at least temporarily.
 Potential Support/Resistance zones develop at previous high and lows, and close to Trend
lines and moving averages, emotional points on a chart and Fibonacci retracements.
 The strength or weakness of Support /Resistance zones is determined by how much buying
or selling interest will be required to break the level. With respect to the length of time for
 which a Support or Resistance level exists, the greater volume traded at any level, the
stronger that level will be.

Chapter 5 Volume Analysis For Stocks

Importance of Volume in Technical Analysis

“Price is the king but volume is the key”. Volumes lead prices. If prices start moving up on high
volumes, there is a very good chance that this rise will be sustained. However, it is very important to
understand where the volumes have occurred and where the price movement has taken place along
with the volumes.
Price Volume Effect

Rising Price Rising Volume Strongly bullish mom

Rising Price Falling Volume Unreliable or even be

Falling Price Rising Volume Strongly bearish mom

Falling Price Falling Volume Unreliable or even bu

Though the above is true and applicable in normal situations, there are some exceptions. For
instance, at extreme points, i.e. at times when prices have moved up sharply, and at lows when the
prices have fallen sharply, this logic may not work.

Volume Analysis on Stocks

Volume is the one of the most important parameters used in Technical Analysis. Volume provides
information of how many shares changed hands and at what price in a stock over a given time
frame, giving an indication of interest in the stock.
Since each stock is different, and has a different number of outstanding shares, volume should
always be compared to the historical volume of the stock in consideration to spot changes in volume
trend. Volume is also used to confirm price trends, breakouts, and spot potential reversals.
Using Volume to Analyze Stock Price Movements
Monitoring volume simultaneously can aid in analyzing stock price movements. There are three
primary ways volume is made use of in conjunction with price analysis: Confirming Trends, Spotting
Potential Price Reversals, and Confirming Price Breakouts.

Confirming Trends
Increasing volume shows conviction of buyers and sellers in either pushing the price up or down
respectively. For example, if the trend is up and volume increases as the price moves higher, it
shows buying interest and this is typically associated with larger moves to the upside going forward.

In the above chart, State Bank of India represents the above mentioned analysis as the volume
gradually increases as the price surges higher. If you have taken a bullish position, the rising volume
helps to confirm the uptrend. If you are short, the rising volume on the price rise tells you the price
could continue to trend higher and it may be time to exit your short position.
A trend can persist on declining volume for long periods of time, but typically declining volume with a
rise in prices indicates that the trend is weakening. For example, if the trend is up but the volumes
are steadily declining, it shows that there are only few traders who are driving the stock leading to a
rise in price without broader participation. Any larger selling pressure could lead to a reversal in the
uptrend leading to a sharp correction in the stock.
Volume should ideally be larger when the price is moving in the trending direction, and lower when
moving against the trend (pullbacks). This shows the movement in the trend direction is strong and
the pullbacks are weak, making the trend more likely to continue.

Spotting Price Reversal

For a trader to spot price reversal, identifying exhaustion move is important. Exhaustion move can
be defined as a scenario wherein a particular stock moves higher with lower volumes and reaches
its peak of its extended rally with maximum volumes i.e. 5x-10x of its average daily volume. This
could possibly indicate the end of current trend.
Example 1: In the chart above of Repco Home Finance, we can observe a classic example of an
exhaustion move, price hits an all time high with a huge spike in volumes, buyers get exhausted and
with few buyers left to push the price higher, we see a reversal in the trend of the stock in the
following days.
Example 2: In the chart below of Bharat Petroleum, we witness a sharp decline in price along with a
significant rise in volumes as the stock price hits its multi-week low, indicating an exhaustion of
sellers as majority of the ones who wanted to exit have exited this stock. And with few sellers left to
push the prices downwards, buyers took the upper hand stock leading to recovery in prices.

Confirming price breakouts

In a scenario, a particular stock has strong Support or Resistance levels, volumes can help to
confirm a breakout. If the price has struggled to get above a certain resistance point, a conviction of
buyers can be witnessed if the breakout is supported with larger volumes. Such breakout is likely to
be legitimate.

In the above example of CESC Ltd, we witness a breakout from the sideways consolidation pattern
on the daily chart backed by a steep surge in volumes. As the volumes increased with price
breaching above Resistance level, a possible bullish breakout can be expected.
A break above Resistance, or below Support, on lower volumes shows little conviction of the trade
leading to the failure of the breakout. A common problem in Technical Analysis is buying an upside
breakout, or selling a downside breakout, when volume doesn’t confirm it.
The chart above of Titan represents a false breakout. Assume that you had bought near the top of
this range at Rs 542 expecting the price to move to Rs 560 levels, which is the target derived from a
rectangle chart pattern breakout with a stop loss of Rs 525. In such a case, your bullish trade would
have resulted into a huge loss as the stop loss price of Rs 525 got triggered since the breakout was
not backed by strong volumes which provided a false signal, leading to a drop in price.

Confirming price pattern breakout

Price pattern breakout is similar to price breakout depending on volumes for confirmation.
In the above example of Ashok Leyland, we witness a cup and handle breakout backed by a rise in
volumes which give an added confirmation to the trader. The stock has managed to hit its target
price of Rs 110 which is derived from the cup and handle formation.

Key Takeaways
 Volume is used as a secondary indicator.
 Volume gives an indication of interest in a stock.
 Volume is also used to confirm price trends, breakouts, and spot potential reversals.

Chapter 6 Candlestick Patterns For

Stocks
Investors’ fear, greed and hope greatly influence stock prices. Candlestick analysis shows the
interaction between buyers and sellers. It offers a quick picture into the psychology of short term
trading; it studies the effect, not the cause. Therefore, combining candlestick with other technical
tools helps select entry and exit points.

Hammer

A Hammer is identified by a small real body, i.e. a small range between the opening and closing
prices, and a long lower shadow, where the low is significantly lower than the open, high, and close.
The body can be empty or filled-in. If the Candlestick occurs after a significant downtrend, it is a
bullish Candlestick, whereas if it occurs after a significant up- trend, it is called a ‘Hanging Man’.

Hammer Formation:

Piercing Line
This is a bullish pattern. The first Candlestick is a long black candle and the second candlestick is a
long white candle. The second candle opens lower than the first candles’ low, but it closes more than
halfway above the first candles’ real body.

Piercing line Formation:

Bullish Engulfing Lines

This pattern is strongly bullish if it occurs after a significant downtrend, i.e. it acts as a reversal
pattern. It occurs when a small bearish (filled-in) Candlestick is engulfed by a large (empty)
Candlestick.

This is a bullish pattern. The first Candlestick is a long black candle and the second candlestick is a
long white candle. The second candle opens lower than the first candles’ low, but it closes more than
halfway above the first candles’ real body.

Bullish Engulfing Formation

Morning Star

This is a bullish pattern, signifying a potential bottom. The “star” indicates a possible reversal and the
bullish (empty) Candlestick confirms this. The star can be empty or filled-in.

Morning Star Formation:

Evening Star

This is a bearish pattern, signifying a potential top. The “star” indicates a possible reversal and the
bearish (filled-in) Candlestick confirms this. The star can be empty or filled-in.
 

Hanging Man
These Candlesticks are bearish if they occur after a significant uptrend. If this pattern occurs after a
significant downtrend, it is called a Hammer. They are identified by small real bodies, i.e. a small
range between the open and closing prices, and a long lower shadow, i.e. the low was significantly
lower than the open, high, and close. The bodies can be empty or filled-in.

Hanging man Formation:

Dark Cloud Cover

This is a bearish pattern. The pattern is more significant, if the second candles’ body is below the
center of the previous candles’ body (as illustrated).
 

Bearish Engulfing Lines

This pattern is strongly bearish if it occurs after a significant up-trend, i.e. it acts as a reversal
pattern. It occurs when a small bullish (empty) candlestick is engulfed by a large bearish (filled-in)
candlestick.

Bearish Engulfing Formation:

Doji

This Candlestick implies indecision. It occurs when the security opened and closed at the same
price. These Candlesticks can appear in several different patterns.
 

Dragonfly Doji

This Candlestick also signifies a turning point. It occurs when the open and the close are the same,
and the low is significantly lower than the open, high, and closing prices.
 

Gravestone Doji

This Candlestick also signifies a turning point. It occurs when the open, close and low are the same
and the high is significantly higher than the open, low and closing prices.
 

Long-legged Doji
This Candlestick often signifies a turning point. It occurs when the open and close are the same, and
the range between the high and low is relatively large.
 

Long legged Doji Formation :

Doji Star

A star indicates a reversal and a Doji indicates indecision. Thus, this pattern usually indicates a
reversal, following an indecisive period. You should wait for a confirmation, for example, an evening
star illustration, before trading a Doji star.
 

Doji Star Formation:

Shooting Star

This pattern suggests a minor reversal when it appears after a rally. The star’s body must appear
near the low price and the candle should have a long upper shadow.
 

Harami

This pattern is usually seen as a reversal of the current trend. It occurs when a Candlestick with a
small body falls within the area of a larger body.
 

Bullish Harami Formation:

Key Takeaways
 Candlestick patterns form as reversal and continuation types.
 Adding volume to the Candlestick charting often brings out actionable technical
characteristics that are not always visible when volume and price are plotted separately.
 Candlestick charts provide a unique visual effect that helps display certain market
characteristics which are not easily identifiable on a bar or line chart

Chapter 7 Forecasting with Classic Chart

Patterns
Continuation Patterns
Continuation Patterns derive their name from the fact that they generally continue in the direction of
the trend. Symmetrical Triangles, Ascending & Descending Triangles, Rectangles and Flags &
Pennants are the most common Continuation Patterns.

Reversal Patterns
Reversal Patterns have a tendency of reversing the trend. These consolidation patterns can signal a
reversal in both uptrend as well as downtrend.

Head and Shoulder

The Head and Shoulder pattern is generally regarded as a Reversal Pattern.Volume is of great
importance in the Head and Shoulder pattern. Volume generally follows the higher price on the left
shoulder. However, the head is formed on diminished volume, indicating the buyers.aren't as
aggressive as they once were. On the last rallying attempt, the right shoulder-volume is even lighter
than on the head, signaling that the buyers may have exhausted themselves.

Head and Shoulder Formation:

Inverted Head and Shoulder
The Head and Shoulder pattern can sometimes be inverted.

Remember that:
 The inverted left shoulder should be accompanied by an increase in volume
 The inverted head should be made on lighter volume.
 The rally from the head, however, should show greater volume than the rally from the left
shoulder
 Ultimately, the inverted right shoulder should register the lightest volume of all.
 When the stock eventually rallies through the neckline, a big increase in volume should be
seen.

Inverted Head and Shoulder Formation:

Symmetrical Triangles
Symmetrical Triangles can be characterized as areas of indecision. A market pauses and future
direction is questioned. Typically, the forces of supply and demand at that moment are considered
nearly equal.

Remember that:
 Attempts to push higher are quickly met by selling, while dips are seen as bargains.
 Each new lower top and higher bottom becomes more shallow than the last, taking on the
shape of a sideways triangle. (It's interesting to note that there is a tendency for volume to
diminish during this period.)
 Eventually, this indecision is met with resolve and usually explodes out of this formation
(often on heavy volume.)

Symmetrical Triangle Formation:

Ascending Triangles
The Ascending Triangle is a variation of the symmetrical triangle. Ascending Triangles are generally
considered bullish and are most reliable when found in an up-trend. The top part of the Ascending
Triangle appears flat, while the bottom part of the Ascending Triangle has an upward slant.

Remember that:
 In Ascending Triangles, the stock becomes overbought and prices are turned back.
 Buying then re-enters the market and prices soon reach their old highs, where they are once
again turned back.
 Buying then resurfaces, although at a higher level than before.
 Prices eventually break through the old highs and are propelled even higher as new buying
comes in.

Ascending Triangles Formation:

Descending Triangles
The Descending Triangle, also a variation of the Symmetrical Triangle, is generally considered to be
bearish and is usually found in downtrends.

Unlike the Ascending Triangle, this time, the bottom part of the Descending Triangle appears flat.
The top part of the triangle has a downward slant.

Remember that:
 Prices drop to a point where they are oversold.
 Tentative buying comes in at the lows, and prices perk up.
 The higher price, however, attracts more sellers and prices re-test the old lows.
 Buyers then once again tentatively re-enter the market.
 The better prices though, once again, attract even more selling.
 Sellers are now in control and push through the old lows of this pattern.
 At the same time, the previous buyers rush to dump their positions.

Descending Triangles Formation:

Wedges
The Wedge formation is also similar to a Symmetrical Triangle in appearance, in that it has
converging trend lines that come together at an apex. However, Wedges are distinguished by a
noticeable slant, either to the upside or to the downside. As with triangles, volume should diminish
during its formation and increase on its resolve.

Remember that:
 A falling Wedge is generally considered bullish and is usually found in up-trends. However, it
can also be found in downtrends. The implication is still generally bullish. This pattern is
marked by a series of lower tops and lower bottoms.
 A rising Wedge is generally considered bearish and is usually found in downtrends. They
can be found in up trends too, but would still generally be regarded as bearish. Rising
Wedges put in a series of higher tops and higher bottoms.
Rising Wedge Breakdown:

Falling wedge Breakout:

Flags and Pennants

Flags and Pennants can be categorized as Continuation Patterns. They usually represent only brief
pauses in a dynamic stock. They are typically seen right after a big, quick move. The stock then
usually takes off again in the same direction. Research has shown that these patterns are some of
the most reliable Continuation Patterns.

Remember that:
 Unlike Wedges, their trend lines run parallel.
 "Bear" flags also have a tendency to slope against the trend. Their trend lines run parallel as
well.
  Pennants look very much like Symmetrical Triangles. However, Pennants are typically
smaller in size (volatility) and duration.
 Volume generally contracts during the pause with an increase on the breakout.

Flag Pattern Breakout:

Rectangles
A Rectangle chart pattern indicates sideways action. When the market enters in a congestion phase,
it is likely to break out in the direction of the preceding trend.If two horizontal lines surround a
retracement, it is a Rectangle chart pattern. Both the bullish and bearish Rectangle patterns look the
same. However, they appear in different trend context.

Remember that:
 The trend before the Rectangle chart pattern determines if the pattern is bullish or bearish.
 A Rectangle pattern continues the prior trend.
 Buy on break-out above the resistance line, or on pullback to the resistance line (now acting
as support), after the break-out.
 Sell on break-down below the support line, or on pullback to the support line (now acting as
resistance), after the break-down.
 Volume should increase when price breaks out of the resistance / support line

Rectangle Breakout:
Key takeaways
 Until a price pattern has been formed and completed, the assumption should be that the
prevailing trend is still operative.
 Price patterns can be formed over any time frame. The longer the time required toform a
pattern, the more substantial the ensuing price movement is likely to be.
 Measuring formulas can be derived for most type of patterns, but these are generally
minimum objectives. Prices usually extend much further.
 Price objectives represent the minimum ultimate target and are not normally achieved in one
move.

Chapter 8 Trading with Technical Indicators

Technical Indicators tell you when to buy or sell

A Technical Indicator is a mathematical formula applied to the security’s price, volume or open
interest. The result is a value that is used to anticipate future changes in prices.
A Technical Indicator is a series of data points derived by applying a formula to the price data of a
security. Price data includes any combination of the open, high, low or close over a period of time.
Some indicators may use only the closing prices, while others incorporate volume and open interest
into their formulas. The price data is entered into the formula and a data point for buy and sell is
produced.

Using Technical Indicators

Technical Indicators broadly serve three functions: to alert, to confirm and to predict. An Indicator
acts as an alert to study price action. Sometimes, Indicators signal to watch for a break of support. A
large positive divergence can act as an alert to watch for a Resistance breakout.
Technical Indicators can be used in combination with other Technical Analysis tools. Investors use
indicators to predict the direction of future prices.

Leading Indicators
These are designed to lead price movements. Benefits of leading indicators are: early signaling for
entry and exit points, generating signals and allowing opportunities to trade. Some of the popular
leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index
(RSI), Stochastic Oscillator and William’s % R.

Price Discounts Everything

Technical Analysis assumes 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.

Lagging Indicators
These are the indicators that would follow a trend rather than 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 trends following indicators make 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.

Moving Averages
Moving Average is a widely used Technical Indicator of stock prices that helps to smooth out the
volatility in the price action by filtering out the noise from random price fluctuations. A Moving
Average is a trend-follow Lagging Indicator as it is calculated taking past data into consideration.  As
its name suggests, a Moving Average is an average that moves as old values are dropped out as
new values become available. Moving Averages can be employed to identify the current trend in a
stock.

Types of Moving Averages

There are 3 types of Moving Averages
a) Simple Moving Average (SMA)
It is obtained by computing the simple average of price data over a defined period of time. In
general, we compute the Simple Moving Average based on the closing price of the security as it is
considered to have more significance as compared to the rest of price points (Namely open/high/low
price for the day). Thus, a 5-day SMA is calculated by adding the closing price of 5 days and dividing
this sum by the total number of days (in this case, five).
For example, the 5 days SMA of ITC is calculated as follows:
While calculating the Moving Average after the close of the trading session on July 7, 2017, we can
compute the SMA value by taking the closing price of the last 5 trading session, including July 7,
2017, and dividing the same by 5. At close of the next trading session on July 10, 2017, SMA is
calculated by excluding the Closing Price of July 3, 2017 by adding the new data point. (Closing
Price of July 10, 2017).
As illustrated in the example below, prices gradually decreases from 342.5 to 328.85 over a period
of eight days in the same timeframe the 5 Period SMA decreases from 336.44 to 332.79, indicating a
lag associated with the Moving Averages. Hence, larger the time period, larger is the lag.

Date Close Price 5P

03-Jul-17 342.5

04-Jul-17 337.25

05-Jul-17 331.05

06-Jul-17 337.10

07-Jul-17 334.30 33

10-Jul-17 333.30 33

11-Jul-17 330.40 33

12-Jul-17 328.85 33

7tH July SMA = 336.44 = (342.50+337.25+331.05+337.10+334.30)

10th July SMA = 334.6 = (337.25+331.05+337.10+334.30+333.30)

11th July SMA = 334.6 = (331.05+337.10+334.30+333.30+330.40)

12th July SMA = 332.89 = (337.10+334.30+333.30+330.40+328.85)

b) Weighted Moving Average (WMA)

Weighted Moving Average moves a step ahead from Simple Moving Average. Here, we assign a
weight to each value, with a bigger weight assigned to the most recent data points as they are more
relevant than historical data points. The sum of weights should add up to 1 (or 100%). As new data
points are added, the new weights will align accordingly. In contrast, in Simple Moving Average,
each value is assigned the same weight. Ideally, traders calculate WMA on the basis of closing
price.
The Weighted Moving Average is calculated by multiplying the given price by its assigned weight
and then dividing the sum by total number of days. The weights assigned are subjective in nature,
and it is based on the discretion of the trader. Because of its calculation methodology, WMA will
follow prices more closely than a corresponding SMA. The WMA reduces the lag effect to an extent.
ITC

Date Close Price Weights

03-Jul-17 342.5 0.07

04-Jul-17 337.25 0.13

05-Jul-17 331.05 0.20

06-Jul-17 337.10 0.27

07-Jul-17 334.30 0.33

10-Jul-17 333.30

11-Jul-17 330.40

12-Jul-17 328.85

7tH July SMA = 335.34 = (342.50*0.07+337.25*0.13+331.05*0.20+337.10*0.27+334.3*0.33)

10th July SMA = 334.29 = (337.25*0.07+331.05*0.13+337.10*0.20+334.3*0.27+333.3*0.33)

11th July SMA = 332.89 = (331.05*0.07+337.10*0.13+334.30*0.20+333.3*0.27+330.4*0.33)

12th July SMA = 331.43 = (337.1*0.07+334.30*0.13+333.30*0.20+330.4*0.27+328.85*0.33)

c) Exponential Moving Average (EMA)

Exponential Moving Average differs from the simple and weighted moving average as an EMA is
calculated by taking all the historical data points since the inception of the stock. Ideally, to calculate
100% accurate EMA, we should make use of all the closing prices right from the time of the listing of
stock.
Calculation of the EMA is a 3 step process
Step 1: Since it is not practical to calculate historical data right from the inception of the stock, we
use the SMA value as the initial EMA value. So, a Simple Moving Average is used as the previous
period's EMA in the first calculation.
Step 2: We calculate the weighting multiplier by dividing 2 by the sum of total periods and 1.
Step 3: We subtract the EMA of the previous day from the current closing price, and multiply this
number by the multiplier. We then add this product with its previous period EMA to find out the final
EMA value.
Therefore, the current EMA value will change depending on how much past data we use in our EMA
calculation. The more data points we use, the more accurate our EMA will be. The goal is to
maximize accuracy while minimizing calculation time.
Initial EMA value = 5-period SMA
Weighting Multiplier= (2 / (Time periods + 1)) = (2 / (5 + 1) ) = 0.3333 (33.33%)
EMA = {Close – EMA of previous day} x multiplier + EMA (previous day).
A 5-period EMA applies a 33.33% weighting to the most recent prices. A 10-period EMA has a
weighting multiplier of 18.18%. The shorter the time period, larger the weighting multiplier will be. We
notice that as the time period doubles, the weighting multiplier drops ~50%.

Date Close Price 5 Period SMA Weighting factor

03-Jul-17 342.5

04-Jul-17 337.25

05-Jul-17 331.05

06-Jul-17 337.10

07-Jul-17 334.30 336.44

10-Jul-17 333.30 334.60 0.3333

11-Jul-17 330.40 333.23 0.3333

12-Jul-17 328.85 332.793 0.3333

7tH July SMA = 336.44 = 5 Period SMA = 336.44

10tH July SMA= 335.39 = (333.30-336.44) x0.33 + 336.44

11tH July SMA = 333.73 = (330.40-335.39) x0.33 + 335.39

12tH July SMA = 336.44 = 5 Period SMA = 336.44

Comparison of the 3 Moving Averages

As we see by comparing the computation methodology of the 3 Moving Averages, different values
are generated. EMA is most commonly used by traders.

Moving SMA WMA

Averages

Advantages  1) Smoothened Average 1)Reduction in price lag, so can be implem

 2) Less prone to whipsaw short term trading
 3) Best average to consider for support &
resistance

Disadvantages  1) Has maximum price lag  1) Omission of previous data poin

 2) Assigns same weight to all price data. all price data not made use of
 3) Omission of previous data points leading to all  2) Chance of whipsaw
price data not made use of
Moving Average Value comparison – The following table represents a comparison between the
different values of the 3 types of Moving Averages over the same period of time

Date Close Price 5 Period SMA 5 Period WMA

03-Jul-17 342.5

04-Jul-17 337.25

05-Jul-17 331.05

06-Jul-17 337.10

07-Jul-17 334.30 336.44 335.34

10-Jul-17 333.30 334.60 334.29

11-Jul-17 330.40 333.23 332.89

12-Jul-17 328.85 332.89 331.43

Graphical comparison on the 3 moving averages.

(Blue-5 Period EMA, Green-5 Period WMA, Pink-5 Period SMA)
As we seen in the above graph, when there is a sharp correction in price as in the case of ITC, EMA
and WMA reacted the most since they are assigned a higher weight to the most recent prices as
compared to the SMA.

Applications of Moving Average

Trend Identification
Traders use moving averages to identify the trend in a stock. A rising 200day Moving Average
reflects that the long term trend is up and stock can be traded with a positive bias. Similarly, a falling
200day Moving Average reflects a long term downtrend and hence we can consider shorting the
stock or refraining from investing in it.

(Blue-10 Period EMA, Green -89 Period EMA, Pink 200 Period EMA)
From the above graph, we can clearly see that L&T Fin is in a long term uptrend, the short term and
medium term averages are trading above its long term, 200day Moving Average which is also
showing an upward momentum. A price dip towards its medium term average can be considered as
a buying opportunity.

Buy/Sell signals based on crossover

A buy signal is generated when a bullish crossover occurs i.e. the short term Moving Average
crosses the long term Moving Average, popularly referred to as a golden cross. For example, when
the 89day EMA crosses above the 200day EMA, a bullish trade can be initiated. On the other hand,
a bearish dead cross occurs when the short term Moving Average crosses below the long term
moving average. The signals generated tend to occur with a lag as we make use of 2 Lagging
Indicators. The best trading opportunities are obtained in a trending market as compared to the
sideways market wherein whipsaws or false signals are generated.

Price 89 Period EMA Acti

Trading Above 200EMA Crosses above 200EMA Bul

Trading Below 200EMA Crosses below 200EMA Bea

From the above graph we see how moving averages can be used to generate trading signals
Moving Averages can also be used to generate signals with simple price crossovers. A bullish signal
is generated when prices move above the Moving Average. A bearish signal is generated when
prices move below the Moving Average. Advantage of price signals is that the time lag is reduced
and traders are able to react at an early stage.
As in the Fortis Ltd case shown above, traders could have initiated a short position or could have
closed their long positions when the stock price closed below its 200day EMA. Consequently, a huge
surge in trading volumes with MACD Histogram getting into the negative territory indicated a change
in momentum which gave added information to traders to take a bearish view, resulting in a fall in
stock price by 18%.

Support & Resistance Levels

Moving Averages also tend to act as support and resistance levels. A stock in a long term uptrend
could find support near its medium term EMA during a pullback, similarly a stock in a long term
downtrend could face resistance near is medium term moving average during any bounce back. In
fact, some moving averages may offer support or resistance simply because it is widely used by
many traders. As an example, a trader may not short a stock if it is trading near its 200day EMA
because of the fear that other traders may be using it as a buying zone.

In the above example of JSW Steel, we see how the stock has taken support along its medium term
89day EMA on multiple occasions and has acted as a good support level to purchase the stock.
Moving Averages in sync with Candlestick pattern

Moving averages can also be traded in tandem with candlestick patterns. In the above chart of Bata
India Ltd, the bullish candlestick pattern can be traded with added confidence as it coincides with the
support of 200day EMA.

In the above chart of United Spirits Ltd, the buy signal generated by the bullish crossover coincides
with a cup and handle breakout on the daily chart, affirming a bullish bias in the stock.

Difference between technical and fundamental analysis

Moving averages are used based on trading horizon.

Moving Average Trading Time frame

5 period MA Short term

13 period MA Short term

50 period MA Medium Term

89period MA Medium Term

200 period MA Long Term

Observations on Moving Average

 It is used in a trending market to give clear trend direction by eliminating the noise.
  In case of a sideways market, Moving Average would lead to whipsaws making the use of
other indicators like RSI and Stochastic more helpful.
 Signals generated by moving averages tend to have a lag.
 It is used best when combined with technical indicators and price patterns.

Bollinger Bands
Bollinger bands, created by John Bollinger, are a Trending Indicator that can show you not only in
what direction the stock price is going, but also how volatile the price movement of the stock is.
Bollinger bands consist of two bands—an upper band and a lower band—and a Moving Average
and are generally plotted on top of the price movement of a chart.

How Bollinger bands are constructed?

Bollinger bands are typically based on a 20-period Moving Average. This Moving Average runs
through the middle of the two bands. The upper band is plotted two standard deviations above the
20-period moving average. The lower band is plotted two standard deviations below the 20-period
moving average.
A standard deviation is a statistical term that measures how far various closing prices diverge from
the average closing price. Therefore 20-period Bollinger bands tell you how wide, or volatile, the
range of closing prices has been. The more volatile the stock price, the wider the bands will be. The
less volatile the stock price, the narrower the bands will be.

Bollinger band trading signal

Entry signal—when the bands widen and begin moving in opposite directions after a period of
consolidation, you can enter the trade in the direction the price was moving when the bands began
to widen.
Exit Signal- when the bands narrow the price of the stock moved away from the breakout turns and
starts moving back toward the current price of the stock set a trailing stop loss to take you out of the
trade if the trend reverses.
Exit Signal- when the bands narrow the price of the stock moved away from the breakout turns and
starts moving back toward the current price of the stock set a trailing stop loss to take you out of the
trade if the trend reverses.
Bollinger band example:

Benefits of Bollinger bands

 They help you identify price trend.
 They identify current market volatility.
Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) is an oscillating indicator that shows you
when trading momentum changes from bullish to bearish and vise versa. The MACD can also show
you when traders are becoming over-extended, which usually results in a trend reversal for the stock
price.
The MACD is usually plotted below the price movement on a chart.

How the MACD is constructed

The Moving Average Convergence Divergence is constructed based on a series of moving averages
and how they relate to one another. The standard MACD looks at the relationship between a stock
price 12-period and 26-period Exponential Moving Average. If the 12-period Moving Average is
above the 26-period Moving Average, the MACD line will be positive. If the 12-period Moving
Average is below the 26-period Moving Average, the MACD line will be negative.
The MACD line is accompanied by a trigger line. This line is a 9-period exponential moving average
of the MACD line.

MACD trading signal

Entry signal—When the MACD crosses above the trigger line, you can buy the stock price knowing
that momentum has shifted from being bearish to being bullish.
Exit signal—When the MACD crosses below the trigger line, you can sell the stock price knowing
that momentum has shifted from being bullish to being bearish.

Benefits of MACD
 They help you identify price trend.
 They identify current market volatility.
MACD example:

Slow Stochastic
The Slow Stochastic is an oscillating indicator developed by George Lane that can show you when
investor sentiment changes from being bullish to bearish and from being bearish to bullish. The Slow
Stochastic can also show you when trades are being over-extended, which usually results in a trend
reversal for the stock price.

How the Slow Stochastic is constructed

The Slow Stochastic consists of two lines—%K and %D—that oscillate in a range between 0 and
100.
%K is constructed based on where the current closing price of a stock is in relation to the range of
closing prices for that same stock price in the past. %D is a moving average of %K.
If the closing price of the stock price is near the top of the range of past closing prices, the %K line
(followed by the %D line) will move higher.
If the closing price of the stock price is near the bottom of the range of past closing prices, the %K
line (followed by the %D line) will move lower.

Slow Stochastic trading signal

The Slow Stochastic produces trading signals as it crosses in and out of its upper and lower reversal
zones. The upper reversal zone is the area of the indicator that is above 80. The lower reversal zone
is the area of the indicator that is below 20. When %K is above 80, it shows the stock price may be
overbought and may be reversing trend shortly. When %K is below 20, it shows the stock price may
be oversold and may be reversing trend shortly.
Entry signal—when %K crosses from above 80 to below 80, you can sell the stock price knowing
that investor sentiment toward the stock price has shifted from being bullish to being bearish.
When %K crosses from below 20 to above 20, you can buy the stock price knowing that investor
sentiment toward the stock price has shifted from being bearish to being bullish.
Exit signal—when %K reverses direction after having crossed either above 20 or below 80 and
crosses over %D, you can exit your trade knowing that investor sentiment is changing direction
again.
Slow Stochastic Example

Benefits of the Slow Stochastic

 It helps you identify when investor sentiment towards the specific stock changes
 It helps confirm the strength of current trends

Retracement
It is the correction that occurs in the price of a share.

Market trend Retracement will be in

 Falling upward direction

Rising downward direction

Normally, it is seen 38.2%, 50% and 61.8% are good retracement levels and the markets have a
tendency to take support in case of an uptrend and face resistance in case of a downtrend at or
around these levels.
These levels also give an indication of the current trend or a likely change in the same. Although the
retracement levels work more often than not, there could be times where prices may move beyond
the normal retracement levels.

Retracement Example

Stop Loss
Stop loss can be defined as an advance order to sell an asset when it reaches a particular price
point. Stop loss is used to limit loss or gain in a trade. The concept can be used for short-term as
well as long-term trading. It is used so that the trader does not suffer unlimited losses.
Key takeaways
 Technical Indicators broadly serve three functions: to alert, to confirm and to predict.
 Technical Indicators are of two types leading and lagging.
 Capital gains from equity funds and debt funds are considered long-term if the investment
horizon if more than 1 year and 3 years respectively.
 Moving Averages and the MACD are examples of lagging indicators.
 There are 3 types of moving averages: SMA, WMA, EMA.
 Bollinger bands expand and contract based on the volatility in a scrip
 MACD is used to indicate change in trading momentum from bullish to bearish and vice
versa.

Chapter 9 Limitations of Technical

Analysis

Limitations of Technical Analysis

Technical Indicators tend to give mixed signals in some cases if they are used in isolation. In such a
scenario, one indicator could show a buy signal, while the other could show a sell signal. This could
confuse traders. To overcome such issues, traders generally use a combination of indicators,
patterns, volume signals and moving averages to determine entry and exit signals.
Technical Analysis is all about probability. For instance, when a possible entry or exit is determined
for a scrip, the signal does not guarantee a successful trade. The trade could end up in a loss even
after thorough analysis.
Biased view: Two technical analysts may have contradicting views regarding the same stock; the
technical methods used for analysis could vary from one analyst to another.
Many times, the technical signals generated tend to have a lag, and by the time a clear signal is
generated the price action could already be over.
As more and more people employ technical analysis and end up having a similar view, the value of
such analysis tends to decline.
Random walk hypothesis casts its shadow over the validity of Technical Analysis.
A single trading strategy may not work in all scenarios as markets tend to be extremely dynamic.

Chapter 1 Introduction to Candlestick

Candlestick
Candlesticks are the most popular chart choice among traders as compared to line chart, bar chart
and the point & figure chart. It has gained popularity among the traders as it conveys wide range of
trading information in one go in a highly visual way. Candlestick charts are also simple to read and
interpret. It consists of a body (rectangle part of the candle) and shadow or wicks (lines above or
below the body). Each candlestick also consists of an open, high, low and close price. The trader
based on his trading horizon sets the time frame of the candlestick chart.

Interpreting Candlestick Chart

Open - The open is the first price traded and is indicated by either the top or bottom of the body of
the candlestick.
High - The high is the highest price traded during the time period set for the candlestick, and is
indicated by the top of the shadow that occurs above the body (called the upper shadow).The high
price could be the open, close or a high hit within the time frame of the candle. If the open was the
highest price then there will be no upper shadow.
Low - The low is the lowest price traded during the candlestick, and is indicated by the bottom of the
shadow that occurs below the body (called the lower shadow).The low could also be one of the three
prices open, close or a low price hit within the time frame of the candle .If the open was the lowest
price then there will be no lower shadow.
The color of a candlestick is based on whether the closing price (or the last traded price, if the
candlestick is incomplete) is above (green) or below (red) the opening price. While the candlestick is
the process of formation, the candlestick could constantly alter as the price fluctuates. The open
remains fixed, but the rest of the parameter i.e. high, low and close could constantly change. When
the time period of the candle comes to an end the last traded price is taken as the closing price, after
which a new candlestick is formed which continues to convey the price movement over the next time
segment.
Close - The close is the last price traded during the candlestick, and is indicated by either the top or
bottom of the body.
Range - The price difference between the upper and lower shadow indicates the range the price
moved during the time frame set for the candlestick. It is calculated by subtracting the high from the
low of the candlestick. Range indicates the volatility associated with the candlestick. Higher the
range, higher is the volatility and vice versa. (Range = High - Low).
Interpreting candlesticks charts is one of the very first steps in learning how to trade. Once a trader
has gained knowledge to interpret a chart he can then move on to the other aspects of technical
analysis and develop trading strategies as per his needs.

Use of Candlesticks
Candlesticks tend to form patterns which are interpreted by traders to indentify a continuation or
reversal of the existing trend. It is also used to spot short term trading opportunities. Different traders
make use of candlestick charts differently. Candlestick patterns should be used in conjunction with
the prevailing trend.
Candlestick also tends to act as a unique leading indicator providing the trader an edge while
entering and exiting a trade. It also gives an early signal of a reversal in trend compared to the rest
of the technical indicators. Hence it is widely used in short term trading and in volatile markets.
Candlestick compliments most of the other technical analysis indicators and works well with the
western technical tools.
Candlestick patters also tend to act as support or resistance levels and indicate the start of a
pullback or bounce.

Time frame
Most candlestick patterns form over a period of 1-3 days, which makes them short-term patterns that
are valid for 10-15 trading sessions. For example hammers and hanging man require just one day.
Engulfing patterns, bullish belt hold and dark cloud cover patterns require two days. Three white
soldier and evening stars require three days for the pattern to complete.

Preceding Trend
Candlestick patterns gain significance based on their location within the trend, a reversal candlestick
pattern has validity only if it is formed at the end of the current trend i.e. there should be a prior trend
to reverse. Bullish reversals require a preceding downtrend while a bearish reversal requires a prior
uptrend. The direction of the trend can be determined using trend lines, moving averages,
peak/trough analysis or other aspects of technical analysis.

Tussle between bulls and bears.

Candlestick depicts the fight between the bulls and bears over the set time period.
 Long green candlestick indicates that the trading session was controlled by the buyer’s i.e.
bulls.
 Long red candlestick indicated that the trading session was controlled by the seller’s i.e.
bears.
 A long lower shadow indicates the bears controlled the price until the bulls took control and
made a strong comeback.
 A long upper shadow indicates that the bulls controlled prices until the bears made an
impressive comeback and took control.
 Small candlestick indicates that neither the bulls nor bears could gain control over prices
during the session.
 A long upper and lower shadow indicates a volatile trading session with both the bulls and
bears having gained control but unable to sustain the advantage.

Color of Candlesticks
The color of the candlestick depends on the preference of the trader. The commonly used
combinations are

+ ve Day (Open Higher than close) -ve Day (Close lowe

Green Red

Blue Red

Hollow Filled
 Chapter 2 Candlestick Patterns

Candlestick Patterns
Bullish Patterns

1) Bullish Hammer
Definition
This pattern occurs at the bottom of a trend or during a downtrend. It is a single candlestick pattern
that has a long lower shadow and a small body at the top of its trading range.

Identification Criteria
 The market is characterized by an existing downtrend.
 A small body at the upper end of the trading range is observed. The color of the body is not
important.
 The lower shadow of this candlestick is at least twice as long as the body.
 There is (almost) no upper shadow.

Candlestick Pattern Interpretation

The Bullish Hammer appears in a downtrend, a sharp selloff is witnessed during trade. After the
decline comes to an end, price almost returns to the high of the day. Market fails to continue on the
selling side. This price movement reduces the previous bearish sentiment causing short traders to
feel increasingly uneasy with their bearish positions. If the body of the Hammer is blue, then the
situation looks even better for the bulls.
Buy/Stop Loss Levels
The confirmation level is defined as the top of the Hammer’s body. Prices should cross above this
level for a buy signal to be initiated. The stop loss level is defined as the low of the candlestick
pattern.
2) Bullish Belt Hold
Definition
Bullish Belt Hold is a single candlestick pattern, basically, a blue Opening Marubozu (long
candlestick with no lower shadow) occurs in a downtrend. It opens at the low of the day, and then
rallies against the current trend in the market to close near the high.

Identification Criteria
 The market is characterized by an existing downtrend.
 The market gaps down and opens at its low, and closes near the high of the day.
 A long blue body that has no lower shadow is observed.

Candlestick Pattern Interpretation

The market opens lower with a significant gap in the direction of the existing downtrend. However,
soon after the market opening, sentiment changes rapidly and the market moves in the opposite
direction from there on. This causes fear among traders who have short positions, leading to the
covering of short positions, which further aids the rally in the market.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for buy signal
to be generated. The stop loss level is defined as the low of the candlestick pattern.
3) Bullish Engulfing
Definition
This pattern is characterized by a large blue body engulfing a prior smaller red body, which appears
during a downtrend. The blue body does not have to engulf the shadows of the prior candle but it
totally engulfs the body.

Identification Criteria
 The market is characterized by an existing downtrend.
 A red body is observed on the first day.
 The blue body is formed on the second day completely engulfing the red body of the prior
day.

Candlestick Pattern Interpretation

While the market is characterized by a downtrend, selling is observed with the occurrence of a red
body on the first day but with light volumes. The next day, the market opens lower. It looks as if
there’s going to be a continuation of the bearish trend, however the selling pressure loses
momentum and the bulls gain control during the day. The buying force overcomes the selling force
and in the end markets manages to close above the open of the prior day.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. A buy signal is generated when prices move
above the second candles close. The stop loss is defined as the low of the candlestick pattern.
4) Bullish Harami
Definition
This pattern consists of a large red body on the first day followed by a small blue body the next day
that is completely inside the range of the red body. It tends to act as a reversal pattern.

Identification Criteria
 The market is characterized by an existing downtrend.
 A red candlestick is observed on the first day.
 The blue body that is formed on the second day is completely engulfed by the body of the
first day.

Candlestick Pattern Interpretation

The market is characterized by a downtrend and a bearish mood, and there is heavy selling reflected
by a red body. The next day prices open higher or at the close of the preceding day and steadily
rises bringing a sense of fear among the short sellers. This leads to the covering of short positions,
causing the price to rise further. Some short sellers however still expect the market to correct and
continue shorting thus limiting the rise. Hence, a small blue body is formed. This may signal a trend
reversal since the second day’s small real body shows that the bearish power is diminishing.

Buy/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first red body, whichever is
higher. Prices should cross above this level for a buy signal to be generated. The stop loss level is
defined as the lowest point among the two candles.
5) Bullish Doji Star
Definition
It consists of a red candlestick followed by a Doji with a downward gap at the opening the next day.
This pattern appears in a downtrend and indicates that the trend will reverse.

Identification Criteria
 The market is characterized by an existing downtrend.
 On the first day a red candlestick is observed.
 Then we observe a Doji on the second day that gaps down.

Candlestick Pattern Interpretation

The market is in a downtrend and a large red candlestick further confirms it. The next day markets
opens lower with a gap down, and trades in a small range. The closing price and opening price are
similar, causing the formation of a Doji. Bearish sentiment was prevalent during the downtrend but
now a change is implied by the formation of a Doji Star, which shows that the bulls and the bears are
in equal control. The bearish sentiment has reduced. It is not favorable to further short at current
levels.

Buy/Stop Loss Levels

The confirmation level is defined as the midpoint of the gap between the Doji and the prior day’s
candlestick. Prices should cross above this level for a buy signal to be generated. The stop loss level
is defined as the lowest point among the two candles.
6) Bullish Morning Star
Definition
This is a three-candlestick pattern indicating a bottom reversal. It is composed of a red candlestick
followed by a short candlestick, which opens lower to form a star. The following day we have a blue
candlestick whose closing price is well into the first session’s red body.

Identification Criteria
 The market is characterized by an existing downtrend.
 We observe a red candlestick on the first day.
 Then, we see a short candlestick on the second day that gaps in the direction of the
prevailing downtrend.
 A blue candlestick is witnessed on the third day.

Candlestick Pattern Interpretation

A downtrend is in progress and the formation of a red candlestick on the first day confirms the
continuation of the downward trend. The appearance of the short candlestick with a gap the
following day indicates that bears are still pushing down the price. However, the narrow price
movement on the second day indicates indecision. The third day is a blue body candlestick where
price closes well into the first day’s red body. Indicating a reversal in trend.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy
signal to be generated. The stop loss level is defined as the lowest point in the candlestick pattern
formation.
7) Bullish Morning Doji Star
Definition
This is a three candlestick pattern signaling bottom reversal. It is composed of a red candlestick
followed by a Doji, which usually gaps down to form a Doji Star. On the third day, we have a blue
candlestick whose closing price is well into the first session’s real body.

Identification Criteria
 The market is characterized by an existing downtrend.
 We observe a red candlestick on the first day.
 Then, we see a Doji with a gap down on the second day.
 A blue candlestick is observed on the third day.

Candlestick Pattern Interpretation

A downtrend is in progress, and the red candlestick on the first day confirms this. The appearance of
the Doji with a gap indicates that bears are still in control. However, the narrow price action between
the open and the close shows indecision. On the third day, the body of the blue candlestick is above
the previous day, and closes well into the body of the red day.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy
signal to be generated. The stop loss level is defined as the lowest point of the candlestick pattern
formation.
8) Bullish Piercing Line
Definition
This is a bottom reversal pattern with two candlesticks. A red candlestick appears on the first day
while a downtrend is in progress. The second day opens gap down at a new low but manages to
closes more than halfway into the prior candlestick’s red body, leading to the formation of a strong
blue candlestick.

Identification Criteria
 The market is characterized by an existing downtrend.
 A red candlestick appears on the first day.
 On the second day we witnesses a gap down opening but the candlestick manages to close
more than halfway into the body of the first red candle

Candlestick Pattern Interpretation

The market is currently in a downtrend. The first red body reinforces this view. The next day the
market opens gap down, showing that the bearishness still persists. After this very bearish open,
bulls take charge. The market surges toward the end of the session, resulting in a close way above
the previous day’s close. A sense of fear develops among the short sellers who consider covering
their position resulting in a further surge in prices.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for a buy
signal to be generated. The stop loss level is defined as the lowest point of the candlestick pattern
formation
9) Bullish Three White Soldiers
Definition
This pattern indicates a bottom reversal in the market. It is characterized by three blue body
candlesticks moving upwards. The opening of each day is slightly lower than previous close and
prices progressively close at higher levels.

Recognition Criteria
 The market is characterized by an existing downtrend.
 Three consecutive slightly long blue candlesticks are observed.
 Each candlestick opens within the body of the previous day.
 Candlesticks progressively close at new highs, above the previous day.

Candlestick Pattern Interpretation

The pattern appears in a prevailing downtrend where price are testing new lows or is already at the
bottom. Then we see the first blue candlestick which makes an attempt to move upwards. The trend
persists for the next two days progressively making new highs at the close. This brings about a
sense of fear among the bears who now consider closing their short positions leading prices to head
further.

Buy/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross above this level for
confirmation. The stop loss level is defined as the lowest point of the candlestick pattern formation
Bearish Candlestick Patterns

1) Bearish Hanging Man

Definition
This pattern occurs at the top of a trend or during an uptrend. It is a single candlestick pattern which
has a long lower shadow and a small body at or very close to the top of its daily trading range. The
name Hanging Man comes from the fact that the candlestick looks somewhat like a hanging man.

Identification Criteria
 The market is characterized by an existing uptrend.
 A small real body at the upper end of the trading range is observed. The color of the body is
not important. The length of the lower shadow is at least twice as long as the body.
 There is (almost) no upper shadow.

Candlestick Pattern Interpretation

The Hanging Man is a bearish reversal pattern. It signals a top for the market or a resistance level.
Since the pattern is observed after an advance, it signals that selling pressure is starting to increase.
The long lower shadow indicates that the bear’s pushed prices lower during the session. Even
though the bulls regained control and drove prices higher towards the close, the appearance of this
selling pressure after a rally is hint of a correction. If the body is red, it indicates that the close was
not able to get back to the opening price level, which has potentially more bearish implications.

Sell/Stop Loss Levels

The confirmation level is defined as the midpoint of Hanging Man’s lower shadow. Prices should
cross below this level for a sell signal to be generated. The stop loss level is defined as the high
point of the candlestick pattern formation.
2) Bearish Belt Hold
Definition
Bearish Belt Hold is a single candlestick pattern, basically, a red Marubozu that occurs in an
uptrend. It opens at the high of the day, and then prices begin to fall during the day against the
overall trend of the market, eventually closing near the low.

Recognition Criteria
 The market is characterized by an existing uptrend.
 The market gaps up and opens at its high, only to closes near to the low of the day.
 A long red body that has no upper shadow.

Candlestick Pattern Interpretation

The market opens higher, with a gap in the direction of the prevailing uptrend. However, after the
market opening, things change rapidly and the market moves in the opposite direction from there on.
This brings about a sense of fear among the bulls, leading them to close their position which tends to
accentuate the selloff.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell
signal to be generated. The stop loss level is defined as the high point of the candlestick pattern
formation.
3) Bearish Engulfing
Definition
This pattern is characterized by a large red body engulfing the prior day’s smaller blue body, which
appears during an uptrend. The red body does not necessarily engulf the shadows of the blue
candle but totally engulfs its body.

Recognition Criteria
 The market is characterized by an existing uptrend.
 A blue body is observed on the first day.
 The red body that is formed on the second day completely engulfs the white body of the
preceding day.

Candlestick Pattern Interpretation

While the market is characterized by a preexisting uptrend, buying on low volumes is observed on
the occurrence of a blue candlestick on the first day. The next day, the market opens gap up at new
highs. It looks as if the bullish uptrend would continue, however the uptrend soon loses momentum
and the bears take charge during the day. The selling pressure overcomes buying and finally the
market closes below the open of the previous day. Indicating a reversal in trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should move below this level for a sell
signal to be generated. The stop loss level is defined as the high point of the candlestick pattern
formation.
4) Bearish Harami
Definition
This pattern consists of a blue body followed by a small red body candlestick that is completely
inside the range of the blue body.

Recognition Criteria
 The market is characterized by an existing uptrend.
 A blue body is observed on the first day.
 The red body that is formed on the second day that is completely engulfed inside body of the
first day candlestick.

Candlestick Pattern Interpretation

The market is characterized by an uptrend and there is heavy buying interest indicated by a blue
body, which further supports the bullishness. However, the next day prices open lower or at the
close of the preceding day and trades in a small range throughout the day, closing even lower, but
still within the prior day’s body. The bulls now begin to doubt the strength of the market, due to this
suddenly deteriorating trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first blue body, whichever is
lower. Prices should cross below this level for a sell signal to be generated. The high point of the
candlestick pattern formation is considered as the stop loss level.
5) Bearish Harami Cross
Definition
This is a major bearish reversal pattern; the pattern is characterized by a blue body followed by a
Doji that is completely inside the range of the prior white body.

Recognition Criteria
 The market is characterized by a prevailing uptrend.
 A white body is observed on the first day.
 The Doji that is formed on the second day is completely engulfed by the body of the first day.

Candlestick Pattern Interpretation

A bullish trend prevails in the market, and the bulls are firmly in control. The first day’s candlestick is
a blue body, which further supports the uptrend. But the next day, prices open lower than the close
or at the close of the prior day and manage to close at the price it opened. This implies a complete
lack of decision, and brings about a sense of fear among the bulls.

Sell/Stop Loss Levels

The confirmation level is defined as the last close or the midpoint of the first blue body, whichever is
lower. Prices should cross below this level for a sell signal to be generated. The high point of the
candlestick pattern formation is considered as the stop loss level.
6) Bearish Shooting Star
Definition
This pattern consists of a blue body followed by an Inverted Hammer that is characterized by a long
upper shadow and a small body. It is similar in shape to the Bullish Inverted Hammer pattern but
unlike it, the Shooting Star appears in an uptrend and signals a bearish reversal.

Recognition Criteria
 The market is characterized by an existing uptrend.
 The first day of the pattern is a blue candlestick.
 On the second day, a small body is observed at the lower end of the trading range. Color of
this body is not important.
 The upper shadow of the candlestick on the second day should be at least twice as long as
the body.
 There is (almost) no lower shadow.

Candlestick Pattern Interpretation

The pattern occurs in a bullish uptrend and the blue candlestick that appears on the first day further
supports the bullishness. On the second day, in which an Inverted Hammer is formed, market opens
at or near the day’s low. Then buying interest is witnessed leading to a rally. However, the bulls are
not able to succeed in sustaining the rally during the rest of the day and prices ultimately close either
at or near the low of the day. The price action generates a sense of discomfort among the bulls.

Sell/Stop Loss Levels

The confirmation level is defined as the low of the Inverted Hammer’s body. Prices should cross
below this level for a sell signal to be generated. The high point of the candlestick pattern formation
is considered as the stop loss level.

7) Bearish Dark Cloud Cover

Definition
This is a top reversal pattern with two candlesticks. A blue candlestick appears on the first day while
an uptrend is in progress. The second day opens at a new high, with a gap up and closes more than
halfway into the prior blue body, leading to the formation of a strong red candlestick.

Recognition Criteria
 The market is characterized by an existing uptrend.
 A blue candlestick is observed on the first day.
 A red candlestick opens on the second day with a gap up and closes more than halfway into
the body of the first day.
 The second day fails to close below the body of the first day.

Candlestick Pattern Interpretation

The market is currently in an uptrend. The blue body on the first day reinforces this view. The next
day the market opens higher via a gap, after this bullish gap up the bears decide to take charge. The
market witness a correction and prices start to go down resulting in a close way below the previous
day’s close. At this stage the bulls decide to close their position as a sense of fear sets in. Looking at
the correction in price short sellers consider to take fresh positions resulting in a reversal in trend.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell
signal to be generated. The high point of the candlestick pattern formation is considered as the stop
loss level.
8) Bearish Three Black Crows
Definition
Three black crows indicate a topping out pattern in the market. It is characterized by three red
candlesticks moving downwards. The opening of each day is slightly higher than previous close and
prices progressively close at lower levels.

Recognition Criteria
 The market is characterized by an existing uptrend.
 Three consecutive slightly long red candlesticks are observed.
 Each candlestick opens within the body of the previous day.
 Candlesticks progressively close at new lows, below the preceding day.

Candlestick Pattern Interpretation

The pattern appears in a prevailing uptrend where the market is testing new highs or is already at
the top. Then we observe the first red candlestick which makes an attempt to move downwards. The
downward correction persists for the next two days progressively making new lows at the close. This
brings a sense of fear among the bulls who now consider closing their long positions leading causing
prices to head lower.

Sell/Stop Loss Levels

The confirmation level is defined as the last close. Prices should cross below this level for a sell
signal to be generated. The high point of the candlestick pattern formation is considered as the stop
loss level.
 Chapter 1 Chart Pattern Breakouts

Breakouts
A breakout is defined as price movement above or below a predefined level. A breakout backed by a
surge in volumes is considered to be more reliable to act upon. A trader trading on the basis of
breakouts would consider entering a long position once price moves above a resistance level or
would consider a short position after price falls below a support level.
The reason chart pattern breakouts have gained popularity is because they are easy to identify,
frequent in occurrence and are the starting point for a major reversal in trend or continuation
accompanied by a surge in volatility.
Most of the results obtained with technical analysis procedures do not indicate the eventual
magnitude of a trend but chart patterns tend to act as an exception, since their formation provides
the technical analyst with limited forecasting abilities.
Chart patterns can be over any time frame – intraday, daily, weekly and monthly. In the following
section we cover some of the common chart patterns which tend to witness a spike in prices after a
breakout.
Chart Patterns are broadly classified into two categories: continuation and reversal patterns

Continuation Chart Patterns

1. Pennant

Pennant is a short-term continuation pattern. It is created when there is significant price movement
in the stock, i.e. strong volume rally on the back of positive fundamental development followed by
several days of narrowing price consolidation in the stock on light volumes. Finally a fresh breakout
is observed in the direction of the prevailing trend with a surge in volumes once again. The duration
of the pattern is usually a few weeks. The pennant is in effect a very small triangle.
The technical price target for a pennant is arrived at by computing the height of the flag pole and
adding it to the eventual breakout point after consolidation.
Characteristics of a pennant
 Prior Trend: To be considered a continuation pattern there should be evidence of a prior
trend in existence.
 Sharp Move: The first leg of the pennants is characterized by a sharp surge in price in the
direction of the current trend.
 Pole: The pole is the distance from the first resistance or support breakout level to the high of
the pennant. The pole should ideally break a trend line or resistance level.
 Pennant: A pennant is a small symmetrical triangle that begins wide and tends to converge
as the pattern develops. Prices tend to consolidate during this phase.
  Time frame: Pennants are short term continuation patterns that usually last from 1-8 weeks.
Pennants that tend to take a longer duration are classified as symmetrical triangle.
 Breakout: The breakout tends to occur in the direction of the prevailing trend. A break above
resistance indicates that the previous up trend has resumed.
 Volume: Heavy volume is observed during the formation of the pole and at the time of
breakout. Volume tends to add credibility to the pattern.

In the above chart of Lakshmi Machine Works, we observe a pennant chart pattern. A swift surge in
prices is observed on the back of positive fundamental development; prices then tend to consolidate
within the triangle before eventually giving a breakout near the apex of the triangle. A bullish trade
can be initiated once we get a breakout.

2. Cup and Handle

Cup and handle is a bullish continuation pattern where an uptrend has paused, but will resume once
the pattern witnesses a breakout. To qualify as a continuation pattern, a prior trend should be in
existence. The pattern derives its name from the clearly visible patter it forms on the chart. The cup
is a curved U-shaped formation with the handle which is formed on the right hand side. The handle
tends to have a slight downward slope. The pattern is a long term chart pattern which in some
instances could take even more than an year to form.
The technical target for a cup and handle pattern is arrived at by computing the depth of the cup
formation and adding it to the breakout point.
Characteristics of a Cup and Handle Pattern
 Cup: The cup tends to be U shaped and tends to resemble a rounding bottom.
 Handle: After the cup has been formed, there tends to be a pullback in prices that forms the
handle. Sometimes this handle resembles a flag or pennant having a downward slope; other
times just a short pullback. The handle represents the final consolidation/pullback before the
breakout occurs and can retrace up to 1/3 of the cup's advance. The smaller the retracement
is, the more bullish the formation and higher the chances of a major breakout. If the pattern
is going to fail, the signal to look for is a break below the lower part of the handle.
 Duration: The cup can extend from 1 to 6 months, sometimes longer on weekly charts. The
handle can be from 1 week to many weeks and ideally completes within 1-4 weeks.
 Volume: Ideally there should be a substantial increase in volume at the time of breakout
above the handle’s resistance. Expansion in volume leads to the added confirmation.
In the above chart of Eveready Industries we witness a cup and handle formation, it tends to act as a
continuation pattern. Prices tend to consolidate sideways before resuming its uptrend. A trade can
be initiated once the breakout point is crossed on a closing basis maintaining the low of the handle
as the stop loss.

3. Ascending Triangle

Ascending triangle usually appears during an uptrend and is considered as a continuation pattern.
Ascending triangles are always bullish patterns whenever they occur on the chart. It is also known
as right angle triangle due to its shape. Ascending triangles are really a special form of symmetrical
triangle with the horizontal line formed at an angle of 90 degrees. In the ascending triangle
formation, the horizontal line represents overhead resistance that prevents the security from rising. It
is as if a large sell order has been placed at this level, thus preventing the price from surging higher.
Even though the price is not able to cross this level, the reaction lows continue to rise. It is these
higher lows that indicate increased buying interest and provides the ascending triangle its bullish
bias.
The technical target is arrived at by computing the vertical height of the triangle and adding this
length to the breakout point. Another method is drawing a line parallel to the base of the triangle
through the peak of the first rally.
Characteristics of an Ascending Triangle
 Top Horizontal Line: At least 2 reaction high points are required to form the upper resistance
horizontal line.
 Lower Ascending Trend line: At least two reaction low points are required to form the lower
rising trend line. The succeeding reaction is higher than its predecessor thus causing the
lower trend line to rise and giving the patter its bullish feature.
 Time frame: The length of the pattern can range from a few weeks to many months with the
average pattern lasting from 1-3 months.
 Volume: As the pattern develops, volume tends to contract. Volumes usually expand at the
time of the breakout which gives the added confirmation.

In the above chart of Page Industries we witness an ascending triangle chart pattern. Prices tend to
gradually rise during the pattern and finally succeed to give an upward breakout towards the end.
Trades can be initiated within the pattern as well at the time of the breakout.

4. Descending Triangle

Descending triangle is a bearish continuation pattern. The pattern is usually observed in a

downtrend. There are few instances the pattern is seen during an uptrend acting as a reversal
pattern but is considered as a bearish pattern regardless of where it occurs. The descending triangle
is also known as right angle triangle because of it shape. The horizontal line acts as a zone of
support. It is as if there is heavy buying interest at this level preventing the stock from falling further.
It is the lower highs along the declining trend line that signals greater selling pressure and gives the
pattern its bearish feature.
The technical target is arrived at by computing the vertical height of the pattern and adding this
height to the breakout point. It can also be computed by drawing a line parallel to the base of the
triangle through the trough of the first correction.
Characteristics of a descending triangle
 Upper Descending Trend line: At least two reaction highs are required to form the upper
descending trend line. The reaction highs should be successively lower.
 Lower Horizontal Line: Minimum tow points are required to form the lower horizontal line of
the descending triangle pattern.
 Duration: The length of the pattern can range from a few weeks to many months, with the
average pattern lasting from 1-3 months.
 Volume: As the pattern develops, the volumes usually reduce. When the breakdown finally
occurs volumes tend to expand which acts as a confirmation signal.

In the above chart of Oil Ltd we witness a descending triangle pattern. Prices constantly face
resistance along the upper descending trend line while taking support along the lower horizontal line,
finally the bears win the battle with price witnessing a breakdown towards the end and resuming the
original downtrend.

5. Flag Continuation
Bullish flag pattern is a continuation pattern in the direction of the existing trend. A flag as the name
implies, the pattern looks like a flag on the chart. It is a sharp, strong volume backed rally on the
back of positive fundamental development, followed by several days of sideways to lower price
consolidation on much weaker volume after which a second sharp rally is observed on strong
volumes. The breakout signal is generated when price breaches the upper resistance level. Flags
seem to form at the halfway point of the move. Flag formation is usually reliable as patterns from a
forecasting point of view; the target price is usually met.
The technical target is arrived at by computing the height of the flag pole and adding it to the
eventual breakout point.
Characteristics of a Flag pattern
 Prior Trend: To be considered a continuation pattern, there should be evidence of an existing
trend.
 Flagpole: The flagpole is a sharp surge in prices on heavy volumes. It is the distance from
the first resistance break to the high of the flag. The flag pole can contain gaps.
 Flag: A flag is a small consolidation zone that tends to slope against the trend i.e. if the
existing trend move is up, then the flag would slope down. If the move was down then the
flag would slope up. We could witness a sideways consolidation in prices as well.
 Duration: Flags are short-term patterns that can last from 1 to 4 weeks.
 Break Out: For a bullish flag, a break above resistance signals that the previous advance has
resumed.
 Volume: Maximum volume is observed during the formation of the flagpole and at the time of
breakout. During the flag formation volumes tend to contract.
In the above chart of Oberoi Realty we observe a flag chart pattern. Prices witness a swift rise on the
back of positive fundamental development followed by price consolidation for nearly two weeks
before eventually witnessing a breakout in the direction of the prevailing trend. A bullish trade can be
initiated at the time of the breakout by maintaining the low of the consolidation zone as the stop loss.

6. Falling Wedge

A Falling Wedge is a generally considered bullish pattern and is usually found during up-trends. The
pattern can also be found in downtrends; however the implication is still generally on the bullish side.
A falling wedge represents a temporary interruption of a rising trend. This pattern is marked by a
series of lower tops and lower bottoms. It is so named because the pattern is in the form of a wedge
pointing downwards with the price appearing to fall lower. The chart pattern is formed by price
action, which is contained within a converging and descending trend line. The pattern appears when
there is profit booking in an uptrend. The wedge and the pennant are very similar, since both consist
of converging trend lines that move in a contra trend direction. The difference is that the breakout
point of a pennant forms very close to or event at the apex whereas for the wedge the two projected
lines would meet way in the future. Wedges take a longer time to form as compared to pennants.
The technical target: For upward breakouts, the highest point of the wedge is considered the
technical target.
Characteristics of a falling wedge
  Prior Trend: For the pattern to qualify as a reversal pattern there must be a prior trend in
existence to reverse.
 Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line,
ideally three. Each successive high should be lower than the previous highs hit.
 Lower Support Line: At least two reaction lows are required to form the lower support line.
Each reaction low should be lower than the previous lows.
 Break Out: A breakout signal is generated when price moves above the pattern’s upper
resistance levels. For additional confirmation a trader could wait till prices move above the
previous resistance high.
 Time frame: The pattern usually takes 2-8 weeks to form.
 Volume: While volume is not particularly important on rising wedges, though it is an essential
factor to confirm a falling wedge breakout. Without an expansion of volume, the breakout will
lack conviction and could be vulnerable to failure.

In the above chart of 3M India Limited we observe a wedge pattern breakout. It is similar to a
pennant but the time taken for pattern formation is slightly longer. The pattern is traded with a bullish
bias at the time of the breakout.

7. Rectangles
Rectangle is generally considered as a continuation pattern, the pattern acts as a sideways
consolidation during a trend. Prices tend to consolidate between two parallel lines known as support
and resistance. The success rate of the pattern is not high and the exact direction of the breakout is
known once we get a clear breakout signal. The pattern can be successfully traded by buying at the
support zone and selling at the resistance or by trading once a breakout signal is generated. There
are instances where the rectangle pattern tends to act as a reversal pattern as well. A rectangle
pattern formed at the top of a trend is known as distribution pattern and one formed at bottom is
known as an accumulation pattern.
The technical target for a rectangle is arrived at by computing the width between the two parallel
lines and adding or subtracting it from the breakout point based on the direction of the breakout.
Characteristics of a Rectangle
 Prior Trend: For the pattern to act as a continuation pattern a prior trend should be in
existence.
 Support/Resistance: Prices tend to fluctuate between these two parallel lines. Minimum of
two contact points should be formed along the support and resistance lines respectively.
Although not a prerequisite, it is preferable that the high and low points alternate.
 Volume: Volume tends to contract at the start of the pattern and expands at the time of
breakout. The expansion in volume at the time of breakout tends to provide added
confirmation.
 Time Frame: Rectangles can extend from many weeks to a few months. If the pattern is less
than 3 weeks, it is usually considered a flag pattern. The longer the prices consolidate in a
sideways range more significant and less probability of it being a false breakout.
 Breakout Direction: During the period of formation , there is no way of knowing in advance
which way the prices will ultimately break; therefore it should always be assumed that the
prevailing trend is in existence until a reversal has been proved. Speculating the breakout
direction with a rectangle pattern formation could be a risky trade.
In the above chart of LIC Housing Finance we witness a rectangle chart pattern. In this case, prices
tend to consolidate between the two parallel lines before finally managing to give a breakout on the
upside breaching its resistance level and managing to continue its original uptrend.

Reversal Chart Patterns

8. Double Bottom

Double Bottom is a reversal chart pattern and is the mirror image of a double top formation. The
pattern is made up of two consecutive troughs separated by a peak in between. The pattern is
generally observed during a downtrend.
The technical target is arrived at by computing the low point of the pattern and adding it to the
breakout point
Characteristics of a double bottom
  Prior Trend: For the pattern to act as a reversal pattern a prior downtrend should be in
existence.
 Lows: Both the lows should be reasonably alike and occur at nearly the same level. If the
depth of second trough is shallower than the first it is considered a bullish sign.
 Volume: High volume is observed at the low points (accumulation) as well at the time of
breakout.
 Time frame: The pattern usually takes between 4 weeks to a few months. The double bottom
formation takes more time to form than a double top formation.

In the above chart of Ambuja Cement we witness a double bottom chart pattern. In this case the
second trough is higher than the first which is considered a bullish sign. The pattern tends to act as a
medium to long term trend reversal pattern. A bullish trade can be initiated once the neckline is
breached.

9. Triple Bottom
Triple Bottom pattern is considered as a reversal pattern; it tends to occur after a long downtrend.
The triple bottom occurs when the price of the stock forms three distinct lows, at around the same
price level, before giving an upward breakout and reversing its downtrend.
The technical target is derived by measuring the vertical depth of the pattern and applying this length
to the breakout point.
Characteristics of a Triple Bottom
 Prior Trend: A downtrend or long trading range should be in place for Triple Bottom to occur.
 Three Lows: All three lows should be reasonably alike and occur at nearly the same level.
 Volume: High volume is observed at the low points (accumulation) as well at the time of
breakout.
 Time frame: The pattern usually takes a few months before a reversal is witnessed. The
triple bottom formation takes more time than a triple top formation.
In the above chart of TV18 Broadcast we witness a triple bottom formation. Prices face resistance on
three successive occasions near the neckline before finally witnessing a breakout. The pattern is a
trend reversal pattern and as can be seen in the above chart, it is witnessed at the bottom of a
downtrend.

10. Inverse Head and Shoulder

Inverse head and shoulder is a bullish reversal pattern and is usually observed after a downtrend.
The pattern contains three successive troughs with the middle trough commonly known as the head,
being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two
shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be
connected to form resistance, or a neckline.
The technical target for an inverse head and shoulder pattern is arrived by adding the difference
between the neckline and the lowest level reached in the formation to the breakout point.
Characteristics of an inverse head and shoulder
  Prior Trend: For the inverse head and shoulder to act as a reversal pattern there should be a
prior downtrend in existence.
 Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks the low point
of the current trend. The reaction high of the decline usually remains below any longer trend
line.
 Head: After making a bottom, the high of the subsequent advance forms the second point of
the neckline. The head forms the low point of the pattern.
 Right Shoulder: Bears push prices lower again, but this time prices fail to make a new low.
This low is always higher than the head and usually in line with the low of the left shoulder.
This is a bullish sign as the bulls start to gain control.
 Neckline: The neckline forms by connecting reaction highs off of the left shoulder and the
head which is extended further. The neckline can slope up, slope down, or be horizontal.
 Volume: Volume plays an important role in the confirmation of an inverse head and shoulder
pattern. Volume tends to decline during the correction phase and tends to expand during the
advance. 
 Neckline Break: The inverse head and shoulder pattern is complete only once the neckline is
comprehensively breached. Breakout must occur with an expansion of volume which tends
to provide added conviction.

In the above chart of Pidilite Industries we witness an inverse head and shoulder chart pattern. A
bullish trade can be initiated when price breaches the neckline. In the above example the price
outburst has been backed by a surge in volumes which tends to provide the trader added
confirmation.

11. Bullish Symmetric Triangle

The symmetrical triangle is usually considered a continuation pattern but there are instances when a
symmetrical triangle acts as trend reversal pattern as well. Continuation or reversal, the direction of
the next major move can only be identified after a valid breakout. A symmetrical triangle is
composed of series of two or more rallies and reactions in which each succeeding peak is lower than
its predecessor. It is among the most common chart patter and also among the most unreliable
pattern. The more times the lines forming the symmetrical triangle have been touched or
approached, the greater the probability that their breakout will be a valid.
The technical target for symmetrical triangle is arrived at by computing the vertical height of the
triangle at its widest point and adding it to the breakout point.
Characteristics of a symmetrical triangle
 Trend: In order to qualify as a continuation pattern, a prior trend should exist. The trend
should be at least a few months old and the bullish symmetrical triangle marks a
consolidation period before continuing its prior trend.
 Volume: Volume diminishes during the formation of the symmetrical triangle before the
breakout where volumes tend to surge.
 Duration: The symmetrical triangle can extend for a few weeks or many months. If the
pattern is less than 3 weeks, it is usually considered a pennant.
 Breakout: The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern's
development or time-span. A break before the 1/2 way point might be premature and a break
too close to the apex or after the apex may be insignificant.
 Breakout Direction: The future direction of the breakout can only be determined after the
break has occurred. Even though a continuation pattern is supposed to breakout in the
direction of the long-term trend, this is not always the case.
 Breakout Confirmation: For a break to be considered valid, it should be on a closing basis.
Breakout backed by a surge in volumes tends to give added confidence.
In the above chart of Bharti Infratel, we observe a bullish symmetrical triangle. Prices move back and
forth within the pattern before witnessing a breakout towards the apex of the triangle. The pattern
should ideally be traded once the breakout has occurred since the direction of the breakout is not
clear.

12. Rounding Bottom

The Rounding Bottom is a reversal chart pattern that tends to act as consolidation period where the
sentiment turns from a bearish bias to a bullish bias. The chart pattern looks similar to a cup and
handle pattern but without the handle. The pattern can take a considerably long time in formation.
Rounding bottoms are fine examples of gradual change over the demand /supply balance that slowly
picks up momentum in the direction opposite to that of the previous trend.
Technical targets for rounding bottom formation are arrived at by computing the depth of pattern and
adding it to the breakout point.
Characteristics of a Rounding bottom
 Prior Trend: A downtrend or long trading range should be in place for rounding bottom to
occur.
 Breakout: Bullish confirmation comes when the pattern breaks above the resistance point
that marked the beginning of the decline at the start of the pattern.
  Volume: It tends to be high at the beginning of the decline gradually declining towards the
bottom and rising once again towards the advance. Volume levels tend to track the shape of
the pattern. Rise in volumes at the time of breakout tends to provide added confirmation.
 Time: The pattern takes anywhere between few months to a few years to form. Due to the
duration of the pattern it’s a slightly difficult pattern to trade on.

In the above chart of Magma Fincorp, we witness a rounding bottom formation. Volume tends to dry
up during the formation of the pattern with a spurt in price and volumes seen towards the end of the
pattern. It is a difficult pattern to trade as the exact point of breakout is difficult to predict.

13. Double Top

Double Top formation is a trend reversal chart pattern. The pattern is usually observed at the top
and acts as a distribution pattern. Double top pattern is characterized by a rally to a new high
followed by a slight pullback in prices and a then a second rally to new highs. Selling pressure is
witnessed as the stock forms fresh highs indicating the dominance of sellers. The stock trends lower
over the course of next few weeks. A reversal in trend is confirmed once the key support levels are
broken. The peaks should ideally be separated by about a month or more. If the peaks are to close,
it could just represent normal resistance rather than a major change in trend. The main characteristic
is that the second top that is formed is with distinctly less volume than the first.
The technical target for double top pattern is arrived at by computing the vertical height of the first
top and subtracting it from the breakdown point once the reversal has occurred.
Characteristics of a Double top
 Prior Trend: As with any reversal pattern, there must be an existing trend to reverse. In the
case of the double top, an uptrend of several months should be in place.
 First Peak: The first peak should mark the highest point of the current trend.
 Trough: A correction is witnessed after the peak. Typically the correction ranges 10-15%.
 Second Peak: The second peak is formed after a time frame of 1-3 months. The peak is
formed on the back of low volumes and faces resistance at its previous high.
 Decline from Peak: The subsequent decline from the second peak usually witnesses an
expansion in volume as the bears take over.
 Trend Reversal: A trend reversal is indicated once the support zone is breached; the
breakdown of the support zone is usually accompanied with a surge in volumes.

In the above chart of Persistent Systems we observe a double top chart pattern. The pattern tends to
act as a distribution pattern with the stock witnessing selling pressure as it tries to surge higher.
Finally the bears manage to take control towards the end and prices crack below the neckline.

14. Triple Top

Triple Top is a distribution pattern and is an extension of the double top formation. The pattern
consists of three distinct tops rather than two. The pattern is formed when bulls try to take the stock
higher on three successive occasions but face resistance at roughly the same resistance zone and
ultimately price breaks down breaching its support zone.
The technical target for a triple top formation is arrived at by computing the vertical length of the high
point of the pattern from support line and then subtracting it from the support line once the
breakdown occurs. No triple top formation is complete until the stock falls through the neckline i.e.
the support level.
Characteristics of a Triple Top
 Prior Trend: For the triple top to act as a reversal pattern, an uptrend or long trading range
should be in existence.
 Three Peaks: The peaks tend to act as resistance zones and prevent prices from surging
higher, then tend to be reasonably well spaced and similar in dimension.
 Volume: As the triple top develops, volume tends to decline during the surge and increase
during the correction phase indicating that the bears are in control. After the third high, an
expansion of volume is observed on the subsequent decline and continues to expand as
price breaches the support level i.e. the neckline of the pattern.
 Trend reversal: The Triple Top is not complete until a support level is breached. The
correction low points are connected to form the support line.
 Time frame: The triple top takes a few months for the pattern formation.
In the above chart of Fortis Healthcare, we witness a triple top chart pattern. The pattern tends to act
as a long term reversal pattern. Prices try to surge higher on three consecutive occasions but are
met by selling pressure. A trader can initiate a sell trade when the neckline is breached.

15. Head and Shoulders Top

Head and Shoulder is a famous chart pattern that implies a likely reversal of the current trend. It is
probably one of the most reliable chart patterns. The head and shoulder pattern is easy to spot on
the chart. It is characterized by three peaks with the middle peak (head) being the highest peak and
along with two other peaks known as shoulders on either side. The shoulders are of roughly equal
height but less than that of the head. The lows of these peaks are connected with a trend line,
commonly known as the neckline of the pattern.
The technical target is arrived at by computing the vertical height of the head from the neckline and
subtracting it from the neckline once the breakdown occurs.
Characteristics of a Head and Shoulder
 Prior Trend: For the head and shoulder to act as a reversal pattern there should be a prior
uptrend in existence.
  Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point
of the current trend. However the new highs are short lived and prices retreat towards the
trend line.
 Head: From the low of the left shoulder, prices advance once again this time surpassing the
previous highs and form the high point of the pattern. After peaking selling pressure is
witnessed, this once again drags prices towards the trend line.
 Right Shoulder: The bulls push prices higher again, but this time fails to make new highs.
This is a very bearish signal; because bears took control and did not allow the bulls to make
a new high or even an equal high. The decline from the peak of the right shoulder should
break the neckline.
 Neckline: The neckline is formed by connecting the two correction points i.e. of the left
shoulder and head which is then extended further. The neckline can slope up, slope down or
be horizontal.
 Volume: Volume plays an important role in the confirmation of a head and shoulder pattern
reversal. Volume tends to decrease during the formation of the peaks i.e. the highest volume
is observed during the formation of the left shoulder and tend to decrease as pattern
develops. Volumes tend to surge again during the correction from the right shoulder and as
prices breakdown from the neckline. Volume expansion is an additional confirmation not a
necessary condition.
 Neckline Break: The head and shoulder pattern is complete only once the neckline is
comprehensively breached.

In the above chart of JP Associates, we witness the formation of a Head and Shoulder chart pattern.
A bearish trade can be initiated once the neckline is breached. The pattern is observed at the top of
an uptrend.

16. Rounding Top

Rounding Top is a top reversal pattern. It is a mirror image of the rounding bottom pattern. The
pattern is formed when there is a sharp rally to a new high on strong volume, several weeks of light
trade with limited upside progress in prices, forming an inverted U shaped pattern, followed by a
sharp move lower with a rise in volumes. It is difficult to obtain breakout points for rounding top and
bottoms since they tend to develop slowly and do not offer any clear support resistance levels on
which to establish a potential benchmark.
Technical targets for rounding top formation are arrived at by computing the height of pattern and
adding it to the breakout point.
Characteristics of a Rounding top
 Prior Trend: For a rounding top to act as a reversal pattern a prior uptrend should be in
existence.
 Breakout: occurs when prices break below (Go from above to below) the support of the
pattern; Support is the lowest low that there is during the Pattern.
 Volume: It tends to be high at the beginning of the advance, gradually declining towards the
top and rising once again towards the advance. Volume levels tend to track the shape of the
pattern. Rise in volumes at the time of breakout tends to provide added confirmation.
 Time: The pattern takes anywhere between few weeks to a few months. It is a long term
pattern.
In the above chart of Castrol, we witness a rounding top pattern. It is a chart pattern where in the
shares gets transferred from the informed traders to the uninformed traders, there is gradual
displacement of shares.

Chapter 1 Introduction To Volatility

Introduction
One often witnesses heavy price fluctuations in the stocks market. The most common term used by
traders to define price fluctuations is volatility.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. It is
measured by using variance or the square root of variance i.e. standard deviation.
Volatility is a double-edged sword; a surge in volatility could either benefit a trader or end up
triggering his stop loss.
Low volatility indicates that a stock does not swing dramatically, but changes in price at a steady
pace over a given period of time. In this chapter, we would cover the types of volatility, the methods
to calculate them and how a trader can successfully interpret and benefit from the same.
Let us understand the concept of volatility (Standard Deviation) better with a simple example.
Consider BCCI has to make a selection between two batsmen based on their past 10 scores.

Match Rohit Dhavan

1 27 11

2 42 101

3 47 20

4 52 119

5 39 40

6 61 27

7 55 31

8 34 17

9 43 21

10 46 60

Total 446 447

Rohit’s Average = 446/10= 44.6

Dhavan’s Average = 447/10=44.7
Both the batsmen have scored nearly the same runs and have a similar average over the course of
10 innings, which makes the selection difficult.
The parameter that can be used in such a situation is to determine the consistency of the batsmen
calculated through the mathematical formula of standard deviation.
First, we calculate the variance through which the standard deviation can be easily computed.
Variance is simply the ‘sum of the squares of the deviation from the mean divided by the total
number of observations'.
Variance for Rohit, who maintains an average of 44.6, is calculated a below:
Variance = [(-17.6) ^2 + (-2.6) ^2 + (2.4) ^2 + (7.4) ^2 + (-5.6) ^2 + (16.4) ^2 + (10.4) ^2 + (-10.4) ^2
+ (-1.6) ^2 + (1.4) ^2] / 10
= 902.4 / 10
= 90.24
Next we calculate the Standard Deviation (SD)
Std deviation = √ variance
Standard deviation for Rohit’s turns out to be Square root (90.24) = 9.49
Similarly we calculate the variance and standard deviation of Dhavan

Player Rohit Dhavan

Total in 10 matches 446 447

Average 44.6 44.7

Variance 90.24 1252.21

S.D 9.49 35.38

Once we have obtained the standard deviation, it can be used to predict the possible/probable runs
both the players are likely to score in the next match. We can arrive at lower and higher projections
by adding and subtracting the S.D from the average.

Player Lower projection Higher projection

Rohit 44.6-9.49=35.11 44.6+9.49=54.09

Dhavan 44.7-35.39=9.31 44.7+35.38=80.08

From this, we can estimate that in the next match Rohit is likely to score between 35 to 54 runs
(rounded off), while Dhavan is likely to score between 9 to 80 (rounded off). Rohit is clearly the more
consistent of the two; Dhavan could either click or get out cheaply.
From the above example we clearly see how standard deviation and volatility estimation can be
used in our day to day activities.
Volatility is a % number as measured by standard deviation.

Chapter 2 Understanding Volatility In The

Market
Historical Volatility
Historical volatility is a measure of how much the stock price fluctuated during a given time period (in
past). It is referred to as the asset's actual or realized volatility.
Traders make use of historical volatility to estimate the future movement, but there is a chance that
the future volatility could deviate from the expected value as the factors influencing the price could
change. Major fundamental changes could cause the asset price to stray away from the expected
historical volatility.
Calculation
Historical statistical volatility is calculated as follows:
1) Daily returns are calculated as return = natural log of (t/t1). Where t is the closing price of the
present day and t1 is the closing price one day prior.
2) Then standard deviation of these returns is calculated for the desired time period.
3) The standard deviation value is then annualized by multiplying by the square root of 356.
Example
Let us calculate the Historical volatility for Nifty futures for a 10 day period.

Symbol Date Expiry Close Daily Returns

 NIFTY 5-Jan-18 25-Jan-18 10573.2

NIFTY 8-Jan-18 25-Jan-18 10631.4 0.61%

NIFTY 9-Jan-18 25-Jan-18 10646.9 0.13%

NIFTY 10-Jan-18 25-Jan-18 10637.05 -0.05%

NIFTY 11-Jan-18 25-Jan-18 10654.05 0.18%

NIFTY 12-Jan-18 25-Jan-18 10686.35 0.28%

NIFTY 15-Jan-18 25-Jan-18 10743.3 0.56%

NIFTY 16-Jan-18 25-Jan-18 10709.55 -0.38%

NIFTY 17-Jan-18 25-Jan-18 10791.8 0.82%

NIFTY 18-Jan-18 25-Jan-18 10810.8 0.26%

Daily Volatility 0.36%

10 day Volatility 1.15%

Step 1. Daily Returns

The daily returns are calculated using the excel formula = LN (10631.4/10573.2) = 0.61%.
The daily returns are similarly calculated for all the 10 days.
Step 2. Daily Volatility
The daily volatility is calculated using the standard deviation function.
Daily volatility = STDEV (0.61%:0.26%) = 0.36%.
Step 3. 10 day volatility
10 day volatility = 0.36%*Square root of (10) = 1.15%.
Therefore, over a 10 day period we could expect movement of 1.15% in Nifty Futures in either
direction.
To compute the annual volatility, some traders take the square root of 252 (number of trading days
in a year), while others take square root of 365 (calendar days in a year).
On the NSE website, daily volatility is multiplied by the square root of 365 to compute the annual
volatility.
The daily and annualized volatility for all the F&O stocks is readily available on the NSE website.
Interpretation of Historical Volatility
 Historical Volatility does not measure direction; it just measures how much the securities
price is deviating from its average.
 When a security’s Historical Volatility is rising, or higher than normal, it means prices are
moving up and down farther/more quickly than usual and is a sign that something is likely to
happen, or has already happened, regarding the underlying security.
 When a security’s Historical Volatility is falling, it implies that that the uncertainty regarding
the security has reduced and things are returning back to usual.
Volatility tends to surge when there is heavy price fluctuation in the market. In the above example,
Nifty Futures witnessed a correction from 10400 levels all the way till 10050, which was followed by
a pullback in the markets back to 10400 levels again. During this phase, volatility increased from 7.6
all the way till 11.9. This was followed by a period of sideways consolidation in the markets during
which the volatility cooled from levels of 11.9 to 6.8.

Implied Volatility
Implied volatility is the expected magnitude of a stock's future price changes, as implied by the
stock's option prices. Implied volatility is represented as an annualized percentage.
If market participants are willing to pay a high price for options, then that implies they are expecting
major movements in the stock price or implied volatility in the near term. On the other hand, if there
is no heavy demand for options and trades aren’t willing to pay much for options, then it indicates
that market is not expecting significant price movement. Implied volatility is just a way to describe the
size of the market's expectations for stock price movements.
Consider the following stocks and their respective option prices (options with 23 days to expiration):

Stock 35 Call Price 30 Put Price Implied Volatility

NHPC(33.5) Rs. 0.7 Rs. 0.20 40.53%

RCOM(34) Rs. 2.9 Rs. 1.45 104.49%

As we can see, both stocks are of nearly the same price. However, same strikes for each stock have
different prices. In the case of RCOM, the call and put prices are much higher than NHPC's options.
The reason of this being the 63.96 % difference in implied volatility between the two options. This
indicates that the traders expect heavy price fluctuation in the price of RCOM compared to NHPC.
Many professional traders consider buying or selling options based on the implied volatility.
Stocks with a high I.V tend to witness major price swings hence the risk-reward ratio is also higher
for traders in such stocks. RCOM is clearly the more risky of the two and more rewarding as well.
Difference between Historical and Implied volatility
Historical Volatility Implied Volatility

Historical volatility is calculated from Implied volatility is derived from option pricing model.
the previous price movement in the
stock.

Can be calculated for any stock Can be calculated only for stocks that trade in options segment

Not a reliable estimate of future Better estimate of the future volatility of the stock, takes into
volatility as the factors influencing price consideration the current scenario i.e. based on present demand
could change. and supply in options

Chapter 3 Ways To Interpret Volatility

Volatility Crush
If implied volatility is high because of an impending event, then it will decline after the event, since
the uncertainty of the event is removed. This rapid deflation of implied volatility is referred to as
a volatility crush.
Generally, we observer that implied volatility in options tends to pick up prior to the company’s result
announcement and decreases significantly immediately after the announcement.
Whether the results turn out good or bad, new information is available to the market participants that
allow the traders to re-value the stock. Large fund houses that have a position in the stock tend to
buy put options before the results in order to hedge their positions. They also tend to close out their
hedge position just after the result once the uncertainty is eliminated, resulting in a drop in volatility.
Unless the company announces something major or the results sway drastically away from
expectation, the volatility in the stock tends to decrease.
Thus, we observe novice traders losing money by trading on the result day even after getting the
direction correct due to factors of implied volatility. The best way to play the volatility crush is to
create option strategies that tend to benefit from a decline in volatility, for instance short straddle -
which are covered below under applications of volatility.

Volatility Surge
It is the exact opposite of a volatility crush. It happens due to unforeseen events by the market
participants. Panic due to such events can cause huge spike in volatility, which could even turn your
losing position into a winning position. Such a case was observed on August 24, 2015 when markets
tanked from 8,300 to 7,809, a crack of nearly 6%. It was the biggest fall in the markets after the 2008
crises and the 4th biggest in the history of the Indian markets.

Instrument Symbol Expiry Strike Option Open High Low Close Settle

OPTIDX NIFTY 27-Aug-15 7800 CE 281.55 281.55 111.85 122.9 122.9

OPTIDX NIFTY 27-Aug-15 7850 CE 115 120 86 97.9 97.9

OPTIDX NIFTY 27-Aug-15 7900 CE 225 225 55.45 73.6 73.6

OPTIDX NIFTY 27-Aug-15 7950 CE 118.55 160.95 30 53.85 53.85

OPTIDX NIFTY 27-Aug-15 8000 CE 102.1 120.35 34.65 40.75 40.75

OPTIDX NIFTY 27-Aug-15 8050 CE 66.55 100 20 29.7 29.7

OPTIDX NIFTY 27-Aug-15 8100 CE 75.6 75.6 16.35 21.4 21.4

OPTIDX NIFTY 27-Aug-15 8150 CE 46.05 46.05 12.45 15.6 15.6

OPTIDX NIFTY 27-Aug-15 8200 CE 41.3 41.3 9.25 11.9 11.9

OPTIDX NIFTY 27-Aug-15 8250 CE 26.45 26.5 6.7 10.1 10.1

OPTIDX NIFTY 27-Aug-15 8300 CE 8 14.6 3.7 7.4 7.4

OPTIDX NIFTY 27-Aug-15 8350 CE 1.5 15 1.5 6.9 6.9

OPTIDX NIFTY 27-Aug-15 8400 CE 3 9.8 2.2 5.8 5.8

OPTIDX NIFTY 27-Aug-15 8450 CE 1.85 7.8 1.85 5.3 5.3

 OPTIDX NIFTY 27-Aug-15 8500 CE 3.05 6.5 2.05 4.4 4.4

OPTIDX NIFTY 27-Aug-15 8550 CE 1.9 4.6 1.75 4.1 4.1

OPTIDX NIFTY 27-Aug-15 8600 CE 1.9 3.5 1.55 3.1 3.1

OPTIDX NIFTY 27-Aug-15 8650 CE 0.15 3.5 0.15 3.25 3.25

OPTIDX NIFTY 27-Aug-15 8700 CE 0.95 2.8 0.95 2.55 2.55

OPTIDX NIFTY 27-Aug-15 8750 CE 0.1 3.5 0.1 2.85 2.85

OPTIDX NIFTY 27-Aug-15 8800 CE 1 2.4 0.8 2.05 2.05

Generally, it is observed that call option premiums tend to fall when there is a crash in the markets.
But on August 24, 2015, something slightly different was observed. Call options that were out of the
money witnessed a surge in option premiums to the tune of 50 to 100%.
This phenomenon can be explained due to two factors of option greeks:
Delta: Delta is the amount an option price is expected to move based on one point change in the
underlying.
Vega:  Vega is the amount option prices will change, for a corresponding one-point change
in implied volatility.

Option Greek Impact of crash on OTM Call options

Delta ↓

Vega ↑

So when markets cracked on August 24, 2015 call options that were out of the money i.e. strikes
8350 and above that already had a low value of delta witnessed a further decrease in value of delta
as markets moved from 8300 to 7809.
While India VIX, a measure of volatility of the entire market, increased to 28% from 17% surging
nearly 65% at the close. This unexpected surge in volatility caused the vega component of the out of
the money call options to increase sharply.
The combination of a decline in an impact of delta and a surge in volatility caused the vega
component to overshadow delta resulting in an unusual price rise in these out of the money call
options
Open Interest and Implied Volatility Interpretation
Option Type O.I Implied Volatility Interpretation
 Call Increasing Increasing Call Buying

Call Increasing Decreasing Call Writing

Put Increasing Increasing Put Buying

Put Increasing Decreasing Put Writing

Call Decreasing Increasing Short Covering in Call

Call Decreasing Decreasing Long Unwinding in calls

Put Decreasing Increasing Short Covering in Put

Put Decreasing Decreasing Long Unwinding in Put

VIX
VIX stands for volatility index. These volatility indices are measure of market expectation of volatility
over a short duration. The first volatility index was VIX introduced at Chicago Board Option
Exchange (CBOE).
India VIX
In India, NSE has constructed a volatility index called India VIX. India VIX indicates the investor’s
perception of the market’s volatility in the near term. The value is calculated based on the best bid-
ask prices of Nifty option contracts. It is an annualized percent figure that estimates the market
volatility over the next 30 day time period. The same computation methodology as CBOE is made
use of with desired change to reflect the Nifty options order book. Constant fluctuations are
witnessed in India Vix values, a high value would imply that market participants expect a significant
movement in the price of Nifty while a low value would imply that markets are expected to trade
range bound in the near term. Historical data suggest that India VIX and Nifty have shown an
inverse relation.
In India future contracts of India VIX are traded. The product allows the trader to
a) Hedge an equity portfolio
b) Take a position based on expected directional movement in volatility
c) Made use of as diversification product in a portfolio

Fear Index
The high level of VIX attracts media attention when the overall stock market is under pressure.
Usually the terms fear and greed index are associated with it. The reason for this being the type of
option trading that occurs during weakness in the market. When traders are concerned about the
direction in the market, they tend to protect their overall position. One common strategy made use of
in times of panic is to purchase put options of the Nifty Index. The aggressive purchase of the Nifty
put option results in a surge in implied volatility. Hence India VIX, which measures the implied
volatility of the Nifty index options, tends to rise when the markets fall and is seen to have an inverse
relationship with Nifty.
Volatility Skew
Volatility skew is a result of different implied volatilities for different strike prices of a call or put
option. Volatility skew further illustrates that implied volatility depends only on the option premium,
not on the volatility of the underlying asset, since that does not change with either different strike
prices or option type.
How the volatility skew changes with different strike prices depends on the type of skew, which is
influenced by the supply and demand for the different options.
The concept of volatility skew came after the Black Monday 1987 crash in the US markets, before
which volatility skew hardly existed. What this means is that if we looked at an option chain, we
would see puts and calls equidistant from the current stock price priced nearly the same.
I.e. If Nifty is trading at 10700 an 11000CE would be priced similar to 10300 PE.
After the crash traders soon realize that it was riskier to short put options compared to shorting call
options as markets tend to correct with more swiftness than move up. Traders, therefore, started
charging a higher premium in order to write put options from the put buyers.
Over the years, as demand for out of the money put options surged in order to hedge the portfolio
from frequent market crashes and as put writers charged a premium in order to balance the risk
reward, a volatility skew was witnessed resulting in a higher premium for out of the money put
options compared to call options.

Reverse Skew/Normal Skew: Is exhibited when out-of-the-money puts are more expensive
compared to out of the money call options.
The popular explanation for the manifestation of the reverse volatility skew is that investors are
generally worried about market crashes and buy puts for protection. In the Indian markets as well we
generally witness a reverse skew as can be seen from the above Nifty option chain.
Nifty 11000 CE is currently trading at Rs 3.40 having a I.V of 8.25%, while Nifty 10300 PE is trading
at Rs 12.35 having a I.V of 15.57%; both the option are trading ~400 points from the current market
price of 10684.
Forward Skew: Although we normally find puts more expensive than calls, there are instances where
the skew reverses as trader’s price calls more expensive than puts. Forward skew is generally
witnessed in the commodity market as we often see a surge in commodity prices due to weather and
supply demand disruption and as commodities tend to have a floor price. Due to the perceived
limited risk, traders are often seen buying more out of the money calls then out of the money put
options.
Smiling Skew: A smiling skew is witnessed when there is heavy demand for out of the money
options, which result in a surge in implied volatility, which in turn results in out of the money option
prices costing more than at the money. This is generally observed before major events such as
Election result outcome, Brexit vote etc. where the traders expect heavy volatile in the underlying
security without having a specific view on the direction.

Flat Skew means that there is no skew and implied volatility is the same for all strike prices;
however, this is hardly witnessed nowadays.
Options with the same strike prices but with different expiration months also exhibit a skew, with the
far months generally showing a higher implied volatility than the near months, reflecting a greater
demand for far-term options over those with later expirations.

Vega
Vega is one of the key option greeks, it is measure of the impact of changes in the implied volatility
on the option price. Vega measures the change in the price of the option for a change in the
securities implied volatility.
Higher the implied volatility of the option, higher is the cost associated with it. Thus, when implied
volatility surges, the price of the option also tends to go higher and similarly, when volatility drops,
the price of the option will also fall.
Example
Reliance Communication is currently trading at Rs 34 and a JAN35 call option is selling for Rs 2.90.
Vega for the option is 0.04
The current implied volatility for the JAN35 call option is 108%. If the implied volatility increases by
4%, then the price of the option should rise to 2.90+0.04*4= Rs 3.06
However, in case the volatility falls down by 10% to 98%, then the option price would drop top to 2.9-
(0.04*10) = Rs 2.5
As seen in the above example, despite of no change in stock price, option price changed
independently on account of a change in implied volatility, measured by Vega.
Volatility is always expressed as a positive number for both for call and put options. A put's option
price will increase as implied volatility increases in the same manner as a call options price.
Form this example we clearly see that a surge in volatility tends to benefit the buyer of the option
and a decline in volatility benefits the seller, provided the rest of the factors remain constant.
Impact of time and strike price on Vega
Option premium is composed of two parts time value and intrinsic value. Intrinsic value is a measure
of how much the option is in the money, while the time value is equal to the option premium minus
the intrinsic value. Thus, time value depends on the probability that the option will go out of the
money or stay in the money by expiration. Volatility only affects the time value of an option.
Therefore, vega, as a measure of volatility, is greatest when the time value of the option is greatest
and least when time value component is small. Since time value is greatest when the option is at the
money that is also when volatility will have the highest effect on the option price. And just as time
value diminishes as an option moves further out of the money or into the money, so goes vega.

Chapter 4 Applications Of Volatility

Volatility based stop loss

Volatility helps determine how much a security can move over a given time frame. Knowing how
much a stock can move within a stipulated time frame can help us decide the stop loss instead of
getting stopped out due to random fluctuations in price. Volatility based stop loss helps manage risk
as well as ensures that your stop loss does not get triggered due to whipsaws.
For instance, if you are a short term trader and know that Sun Pharma has a tendency to move 25
points over the course of 3 days, by setting a small stop loss less than 25 points while trading over
this timeframe would result in a high chance of the stop loss getting triggered due to price
fluctuations in the stock.
Steps to compute the stop loss based on volatility. The stop loss is computed based on the previous
day’s closing price of the stock.
a) Compute the daily volatility of the security. (Readily available on NSE website)
Eg Hero Motocorp has a daily volatility of 1.26%
b) In order to trade in the stock the next day, we determine the stop loss by subtracting the daily
volatility from the previous day’s closing price.
3760-(1.26%*3760) = 47.37
Hence, the trader can consider maintaining a stop loss of slightly more than Rs 47.37 while taking an
intraday position in the stock.
For the positional trader who considers to take a position over a few day, stop loss can be computed
as Previous Closing Price-( Previous Closing Price*(Daily volatility*Square root of no of days))
E.g. The stop loss over a 5 day period can be calculates as
Stop Loss=3760-(3760*(1.26%*Square root of 5))
Stop Loss = 3760-3760*2.81%
Stop Loss=3760-105.6
The stop loss for Hero Motocorp can be placed below 3654.4.
Traders also tend to make use of volatility indicators to determine the stop loss. Commonly used
indicators are
a) Bollinger Band
b) ATR
Benefits of using volatility stop loss
There are times when we may not get a price action formation as a stop loss while trading. In such a
case, volatility-based stop loss comes handy. It acts as an effective trailing stop loss. Also since
volatility stop loss is an objective method, it is easy to compute for trades.
Calculating a securities move for any time frame
Determining the range a security could trade in can be extremely useful for traders in the derivative
market. Implied volatility is made use of to determine the upper and lower range for the security for a
defined timeframe. This expected range is used by option writers to decide which option to write
while option buyers use it do decide the strike price to purchase or to create spread positions.
Determining the range
So, if we want to determine the range Nifty Futures could trade in for the FEB2018 series, we
compute it as follows:

Nifty Futures Cmp (1.23.2018) 11080

Implied Volatility (ATM CALL IV +ATM PUT IV)/2 14.03

Calendar days for Expiration in FEB2018 series 30 (8 days of Jan Series+22 days of Feb Series)

Likely Movement =11080*14.04%*Square root of (30/365) = 446 points

Hence we could expect a movement of +/- 446 points in the next 30 days.
Expected upper range 11080+ 446= 11526
Expected Lower range 11080- 446= 10634

Hence, an option writer can consider selling strikes above 11550CE or below 10600PE. This is the
range Nifty Futures is expected to trade in provided there is no major unexpected event that causes
the implied volatility to jump up significantly.
Option Strategies based on Implied Volatility
Implied volatility is a dynamic figure that changes based on activity in the options marketplace.
Usually, when implied volatility rises, the price of option also tends to surge provided all other factors
remain constant. So, when implied volatility increases after an option has been purchased, it is good
for the option buyer and bad for the option seller.
Conversely, if implied volatility decreases after the option has been purchased, the price of options
usually decreases. Option sellers tend to befit in such a scenario.
Option strategies that can be implemented based on Implied Volatility

Strategies that benefit with increase in I.V Strategies that benefit with decline in I.V

Long Call Strategy Bull Put Spread

Long Put Bear Call Strategy

Bear Put Strategy Short Strangle Strategy

 Long Strangle Strategy Short Straddle Strategy

Long straddle Strategy Short Iron Butterfly Strategy

Long Iron Butterfly Strategy Short Put Strategy

Put Back - spread Strategy Covered Call Strategy

Short Call Condor Strategy Short Call Strategy

Short Call Butterfly Strategy Call Ratio Spread

Long Call Condor Strategy

Chapter 1 Gaps - Technical Analysis

What are Gaps?

Gaps represent an area on the chart where the price of the stock moves swiftly either up or down
with no trading activity in between. Gaps are witnessed when there is frantic buying or selling in the
markets. It can be witnessed on the chart in any timeframe but is more commonly found on the daily
chart. This is because traders digest the information obtained after market hours and tend to act
upon it at the start of the next trading session. Another reason is that gap on a weekly chart can fall
only between Friday’s price range and Monday’s price range and even more rarely in the monthly
time frame.
On which chart types are gaps observed?
Gaps can only be observed on the candlestick chart or the bar chart. A technical analyst making use
of a line chart would not be able to spot a gap as all the points tend to be connected.
For e.g. Gap can be witnessed on a Nifty candlestick chart

For e.g. Gap cannot be noticed on a Nifty line chart

Gap direction
Gaps can be witnessed in either of the two directions:
Upside gap: Upside gap is witnessed when the lowest price of a specific trading period is above the
highest level of the previous trading period.
For e.g., Let us consider that a stock closed at Rs.1,000 on day 1 and opened at Rs.1,050 on day 2.
This jump in price from 1,000 to 1,050 is termed as a gap up opening. There are several reasons for
this gap up opening. One common reason is the announcement of positive financial results of the
company. The upside gap signifies a very strong bullish sentiment.
In the above chart, we witness a gap up opening; Andhra Bank’s stock closes at Rs58.8 on October
24, 2017, and opens at Rs64.35 the next day. This gap up opening was witnessed on account of the
bank recapitalization program, which the government announced for PSU banks.
Downside gap: Downside gap is observed when the highest price for a specific trading period is
below the lowest price of the previous trading period.
For e.g., If a stock closed at Rs1,000 on day 1 and opened at Rs950 on day 2, it is termed as a gap
down opening. Gap down opening signifies a strong bearish sentiment.

In the above chart, Nifty closed at 10,760 on February 2, 2018, and opened at 10,604 in the next
trading session, witnessing a gap down opening of 156 points. The gap down opening was
witnessed on account of a selloff in global markets.

Do all gaps get filled?

It is observed that most gaps are eventually filled, but it is not always the case. However, we cannot
explicitly ascertain a fixed time duration within which a gap gets filled. Thousands of gaps are
created in different stocks with some of them never getting filled; hence, it would not be appropriate
to base trading strategies purely on the assumption that the gap will be filled in the immediate future.
Quite often, we also witness partial filling up of the gaps before prices reverse and continue their
original trend.
An example of a gap getting filled immediately can be seen in the chart below.

In the above example of Lakshmi Vilas Bank, the upward gap got filled within three trading sessions.
Another example of a gap not getting filled for years can also be seen below.

In the above chart, the bullish gap in CCL Products was formed in 2016 and has still not been filled.
There is a good chance that this upward gap may not be filled for a few more years.

Gaps that do not mean much

It is important to avoid giving weightage to gaps that do not carry much technical significance.
a) Illiquid securities which form numerous gaps on a regular basis do not signify that anything
special has occurred. Due to low liquidity, such stocks easily tend to hit exchange-set circuit limits
while the bid/ask quotes tend to a have wide spread, which results in these frequent gaps.

Penny stocks that tend to witness gaps on the chart due to low liquidity do not carry much technical
significance either, as is the case in the above chart of Stampede Capital, which witnessed a gap up
opening almost on a daily basis.
b) Options charts also tend to show wide gaps. Gaps occur due to two reasons on option premium
charts: (i) decay in time value, and (ii) low liquidity in most options that are traded.
Below is an example of an option premium chart:
c) Gaps that appear on the chart when a stock goes ex-dividend or gives bonus possess no trend
implication. These are gaps created due to corporate actions and not due to a change in supply-
demand relation that governs the trend. Most advanced charting softwares provide the option to
adjust the chart for dividend and bonus gaps.
In the above chart of Coal India Ltd (CIL), we witness a gap down opening due to the company
going ex-dividend. CIL announced a dividend of Rs18.75 and went ex-dividend on March 14, 2017,
witnessing a gap down opening of nearly the same amount.

Chapter 2 Classification of Gaps

Common Gaps : These gaps are named after the frequency with which they occur. They are also
known as area gaps, pattern gaps, or temporary gaps. Common gaps often occur when trading is
bound between support and resistance levels and market price tends to consolidate sideways.
Common gaps usually get filled up fairly quickly.
Forecasting significance: Nil or very little trading opportunity provided.
An example of a common gap can be seen below.

In the above chart of HDFC Ltd, we observe a number of common gaps which occur with high
frequency when the stock consolidates in a sideways zone.
Breakaway gap : These gaps occur when the price action is breaking out of a trading range or price
pattern. The presence of the breakaway gap, depending on its direction, emphasizes the bullishness
or bearishness of the breakout. A breakout of a trading range is the main distinction that separates
breakaway gaps from other types of price gaps.
Forecasting significance: Implies that a genuine breakout has occurred, i.e. the buying demand is
much stronger than the selling demand if an upward gap is witnessed. Volume plays a major role in
confirming the breakout. A large spike in volume is a sign that large institutional investors - usually
known as ‘smart money’ - have jumped on board the stock. This usually ensures that the stock price
will be supported near the breakout level and the stock will continue to rise. Trading a breakout
without volume is a risk.
Stop loss: Can be placed below the opening or intraday low of the breakout. This area generally acts
as a support level, though the price will sometimes dip below the intraday low only to witness fresh
buying which will support the stock. To reduce this risk, some traders place a stop loss below the top
of the previous trading range if the gap formed is not too large.
Breakaway gaps may occur from an earnings surprise or any other significant corporate news
announcement. Let us take a look at the example below:

In the above chart of Polaris, we witness a breakaway gap from a sideways price consolidation
backed by a surge in volumes which confirms the breakout. Stop loss can be placed below the low
of the breakout or a few points below the high of the previous day.
Continuation Gaps : They tend to occur during strong trends, i.e. near straight line advances or
declines in prices. These gaps are either closed very quickly or tend to remain open for a significant
period of time till the market witnesses a major reversal in the opposite direction.
Forecasting significance: Continuation gaps usually occur at the halfway point of a trend, and hence,
can be used to measure the ultimate price movement. It is for this reason that they are also
commonly referred to as measuring gaps.
Identifying a continuation gap:
 Initial trend (generally vertical)
 Substantial gap backed by volumes
 Continuation of the initial trend
Below is an example of a continuation gap.

Forecasting significance: Calculate the initial movement in the security. In our example, we calculate
the distance from point A to B. Titan witnessed a movement of 115 points from 580 to 695, which is
the midpoint of the gap. To determine the target price, we add this distance to the midpoint of the
gap thus obtaining a target price of 810. The up-move in Titan was quite swift, managing to hit the
target price on the same day as the continuation gap. Usually, the target is reached within a few
days.
Exhaustion gap: As the name suggests, an exhaustion gap occurs at the end of a trend. In the case
of an uptrend, the price makes one last attempt to move higher on the back of bulls; however,
exhaustion is witnessed and the price is not able to sustain at higher levels.
Historically, it has been observed that exhaustion gaps can be dangerous as they tend to induce
traders into a trade only to witness price move against the anticipated movement in the following
days. In fact, an exhaustion gap signals the end of a trend. There are two probabilities in an
exhaustion gap scenario: (i) the trend may reverse immediately, or (ii) price may remain in sideways
consolidation for some time. An exhaustion gap signals a trader to exit a position but does not
necessarily indicate the beginning of a new trend in the opposite direction.
Forecasting significance: It is difficult to differentiate an exhaustion gap from a measuring gap during
formation. One factor to look out for is volume; large unsustainable volumes are observed with the
price witnessing a trend reversal in the following days. An example of an exhaustion gap can be
seen below.

We can witness an exhaustion gap in the above chart of Jubilant FoodWorks. Price witnesses a
large gap during the uptrend and multi-month high volumes only to see a trend reversal in the
following days, thus, trapping the bulls. Two back-to-back Doji candlesticks indicating indecisiveness
are also witnessed right at the top. A close below the Dojis provides additional confirmation of a
reversal in trend.
Island reversal: This does not fall under the category of gaps per se, but is a famous candlestick
pattern formed due to gaps.
An island reversal is short-term reversal pattern that forms with two overlapping gaps. A bullish
island reversal forms with a gap down: short consolidation in prices and gap up. A bearish island
reversal forms with a gap up: short consolidation in prices and gap down. Technically, both the gaps
should overlap to create an empty space above or below the island. Traders with positions between
the two gaps are stuck with losing positions.
Identifying of an island reversal:
 Stock gaps in a bearish or bullish direction
 After the price consolidation of at least one candle, the stock gaps back in the opposite
direction
 None of the candles from the island overlap with the candles from the general price action,
including the body or the candle wick
Forecasting significance: A long position can be initiated in case of an island bottom, while a short
position can be initiated in case of an island top. The pattern tends to be quite reliable and has a
good success ratio. It is also more trustworthy if the two gaps are very large.
Stop loss: A stop loss should be placed below the island bottom pattern when entering a long
position and should be placed above the island top pattern while entering a short position.
Below is an example of an island reversal.

In the above chart, we witness a bearish island reversal pattern in Bharti Airtel’s price chart. Price
gap is up but is unable to sustain the uptrend. After a few days of consolidation at the top, price
corrects with a gap down formation. A short position can be initiated by maintaining the top of the
island as the stop loss.

Chapter 1 Technical Indicators - Technical

Analysis
What is a technical indicator?
A technical indicator is a series of data points that are obtained by applying a formula to the price
data of the underlying security. Price data includes open, high, low, close, or a combination of such
data over a period of time. The most commonly used price data is the closing price, but some
indicators also make use of open interest and trading volume as well.
Technical analysts use indicators in tandem with share prices and volumes to confirm trends and
possible reversal points in stocks.
Technical indicators are usually shown in a graphical format plotted below or on top of the price
chart.

Benefits of using Technical Indicators

A technical indicator provides a different angle/perspective on a security to determine its price action
as well as help analyze its strength and momentum.
Indicators are used to perform three broad functions i.e. to alert, to confirm, and to predict price
trends in stocks.
 To alert: A bearish signal on the indicator may serve as an alert to watch for a price
correction in the stock in the near term.
 To confirm: A breakout on the price chart and a positive bounce from the oversold levels on
momentum indicators such as RSI tend to provide confirmatory signals.
 To predict: Technical analysts tend to make use of leading indicators to predict the future
price movement in a security.

Category of Indicators
There are two main categories of indicators:
 Leading indicators:
Leading indicators are those created to precede the price movement of a security and have
predictive qualities. They are best used during periods of sideways consolidation in price i.e.
non-trending sideways movement. This is because leading indicators tend to generate
frequent buy/sell signals, which make it best suited for choppy markets compared to trending
markets. Traders need to make sure the indicator is heading in the same direction as the
underlying trend in the security.
 Traders use leading stock indicators to predict future price moves. Ideally, leading stock
indicators signal you to enter a trade before a new trend develops or an existing trend
reverses so that you can ride the momentum for maximum profit. But the issue with leading
indicators is that they may generate many whipsaws or false signals.
Most of the leading indicators are oscillators. This means that these indicators are plotted
within a bounded range. As the value of the oscillator reaches the extreme upper value, the
security is considered to be overbought. Similarly, it is considered oversold when it reaches
the lower end of the band.
 Lagging indicators:
Lagging indicators follow a stock's price and provide confirmatory signals. For example, a
lagging indicator can confirm that a stock has developed an uptrend and is likely to continue
to surge.Lagging indicators are not suitable to predict future rallies or pullbacks. They can
confirm what trends have developed up until the current point but are not able to predict the
next price movement.
Lagging indicators are more useful during trending periods. This is because lagging indicators tend
to focus more on the trend and produce fewer buy-and-sell signals, which is the best strategy in
such markets.

How to interpret indicators?

There are two main ways to interpret the buy/sell signals that are generated using indicators.
 Crossover: Crossover occurs when the indicator moves through an important level or the
centerline. It signals that the trend is reversing and this trend reversal will lead to an
expected movement in the price of the security.
For example, if the RSI crosses above the 30-level, it signals that the security is moving
away from an oversold level and a short-term bounce in its price can be expected.
 Divergence: Divergence occurs when the price and the direction of the indicator are trending
in opposite ways.
Divergence is of two types – positive and negative.
A positive divergence occurs when the price of the security is trending downwards, i.e.
making new lows, while the indicator is trending higher. This is a bullish signal which
indicates that the underlying momentum is starting to reverse and a reversal in the price of
the security may soon be witnessed.
A bearish divergence occurs when the price of the security is trading higher, i.e. making new
highs while the indicator is trending lower. This is a bearish signal that indicates a weakening
in the underlying momentum of the stock.
Indicators provide analysts with useful, additional information and help them make better
informed decisions. However, taking your trading decisions solely based on a single indicator
could be misleading. Hence, indicators are best used in conjunction with price charts.

Chapter 2 Leading Indicators

1) Relative Strength Index
RSI is a popular momentum oscillator that is computed on the basis of the speed and direction of a
stock’s price movement. It helps spot overbought and oversold areas on the price chart.

Computing RSI
RSI = 100-100/(1+RS)
RS = Average up point for period (14 days)/Average down point for period (14 days)
Nine and 14 days are the most commonly used time periods to calculate RSI; however, this can be
customized as per the trader’s need and choice. Shorter durations of five or seven days are also
used to increase the volatility of the RSI line, while on the other hand, some take a time frame of
either 21 or 28 days to smoothen it out.

Overbought and oversold zones

The RSI oscillates between 0 and 100. It is considered to be in the overbought zone when it moves
above 70 and in the oversold zone when it slips below 30. Buy signals are generated when RSI
crosses the oversold zone and sell signals are generated when it crosses the overbought zone.
However, these standard levels can be adjusted, if required, to better fit the security.
For e.g., as can be seen in the following chart of Jet Airways, the down arrow indicates the
overbought zone, where the RSI has also crossed the signal line from top to bottom. This indicates
the beginning of short-term price erosion. On the other hand, the up arrow indicates the oversold
zone, followed by a crossover of the RSI and the signal line from down to up, to indicate a short-term
up move. Some investors also pay attention to the centerline crossover, i.e. the scenario when the
RSI line crosses the 50-line mark. Here, if the RSI crosses from above, it is considered as bearish,
whereas if it crosses from below, then it is considered as bullish.

RSI: Technical Analysis Chart

Divergence:
Divergence between the RSI and the price line is very crucial. The RSI should be closely observed
when it is above 70 or below 30, or when the market makes a new high but the RSI does not.

DIVERGENCE PRICE

Regular Bullish Divergence Lower Low

Regular Bearish Divergence Higher High

Hidden Bullish Divergence Higher Low

Hidden Bearish Divergence Lower High

Regular Bullish Divergence:

Regular bullish divergence can be observed when the stock is making a lower low (LL) and the RSI
is making a higher low (HL). This indicates the strength in the underlying assets, where bears are
exhausted, and hints of a possible trend reversal from down to up.
Regular Bearish Divergence:
Regular bearish divergence can be seen when the stock is making a higher high (HH) and the RSI is
making a lower high (LH). It indicates weakness in the underlying assets, where bulls are exhausted,
and warns of a possible reversal in the trend from up to down.
Hidden Bullish Divergence:
Hidden bullish divergence occurs when the price is making a higher low (HL) and the RSI is making
a lower low (LL). This indicates good strength in the underlying assets. It occurs during the
retracement in an uptrend. In this scenario, one can consider “buy on dips” strategy.
Hidden Bearish Divergence:
Hidden bearish divergence occurs when the price is making a lower high (LH) and the RSI is making
a higher high (HH). This indicates weakness in the underlying assets and is found during the
retracement in a downtrend. “Sell on rise” should be the ideal strategy one can use in this situation.
RSI may remain in the overbought and oversold zone for extended periods when the prevailing trend
is strong. RSI cannot be used solely to identify market trends as sudden large price movements can
create false buy or sell signals in the RSI. It is, therefore, best used with refinements to its
application or in conjunction with other confirming technical indicators.

For Advanced Traders

RSI also forms chart patterns, such as support or resistance, trend lines, and double top and
bottoms, that may not be seen on a price chart. Like many other momentum oscillators, RSI works
best when prices move sideways within a range.

2.) Stochastic Oscillator

Stochastic oscillator follows the speed or the momentum of a stock’s price as momentum changes
direction before price. Thus, bullish and bearish divergences in the stochastic oscillator can be used
to foreshadow reversals. As the stochastic oscillator is range-bound, it is also useful for identifying
overbought and oversold levels.
The stochastic oscillator operates in a range of 0 to 100 to identify possible entry and exit points in a
trade. The two stochastic oscillator lines are identified as %K and %D. The oscillator gives a bullish
sign when the %K line crosses over the %D line. On the flipside, when the %K line moves below the
%D line, you have a bearish sign. If at least one of the lines dips below 20 and comes back up, it is
considered as a buy signal, and when at least one of the lines rises above 80 before dropping again,
it is a sell signal.

Computing a stochastic oscillator

%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100
%D = 3-day SMA of %K
Lowest Low = Lowest low for the selected period
Highest High = Highest high for the selected period
%K is multiplied by 100 to move the decimal point by two places.
Traders generally make use of 14-day stochastic oscillators, which is also the default setting. A 14-
day %K would use the most recent close, the highest high over the last 14 periods, and the lowest
low over the last 14 periods. %D is a three-day simple moving average of %K. This line is plotted
along with %K to act as a signal or trigger line.

Interpretation
The stochastic oscillator measures the level of the close relative to the high-low range over the
selected time period. For e.g., assume that 190 was the security’s highest high in the selected time
period, the lowest low was 170, and the current price is 185.
The high-low range here is 20, which is the denominator in the %K formula. Subtracting the close
from the lowest low gives us 15, which is the numerator. Thus, 15 divided by 20 equals 0.75. We
multiply this number by 100 to find %K.

Overbought and oversold zones

The stochastic is a bounded oscillator like RSI, which makes it easy to identify overbought and
oversold levels. It ranges from zero to 100. Conventional settings use 80 as the overbought zone
and 20 as the oversold. However, these levels can be adjusted based on the market of trade as well
as the security’s characteristics. Readings above 80 for the 14-day stochastic oscillator would
indicate that the underlying security was trading near the top of its 14-day high-low range. Readings
below 20 occur when a security is trading at the low end of its high-low range.
It is important to note that overbought readings are not necessarily bearish. Securities can become
overbought and remain overbought during a strong uptrend. Closing levels that are consistently near
the top of the range indicate sustained buying pressure.
Similarly, oversold readings are not necessarily bullish. Securities can become oversold and remain
oversold during a strong downtrend as well. Closing levels consistently near the bottom of the range
indicate sustained selling pressure.
It is, therefore, important to identify the bigger trend and trade in that direction. Look for occasional
oversold readings in an uptrend and ignore frequent overbought readings. Similarly, look for
occasional overbought readings in a strong downtrend and ignore frequent oversold readings.
In the above example of ACC, the up arrow indicates the oversold zone, followed by a crossover of
the stochastic and the signal line from down to up indicating a short-term up move in the price of the
stock. On the other hand, the down arrow indicates the overbought zone, where the stochastic has
also crossed the signal line from top to bottom. This indicates that there could be a correction in the
price of the security in the short term. The indicator is both overbought and strong when above 80. A
subsequent move below 80 is needed to signal some sort of reversal. Conversely, the oscillator is
both oversold and weak when below 20. A move above 20 is needed to show an actual upturn.

Divergence
Divergence is witnessed when a new high or low in price is not confirmed by the stochastic
oscillator. A bullish divergence is formed when the price records a lower low but the stochastic
oscillator forms a higher low. This shows less downside momentum that could warn of a bullish
reversal. Likewise, a bearish divergence forms when the price records a higher high, but the
stochastic oscillator forms a lower high. This shows less upside momentum, which could foreshadow
a bearish reversal. Once a divergence takes hold, chartists should look for a confirmation to signal
an actual reversal.
A bearish divergence can be confirmed with a support break on the price chart or a stochastic
oscillator break below 50, i.e. the centerline. A bullish divergence can be confirmed with a resistance
break on the price chart or a stochastic oscillator break above the centerline.
In the above example of Tech Mahindra, we observe that the stock continued to form a lower top-
lower bottom chart structure on the price chart between March 20, 2017 and July 28, 2017.
Simultaneously, the stochastic witnessed a bullish divergence forming a higher top-higher bottom
structure and indicated a reversal in the price trend. This was confirmed after the stock finally
managed to give a breakout above the declining trend line.

3.) Commodity Channel Index

Commodity Channel Index (CCI) is a versatile indicator that can be used to identify a new trend or
warn of extreme conditions. Although this indicator was originally developed for commodities, it is
used to signal cyclical turns in stocks.
The CCI gives entry signals when it is above +100 and exit signals when it is below -100. A
potentially bullish signal occurs when the indicator moves from the negative range into the positive
range and vice versa when it falls from the positive into the negative. Since there is no upper or
lower range limit with this indicator, identifying overbought tops and oversold bottoms with CCI is
difficult.

Computing CCI
CCI = (Typical Price - 20-day SMA of TP) / (0.015*Mean Deviation), where typical price (TP) is
(High+Low+Close)/3, and constant = 0.015.
To find the mean deviation, we need to apply the following steps:
 Subtract the most recent 20-day average of the typical price from each period's typical price
 Take the absolute values of these numbers
 Sum the absolute values
 Divide by the total number of periods (20)

Identifying a new emerging trend

As noted above, a majority of the CCI movement occurs between -100 and +100. A move that
exceeds this range shows unusual strength or weakness that can foreshadow an extended move.
Think of these levels as bullish or bearish filters. Technically, CCI favors the bulls when positive and
the bears when negative. However, using a simple zero line crossover can result in many whipsaws.
Although entry points will lag more, requiring a move above +100 for a bullish signal and a move
below -100 for a bearish signal reduces whipsaws.

The chart above shows Adani Enterprises’ 20-day CCI. The stock bottomed on December 4, 2017,
and witnessed a reversal in price. CCI moved above +100 on December 18, 2017 (10 trading days
later) to signal the start of an extended move. Similarly, the stock topped on February 8, 2018, and
the CCI moved below -100 on March 6 (13 trading days later) to signal the start of an extended
decline. CCI does not catch the exact top or bottom, but it can help filter out insignificant moves and
focus on the larger trend in the security.

4.) Williams %R
The Williams %R is a momentum based leading indicator that helps identify when a stock is
overbought or oversold. Unlike other leading indicators, Williams %R uses a negative trading range
to predict stock movement. The indicator oscillates between a low of -100 to a high of 0. A stock is
considered to be overbought when the indicator reaches -20 and oversold when the reading is below
-80. Analysts also make use of the centerline (-50), to generate buy and sell signals.
The CCI gives entry signals when it is above +100 and exit signals when it is below -100. A
potentially bullish signal occurs when the indicator moves from the negative range into the positive
range and vice versa when it falls from the positive into the negative. Since there is no upper or
lower range limit with this indicator, identifying overbought tops and oversold bottoms with CCI is
difficult.
Computing Williams %R
%R = (Highest High-Close)/(Highest High-Lowest Low) * -100
Lowest Low = Lowest low for the selected period
Highest High = Highest high for the selected period
%R is multiplied by -100
Analysts generally use a default period of 14 days to calculate William’s %R.

Interpretation
Similar to the stochastic indicator, Williams %R reflects the level of the close relative to the high-low
range over a given period of time. Consider that a stock hits a high of 210 in the selected time
period, a low of 200, and manages to give a close at 208. Then, according to the Williams %R
formula, the numerator is calculated as highest high less the close, i.e. 210-208 = 2, while
denominator equals the range between the high and the low, i.e. 210-200 = 10. The numerator is
then divided by the denominator, which yields a value of 0.2. This value is then multiplied by -100 to
give us the final value of -20 for % R.
A Williams %R cross above -50 signals that prices are trading in the upper half of their high-low
range for the selected period. Conversely, a cross below -50 means prices are trading in the bottom
half of selected period.
Low readings (below -80) indicate that price is near its low for the given time period. High readings
(above -20) indicate that price is near its high for the given time period.

Overbought and oversold zones

As a bounded oscillator, Williams %R makes it easy to identify overbought and oversold levels. The
oscillator ranges from 0 to -100. No matter how quickly a security advances or declines, Williams
%R will always fluctuate within this range. Traditional settings use -20 as the overbought threshold
and -80 as the oversold threshold. These levels may be adjusted according to the nature of the
market and the type of security. Readings above -20 for the 14-day Williams %R would indicate that
the underlying security was trading near the top of its 14-day high-low range. Readings below -80
occur when a security is trading at the low end of its high-low range.
It is important to note that a security may remain in an overbought or an oversold zone for a
considerable period of time during strong trending markets. Closing levels that are consistently near
the top of the range indicate sustained buying pressure, while closing levels consistently near the
bottom of the range indicate sustained selling pressure.
In the above example of Arvind, the up arrow indicates a bullish crossover from the oversold zone on
the William %R which occurred on February 6, 2018. The stock also formed a bullish piercing
candlestick pattern on the daily chart and provided a confirmation signal for traders to initiate a
bullish trade the next day.
Similarly, on March 1, 2018, the stock witnessed a bearish crossover from the oversold levels
indicated by the down arrow, with the stock price forming a bearish candlestick, giving a confirmatory
sell signal the next day.

5.) On-Balance Volume

On-balance volume (OBV) measures buying and selling pressure as a cumulative indicator that adds
volume on days the stock moves up and subtracts volume on days it witnesses a correction in price.
It was one of the first indicators to measure positive and negative volume flow. Analysts make use of
the indicator to identify the divergence between OBV and the price or to confirm price trends.

Computing OBV
OBV is simply a running total of volume. A period's volume is taken as positive when the close is
above the prior period’s close, while its volume is taken as negative when the close is below the
prior close.
If the closing price is above the prior close price, then:
OBV = Previous OBV + Today’s Volume
If the closing price is below the prior close price, then:
OBV = Previous OBV – Today’s Volume
If the closing prices equals the prior close price, then:
OBV = Previous OBV (no change)

Interpretation
Technical analysts use volume as a secondary indicator as it is considered to precede price. OBV
rises when the volume on up days outpaces the volume on down days and falls when the volume on
down days is higher.
OBV can provide insight because it is dependent on the quantity of trade volume, and not just the
price direction. For e.g., a down day with 20,00,000 volume is not as significant if the price surges
with 70,00,000 volume the next day. Here, volume indicates that buyers are more bullish compared
to earlier, and hence, OBV will move higher over the two-day period even though it moved in
different directions in the duration.
The absolute value of OBV isn’t important, since the number can be huge for low-priced stocks, and
near zero for illiquid stocks. What matters is how OBV is acting and its trend.
A rising OBV reflects positive volume pressure that can lead to surging prices. Conversely, a falling
OBV reflects negative volume pressure that can foreshadow lower prices. A key point to take note of
is that OBV is based on the closing prices, and hence, the closing price in the security is considered
when identifying divergence or trend confirmation.

A confirmatory tool
OBV is primarily used as a confirmation tool for trends. OBV should rise when the price is rising and
vice versa. It helps confirm the direction in which the price is likely to continue. Trend lines are used
to indicate the current direction of both the price and the OBV.

In the above example of Ashok Leyland, OBV has been constantly rising from February 2018, in-line
with the price surge, confirming the bullish trend in the stock, thus providing additional confidence to
the trader to maintain his long position.

Divergence
OBV can also be used to anticipate trend reversals by observing the divergence signals it generates.
A bullish divergence is observed when OBV moves higher or forms a higher low even as prices
move lower or form a lower low. A bearish divergence forms when OBV moves lower or forms a
lower low even as prices move higher or form a higher high. The divergence between OBV and price
should alert chartists that a price reversal could soon be witnessed.
The chart for Lupin shows a bullish divergence forming in December 2017. On the price chart, Lupin
moved below its December low with a lower low in March 2018. OBV, on the other hand, held above
its December 2017-low to form a bullish divergence. The stock has currently witnessed a breakout
on the price chart. We expect this positive momentum to continue in the coming days.

Chapter 3 Lagging Indicators

1.) Moving Averages

Moving average is a widely used technical indicator that helps smoothen out the volatility in a stock’s
price action by filtering out the noise from random price fluctuations. A moving average is a trend-
follow lagging indicator as it is calculated taking past data into consideration. As the name suggests,
a moving average is an average that moves as old values are dropped with the availability of new
values. Moving averages can be employed to identify the current trend of a scrip.

Types of moving averages

There are 3 types of moving averages
 Simple Moving Average (SMA)
It is obtained by computing the simple average of price data over a defined period of time. In
general, we use the closing price of the security to compute the SMA as it is considered to
have more significance compared to the remaining price points (namely, open/high/low price
for the day). Thus, a five-day SMA is calculated by adding the closing price of five days and
dividing this sum by the total number of days (in this case, five).
For e.g., the five-day SMA of ITC can be calculated as follows:
ITC

Date Close Price

Jul 3, 2017 342.5

Jul 4, 2017 337.25

Jul 5, 2017 331.05

Jul 6, 2017 337.10

Jul 7, 2017 334.30

Jul 10, 2017 333.30

Jul 11, 2017 330.40

Jul 12, 2017 328.85

5-day SMA on July 7 = 336.44 =(342.50+337.25+331.05+337.10+334.30)

5
5-day SMA on July 7 = 336.44 =(342.50+337.25+331.05+337.10+334.30)

5
5-day SMA on July 7 = 336.44 =(342.50+337.25+331.05+337.10+334.30)

5
5-day SMA on July 10 = 334.6 =(337.25+331.05+337.10+334.30+333.30)

5
5-day SMA on July 11 = 333.23 =(331.05+337.10+334.30+333.30+330.40)

5
 5-day SMA on July 12 = 332.89 =(337.10+334.30+333.30+330.40+328.85)

5
To calculate the moving average of the scrip after the close of market hours on July 7, 2017,
we will consider the closing price of the last five trading sessions (from July 3 to July 7) and
divide it by 5.
To recalculate the five-day SMA at the close of the next trading session on July 10, 2017,
exclude the closing price from July 3 and consider the one on July 10 i.e. the new data
value.
As illustrated in the example, price gradually decreases from 342.5 to 328.85 over a period
of eight days; in the same timeframe, the five-day SMA also decreases from 336.44 to
332.89, indicating a lag associated with the moving averages. Hence, larger the time period,
larger is the lag.
 Weighted Moving Average (WMA)
Weighted moving average moves a step ahead of simple moving average. Here, we assign a
weight to each value, with bigger weights assigned to the most recent data points as they
are more relevant than historical data points. The sum of weights should add up to 1 (or
100%). As new data points are added, the new weights will align accordingly. In contrast,
each value is assigned the same weight in SMA. Ideally, traders calculate WMA on the basis
of the closing price.
WMA is calculated by multiplying the given price by its assigned weight and then dividing the
sum by the total number of days. The weights assigned are subjective in nature are at the
discretion of the trader. Because of its calculation methodology, WMA follows prices more
closely than a corresponding SMA. This reduces lag to an extent.
ITC

Date Close Price W

Jul 3, 2017 342.5 0

Jul 5, 2017 331.05 0

Jul 5, 2017 331.05 0

Jul 6, 2017 337.10 0

Jul 7, 2017 334.30 0

Jul 10, 2017 333.30

Jul 11, 2017 330.40

Jul 12, 2017 328.85

5-day WMA on July 7 = 335.34
=(342.50*0.07+337.25*0.13+331.05*0.20+337.10*0.27+334.3*0.33)
 5
5-day WMA on July 10 = 334.29
=(337.25*0.07+331.05*0.13+337.10*0.20+334.3*0.27+333.3*0.33)

5
5-day WMA on July 11 = 332.89
=(331.05*0.07+337.10*0.13+334.30*0.20+333.3*0.27+330.4*0.33)

5
5-day WMA on July 12 = 331.43
=(337.1*0.07+334.30*0.13+333.30*0.20+330.4*0.27+328.85*0.33)

5
 Exponential Moving Average (EMA)
Exponential moving average widely differs from the simple and weighted moving averages
methodologies as it is calculated by considering all historical data points since the inception
of the stock. Ideally, to calculate 100% accurate EMA, we should use all closing prices right
from the first day a stock was listed.
Calculating the EMA involves a three-step process:
Step 1: Since it would not be practical to calculate historical data right from the inception of
the stock, we use the SMA value as the initial EMA value. So, a simple moving average is
used as the previous period's EMA in the first calculation.
Step 2: To calculate the weighting multiplier, we divide 2 by the sum of total periods and add
it to 1.
Step 3: We subtract the EMA of the previous day from the current closing price and multiply
this number with the multiplier. We then add this product with its previous period EMA to find
out the final EMA value.
Therefore, the current EMA value will change depending on how much past data we use in
our calculation. The more data points we use, the more accurate our EMA will be. The goal
is to maximize accuracy while minimizing calculation time.
Initial EMA value = 5-day SMA
Weighting Multiplier= (2 / (Time periods + 1)) = (2 / (5 + 1)) = 0.3333 (33.33%)
EMA= {Close – EMA of previous day} x multiplier + EMA of the previous day
A five-day EMA applies a 33.33% weighting to the most recent prices, while a 10-day EMA
has a weighting multiplier of 18.18%. The shorter the time period, larger the weighting
multiplier will be. We notice that as the time period doubles, the weighting multiplier drops
50%.

Date Close Price Five-day SMA Weight

Jul 3, 2017 342.5 -- --

Jul 4, 2017 337.25 -- --

Jul 5, 2017 331.05 -- --

 Date Close Price Five-day SMA Weight

Jul 6, 2017 337.10 -- --

Jul 7, 2017 334.30 336.44 --

Jul 10, 2017 333.30 334.60 0.3333

Jul 11, 2017 330.40 333.23 0.3333

Jul 12, 2017 328.85 332.79 0.3333

5-day EMA on July 7 = 5-day SMA= 336.44
5-day EMA on July 10 = 335.39 = (333.30-336.44) x 0.33 + 336.44
5-day EMA on July 11 = 333.73 = (330.40-335.39) x 0.33 + 335.39
5-day EMA on 12 = 332.10 = (328.85 -333.72) x 0.33 + 333.72

Comparison of the three moving averages

Different values are generated when we compare the computation methodology of the three different
moving averages. The most common moving average among traders is EMA.

Moving
Averages SMA WMA

Advantages  Smoothened average  Reduction in price lag, so can b

for short-term trading
 Less prone to whipsaws
 Best average to consider for support &
resistance

Disadvantages  Has maximum price lag  Omission of previous data poin

price data not being considered
 Assigns same weight to all price data
 Chance of whipsaws
 Omission of previous data points leads to all
price data not being considered

Moving average value comparison: The following table represents the comparison between the
values of the three different moving averages over the same period of time

Date Close Price Five-day SMA Five-day W

Jul 3, 2017 342.5 -- --

Jul 4, 2017 337.25 -- --

Jul 5, 2017 331.05 -- --

 Date Close Price Five-day SMA Five-day W

Jul 6, 2017 337.10 -- --

Jul 7, 2017 334.30 336.44 335.34

Jul 10, 2017 333.30 334.60 334.29

Jul 11, 2017 330.40 333.23 332.89

Jul 12, 2017 328.85 332.89 331.43

Graphical comparison on the three moving averages

As seen in the above graph, where blue, green, and pink are the five-day EMA, WMA, and SMA,
respectively, when there is a sharp correction in the price, EMA and WMA react the most as they
assign a higher weight to the most recent prices compared to the SMA.

Applications of Moving Averages

Trend Identification
Traders use moving averages to identify the trend of a stock. A rising 200-day moving average
reflects that the long-term trend is up and the stock can be traded with a positive bias. Similarly, a
falling 200-day moving average reflects a long-term downtrend and hence, we can consider shorting
the stock or refrain from investing in it.
(Blue: 10-day EMA; green: 89-day EMA; pink: 200-day EMA)
From the above graph, we can clearly see that L&T Finance is in a long-term uptrend as the short-
and medium-term averages are trading above its long-term 200-day moving average, which is also
showing an upward momentum. A price dip towards its medium-term average can be considered as
a buying opportunity.

Buy/sell signals based on crossover

A buy signal is generated when a bullish crossover occurs, i.e. the short-term moving average
crosses the long-term moving average, popularly referred to as a golden cross. For e.g., when the
89-day EMA crosses above the 200-day EMA, a bullish trade can be initiated.
On the other hand, a bearish death cross occurs when the short-term moving average crosses
below the long-term moving average. The generated signals tend to occur with a lag as we make
use of two lagging indicators. The best trading opportunities are obtained in a trending market as
compared to a sideways market, wherein whipsaws or false signals are generated.

Price 89-day EMA A

Trading above 200-EMA Crosses above 200-EMA B

Trading below 200-EMA Crosses below 200-EMA B

In the above graph, we see how moving averages can be used to generate trading signals. Moving
averages can also be used to generate signals with simple price crossovers. A bullish signal is
generated when prices move above the moving average and a bearish signal is generated when
prices move below it. The advantage of price signals is that it reduces time lag and allows traders to
react quicker.

As in the Fortis case represented above, traders could have initiated a short position or could have
closed their long positions when the stock closed below its 200-day EMA. Consequently, a huge
surge in trading volumes, with the MACD-Histogram moving into the negative territory, indicated a
change in momentum. This hinted traders to take a bearish view, thus resulting in an 18% fall in the
stock.

Support & Resistance Levels

Moving averages also tend to act as support and resistance levels. A stock in a long-term uptrend
could find support near its medium-term EMA during a pullback. Similarly, a stock in a long-term
downtrend could face resistance near its medium-term EMA during any bounce backs.
In fact, some moving averages may offer support or resistance simply because they are widely used
by many traders. For e.g., a trader may not short a stock if it is trading near its 200-day EMA out of
fear that other traders may be using it as a buy zone.

In the above example of JSW Steel, we see how the stock has taken support along its medium-term
89-day EMA on multiple occasions and has acted as a good support level to purchase the stock.

Moving Averages in sync with the Candlestick Pattern

Moving averages can also be traded in tandem with candlestick patterns. In the above chart of Bata
India, the bullish candlestick pattern can be traded with added confidence as it coincides with the
support of the 200-day EMA.

Moving Average in sync with Price Pattern

In the above chart of United Spirits, a buy signal is generated when the bullish crossover coincides
with a cup and handle breakout on the daily chart, affirming a bullish bias in the stock.

Construction of Indicators
Moving averages are used to construct technical indicators such as Bollinger Band and MACD,
which are widely used by market technicians.

Key Moving Averages Used by Technical Analysts

Moving averages are used based on the trading horizon.
For e.g.,

Moving Average Trading Period

5-day MA Short-term

13-day MA Short-term

50-day MA Medium-term

89-day MA Medium-term

200-day MA Long-term

Observations on Moving Averages

 It is used in a trending market to indicate a clear trend direction by eliminating the noise
 In case of a sideways market, the moving average would lead to whipsaws, hence, using
other indicators like RSI and stochastic would be more helpful
 Signals generated by moving averages tend to have a lag
 Provides best results when combined with other technical indicators and price patterns

2.) Bollinger Bands®

Bollinger Bands® are one of the most widely indicators used in technical analysis. They are volatility
bands that are placed above and below a moving average and automatically expand or contract with
a change in volatility. The dynamic nature of Bollinger Bands allows them to be used on different
securities without having to change the setting. Famous technical trader John Bollinger developed
this tool and registered it as his trademark.

Computing Bollinger Bands

There are three lines that compose Bollinger Bands: a simple moving average (middle band) and an
upper and a lower band.
Middle band = 20-day SMA of the closing price
Upper band = 20-day SMA + (20-day standard deviation of price * 2)
Lower band = 20-day SMA - (20-day standard deviation of price * 2)
The default setting of the middle band, i.e. the simple moving average is usually set at 20 days. A
simple moving average is used because the standard deviation formula also uses a simple moving
average. The upper and lower bands are usually set two standard deviations above and below the
middle band, respectively.

Interpretation
Overbought and oversold levels
Traders use Bollinger Bands to determine overbought and oversold levels. A trader will try to sell
when the price, backed by a bearish signal on the price chart, reaches the top of the band, and will
execute a buy when the price, backed by a bullish signal on the price chart, reaches the bottom of
the band. According to Bollinger, the bands should contain 88-89% of price action, which suggests
that the price would move within the band for a majority of the time.
The interpretation is that the stock price should hover around the average price. However, if the
current stock price is around its upper band, it is considered expensive in respect to the average.
Here, one should look at shorting opportunities if there is a confirming signal on the price chart with
an expectation that the price will scale back to its average.
Likewise, if the current market price is around the lower band, it is considered cheap in respect to
the average prices. Here, one can look at buying opportunities with an expectation that the price will
scale back to its average.

In the above example of Pidilite Industries, we observe instances where a trader can initiate trades
based on oversold and overbought levels on the Bollinger Band conceding with bullish and bearish
candlestick patterns on the price chart.
An important point to keep in mind is that the upper and lower Bollinger Bands together form an
envelope, which expands whenever the price drifts in a particular direction, indicating a strong
momentum. The Bollinger Band signal fails when there is an envelope expansion. This leads us to
an important conclusion, Bollinger Bands work well in a sideways markets, and fail in a trending
market.

3.) Standard Deviation

Standard deviation is a statistical measure to gauge the amount of variability or dispersion around an
average. It measures the difference between the actual value and the average value. If a security
trades in a narrow price range, the standard deviation will give a lesser value, which indicates low
volatility. Conversely, if the security witnesses wild price swings, either up or down, then standard
deviation gives a higher value, which indicates high volatility.

Computing Standard Deviation

 Calculate the average (mean) price for the number of periods selected
  Determine each period's deviation (close less average price)
 Square each period's deviation
 Sum the squared deviations
 Divide the sum by the number of observations
 The standard deviation is then equal to the square root of that number

Interpretation
Standard deviation is mainly used as a confirmatory indicator. It tends to surge as price gets volatile.
As the price action declines, the standard deviation moves lower. A price move backed by a surge in
standard deviation indicates above-average strength and weakness.
Market bottoms that are accompanied by decreased volatility over longer periods of time indicate a
lack of interest in the security among traders, while market bottoms accompanied by a surge in
volatility over a short duration indicate panic sell-offs.

Standard Deviation Values

Standard deviation values depend on the price of the security in question. Securities with a higher
price tend to have a higher standard deviation value compared to stocks with low price. Hence, a
stock like Eicher Motors or Page Industries (current market price at ~Rs30,000) will always have a
higher value compared to a stock like Ashok Leyland (CMP ~Rs144). However, the absolute value is
not of much importance; what traders look for is the trend in the standard deviation with respect to
the price action.
Standard deviation values are also affected if a security experiences a large price change over a
short period of time. A stock that has surged from 15 to 60 is most likely to have a higher standard
deviation at 60 than at 15. Likewise, a security that moves from 10 to 50 will most likely have a
higher standard deviation at 50 than at 10.

Aban Offshore’s chart above depicts a decline in price and a gradual decline in volatility, indicating a
lack of buying interest in the stock.
Alkem’s chart above, depicts a panic sell-off; the decline in price is accompanied by a surge in the
standard deviation, indicating that traders are expecting the correction in the stock to accentuate
and, hence, want to exit at any cost.

On the contrary, the above chart of Bata India shows a surge in prices backed by a surge in
standard deviation, thus indicating strength in the stock. This is usually witnessed when there is a
huge buying interest in the stock.

4.) MACD-Histogram
The MACD-Histogram (Moving Average Convergence Divergence-Histogram) is an oscillator that
fluctuates above and below the zero line. The MACD-Histogram is used to anticipate signal line
crossovers in MACD, which turns moving averages into momentum indicators by subtracting a
longer moving average from a shorter one. Since MACD-Histogram makes use of moving averages
and as moving averages inherently lag behind price, there can be a delay in signal line crossovers,
which could affect the reward-to-risk ratio of a trade. Bullish or bearish divergences in the MACD-
Histogram can alert chartists to an imminent signal line crossover in the MACD.

How to compute
MACD = (12-day EMA - 26-day EMA)
Signal Line = 9-day-EMA of MACD
Thus, MACD-Histogram = MACD - Signal Line
The default MACD indicator is the 12-day-EMA minus the 26-day-EMA, while a 9-day-EMA is plotted
alongside the chart to act as the signal line to identify turns in the indicator. The histogram is positive
when MACD is above its 9-day-EMA and negative when it is below it.

Interpretation
The MACD-Histogram is designed to identify convergence, divergence and crossovers. It displays
the extent of separation between the MACD and its signal line. The histogram is positive when
MACD is above its signal line. Positive values increase as MACD diverges further from its signal line
and decrease as it converges with its signal line. The MACD-Histogram crosses the zero line as
MACD crosses below its signal line. The indicator is negative when MACD is below its signal line.
Negative values increase as MACD diverges further from its signal line. Conversely, negative values
decrease as MACD converges on its signal line.

Signal Line Crossover

With this method, a buy signal occurs when the MACD line crosses above the signal line forming a
confirmatory bullish candlestick pattern on the price chart. A sell (short) signal occurs when the
MACD line crosses below the signal line along with a bearish candlestick on the price chart.

In the above example of Shiram Transport Finance, we witnessed a sell signal on January 18, 2018,
when the MACD-Histogram crossed below the center line with a confirmatory bearish signal on the
price chart. On the other hand, a bullish signal was generated on February 23, 2018, when the
MACD-Histogram witnessed a positive crossover over the center line.
There are no built-in targets with this indicator, so trades are generally held until a crossover in the
opposite direction occurs. New trades can then be initiated in the direction of the new crossover.
The downfall of this strategy is that it can result in whipsaw trades, when the MACD and signal lines
cross back and forth in a short amount time; hence, the indicator, just like moving averages, should
be made use of in trending markets. Another way to avoid whipsaws is to only take trades in the
direction of a long-term trend. If the trend is up, only take buy signals, and exit when the MACD line
crosses back below the signal line.

Divergence
The MACD-Histogram anticipates signal line crossovers in MACD by forming bullish and bearish
divergences. Bearish divergence is when the price is making new highs, but the MACD is not. It
shows that momentum has slowed, and that a reversal could be witnessed soon.
Bullish divergence is when the price is making new lows, but the MACD is not. It shows that selling
pressure has slowed, and that a reversal could be around the corner.
It is risky to base trades solely on divergence, wait for the confirmation signal on the price chart. A
stock can continue to rise (fall) for a long time even while bearish (bullish) divergence is occurring.

In the above example of Bosch, notice that the price tries to make a new low late in March 2018, but
the MACD is already making higher highs. This indicates that a reversal is around the corner, and it
is exactly what is witnessed in the following days, with the stock witnessing a breakout on the price
chart and a bullish signal line crossover on the MACD-Histogram.

5.) Force Index

The force index is a technical indicator that combines the price and volume to determine the strength
behind a move or help identify possible turning points. Put simply, it helps gauge the strength behind
price movements by looking at a combination of three key pieces of market data, i.e.
 Direction of price change
 Magnitude of price change
 Trading volume
Computing Force Index
Force index = {Close (current period) - Close (prior period)} * Volume
Calculation of the one-day force index is straightforward. We simply subtract the prior close from the
current close and multiply the difference by current period’s volume. The force index for more than
one day is computed by taking the EMA of the one-day force index. For example, a 20-day force
index is the EMA of a one-day force index value for the last 20 days.
Force index is positive when the current close is above the prior close, and negative when the
current close is below the prior close. For the force index to produce a large value, the price change
and volume have to be significant.
In order to smoothen the one-day force index and produce less whipsaws, a trader can consider
using the indicator with a 10-day- or 14-day-EMA to reduce the positive-negative crossovers.

Interpretation
Force index produces either a positive or negative value based on the price movement. A positive
price change signals that buyers were stronger than sellers, while a negative price change signals
the opposite. Meanwhile, the extent of the price move along with the volume shows the commitment
of the trader, i.e. a big advance on heavy volume show the bullishness of the buyer, and likewise, a
big decline on heavy volume displays the bearishness of the seller.

Trend Identification
The force index can also be used to determine the medium or long-term trend of a stock as well as
reinforce the trend. The trend in question, short, medium, or long-term, depends on the parameters
of the force index. While the default force index parameter is 13, chartists can use a higher number
to further smoothen the chart or a lower number for less smoothening.

In the above example of Avenue Supermarts, the stock witnessed a breakout on the price chart on
April 5, 2018. At the same time, the 10-day-EMA force index traded in a higher top-higher bottom
chart structure and gave an additional confirmation signal to the trader to place a bullish trade.
Likewise, the stock witnessed a continuation in the uptrend and rallied from 1,400 to 1,490 levels in
the next three trading sessions.
Divergence
Bullish and bearish divergences can alert traders about a potential change in trend. Divergences are
classic signals associated with oscillators. A bullish divergence forms when the indicator moves
higher as the security moves lower. Contrariwise, a bearish divergence forms when the indicator
moves lower as the security moves higher. Here, even though the security is moving higher, the
indicator shows underlying weakness by moving lower.
Confirmation is an important part of bullish and bearish divergences. A bullish divergence can be
confirmed with the force index moving into positive territory and with a resistance breakout on the
price chart. A bearish divergence can be confirmed with the force index moving into the negative
territory and a support break on the price chart. Chartists can also use candlesticks, moving average
crosses, pattern breaks, and other forms of technical analysis for confirmation.

In the above chart, a bullish divergence can be witnessed as Nifty forms a lower top-lower bottom
structure while the force index manages to form a higher bottom structure. Nifty finally witnesses a
breakout and gives a close above the declining trend line, thus, confirming the bullish divergence.

Chapter 1 Elliott Wave Theory

Introduction
Elliott Wave theory is one of the most acknowledged and widely used forms of technical analysis.
RN Elliott developed the theory after analyzing nearly 75 years of stock data, and Robert Prechter
later popularized it.
According to the Wave theory, the market trades in repetitive cycles, which Elliot primarily attributed
to the emotions of investors (or the psychology of the masses at the time) as well as outside
influences.
The Elliot Wave theory proves that the upward and downward price swings caused by the collective
psychology always reflect the same repetitive patterns. Elliot observed that all financial markets
move in a zigzag formation, which he termed Wave cycles. With this theory, Elliot was able to
analyze markets in greater depth by identifying the specific characteristics of wave patterns and was
able to make detailed market predictions based on these patterns.
This is what makes the Elliott Wave theory so appealing to traders as it provides them with a method
to spot precise price points where the market is likely to reverse. In simpler words, Elliott came up
with a system that enables traders to catch tops and bottoms.

Basic Principals of the Theory

The Elliott Wave theory states that the market is fractal in nature i.e. it forms the same patterns that
are observed on larger degree charts on smaller timeframe as well, and that it can be used to predict
future price movement. The theory states that it does not depend on the timeframe one analyzes as
a similar price pattern is observed across all time frames.
The theory claims that that market action among the participants produces wave patterns and
trends, defined by Elliott as the physical sign of mass psychology.
The complete cycle of the Elliot Wave development consists of eight waves that make up two
phases:
1) An impulse wave sub-divided into five waves and,
2) A corrective wave sub-divided into three waves
According to the theory, price movement in the direction of the main trend is defined as the impulse
or motive phase, which unfolds in five waves. Three of those waves (1, 3, and 5) move in the
direction of the underlying trend, while the two intervening waves (2 and 4) act as counter-trends or
minor retracements within the phase.
Wave 5’s up move is followed by a correction 3, which traders usually label as A, B, and C. The 5-3
wave pattern can be seen across all timeframes.
The corrective phase consists of two waves (A and C) that move in the opposite direction of the
motive phase, and an intervening retracement wave (B) that moves in the same direction of the
motive phase.
The 5-3 wave pattern establishes a complete Elliot wave cycle. The theory tends to get more
complicated as more degrees of waves get added. The key to using the Elliot wave successfully lies
in counting the waves correctly and identifying the wave in which the market is currently trading in.

Wave Degrees
Elliott identified nine degrees of waves that could range from a multi-century timeframe to short-term
intraday movements. A labeling convention is used to identify the degree of each wave. The largest
degree wave is labeled as Grand Supercycle, followed by Supercycle, while the smallest degree
wave is labeled as ‘sub-minuette’.
Here is the hierarchy of the nine degrees of waves:
 A Grand Supercycle is made up of Supercycle waves
 Supercycle waves are made up of Cycle waves
 Cycle waves are made up of Primary waves
 Primary waves are made up of Intermediate waves
 Intermediate waves are made up of Minor waves
 Minor waves are made up of Minute waves
 Minute waves are made up of Minuette waves, and
 Minuette waves are made up of Subminuette waves
Here is the timeframe for each of these nine degrees of waves:
 Grand Supercycle (multi-century)
 Supercycle (about 40–70 years)
 Cycle (one year to several years)
 Primary (a few months to a couple of years)
 Intermediate (weeks to months)
 Minor (weeks)
 Minute (days)
 Minuette (hours)
 Sub-Minuette (minutes)
Most chartists use only 1-4 wave degrees, as applying all nine degrees of waves while trading tends
to get quite complicated. The labeling convention is shown in the table below.
An example of how Roman characters are used to represent the different waves.
Basic 5-Wave Sequence
As we saw earlier, there are two types of waves: impulse and corrective. An impulse wave’s
movement is seen in the direction of the larger degree wave. In a rising market, where the direction
of the larger degree wave is upwards, the advancing waves are impulsive, while the declining waves
are corrective.
Waves 1, 3, 5 are impulse, meaning they go along with the overall trend, while Waves 2 and 4
are corrective.
*Do not confuse Waves 2 and 4 with the ABC corrective pattern though*
Likewise, in a bear market, where the larger degree wave is down, the impulsive waves are also
down and vice versa for corrective waves.
We can see a rising 5-wave sequence in the chart above. Waves 1-3-5 (marked in green) tend to
move in the direction of the main trend, while 2-4 (marked in red) are minor corrections within the
main trend. The entire 5-wave sequence forms the impulse advance phase.

Basic 3-Wave Sequence

The 5-wave trends are then corrected and reversed by 3-wave countertrends and letters are used
instead of numbers to track the correction.

The above chart shows a simple corrective wave labeled a, b, and c. Notice that a-c waves (marked
in green) act as a correction to the main impulse phase, while wave b (marked in red) tends to act as
a minor up move within the correction phase.

Complete 5-3 Elliot Wave Sequence

The above chart depicts a complete Elliot Wave sequence with the initial 5-wave impulse phase
followed by the 3-wave corrective phase. The ‘a-b-c’ corrective phase represents a correction in the
larger impulse phase.

In the above chart, we witness the inverse. The impulse phase, which is the main trend, is
downwards, while the correction phase, comprising of waves a-b-c, trends upwards.
Rules of Elliot Wave Theory
There are three main rules to the Elliot Wave theory that analysts must know. These rules apply only
to the impulse phase.
 First rule: Wave 2 cannot retrace more than 100% of Wave 1
 Second rule: Wave 3 cannot be the shortest among waves 1, 3, and 5
 Third rule: Waves 1 and Wave 4 must not overlap

The above image clearly explains the three rules in a simple manner.
 Wave 2 cannot move below the low of Wave 1. A break below this low would invalidate the
theory.
 Wave 3 is usually the longest of the three impulse waves; the theory states that it cannot be
shorter than wave 1 and 5. Wave 3 should also exceed the height of wave 1.
 Wave 4 cannot overlap Wave 1, which means the low of Wave 4 cannot exceed the high of
Wave 1.

Guidelines
There are numerous guidelines to this theory, but we will take a look at the most prominent ones.
Unlike the three cardinal rules, these guidelines can be broken.
They are:
Guideline 1: When Wave 3 is the longest impulse wave, Wave 5 will approximately equal Wave 1.
Guideline 2: The forms for Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, then
Wave 4 will be a flat correction. If Wave 2 is flat, then Wave 4 will be sharp.
Guideline 3: Sometimes, Wave 5 does not move beyond the end of Wave 3. This is known
as truncation.
Guideline 4: After a 5-wave impulse advance, corrections (a-b-c) usually end in the area of prior
Wave 4 low.
Guideline 5: Wave 3 tends to be very long, sharp, and extended.
Guideline 6: Waves 2 and 4 frequently bounce off Fibonacci retracement levels.
Practical Example

In the above example of Time Technoplast, we observe the complete Elliot Wave plotted in the
graph. As we can see, the waves are not shaped perfectly in real life, however, all the technical rules
can be perfectly observed. An analyst who is successfully able to identify the wave in which the
stock is currently trading would be in a position to preempt future movement in the stock and profit
from it.