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Chapter 1

Chapter 2

INTRODUCTION

DEFINITION

The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis
and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value.
Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity.
Technicians (sometimes called chartists) are only interested in the price movements in the market.
Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an
attempt to determine what direction or trend will continue in the future. In other words, technical analysis attempts to understand
the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and
limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

In this tutorial, we'll introduce you to the subject of technical analysis. It's a broad topic, so we'll just cover the basics, providing
you with the foundation you'll need to understand more advanced concepts down the road.

What does Technical Analysis mean?


Technical analysis is a method of evaluating securities by analyzing the statics generated by market activity, such as past prices
and volume. Technical analysts do not attempt to measure a securitys intrinsic, value, but instead use charts and other tools
to identify patterns that can suggest activity.
Just as there are many investment styles on the fundamental side, there also many different types of technical traders. Some
rely on chart patterns, other use technical indicators and oscillators, and most use some combination of the two. In any case,
technical analysis exclusive use of historical price and volume data is what separates them from their fundamental counterparts.
Unlike fundamental analysts, technical analysis do not care whether a stock is undervalued the only thing that matters is a
securitys past trading data and what information this data can provide about where the security might move in the future.
The purpose of technical analysis is identify trend changes that precede the fundamental trend and do not (yet) make sense
if compared to the concurrent fundamental trends.
According to Wikipedia the free encyclopedia, Technical analysis is a security analysis discipline for forecasting the future
direction of prices through the study post market data, primarily price and volume {1}. In its purest form, technical analysis
considers only the actual price and volume behavior of the market or investment.
Investopedia explains Technical analysis as Technical analysts believe that the historical performance of stocks and markets
are indications of future performance.
It further explains the same with the help of the following example:
In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide
whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores.
Disregarding the intrinsic value of the products in the store, his or her decision would be based on the patterns or activity of
people going into each store.

Figure 1.1

Chapter 3

PRINCIPLES
Technicians say that a marketss price reflects all relevant informations, so their analysis looks more at internals than at
Application of Technical Analysis:
Stock charts us a lot about what companies are doing, what they will be doing and what the markets thinks of it all. However,
we have to learn how to read the stock charts. At the most basics level, there are some important concepts that should be kept
mind:

externals such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned
behavior hence technicians focus on identifiable trends and condition. The study of technical analysis is based on the following
three broad principles:
The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company.

Uptrends are characterized by rising bottoms on the stock chart and can be described as periods of optimism.

However, technical analysis assumes that, at given time, a stocks price reflects everything that has or could affect the company
including fundamental factors. Technical analysts believe that the companys fundamentals, along with broader economic

Downtrends are characterized by falling tops on the stock charts, and can be described as periods of pessimism.

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 dement for

Abnormal trading activity often signals significant fundamental change in the companys business.

Support is a floor price that the market has shown an unwillingness to trade under in the past.

Resistance is a ceiling price that the market has shown unwillingness to trade above in the past.

particular stock in the market.


Price Moves in Trend
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the
future price movement is more likely to be in the same direction as the trend that to be against it. Most technical trading strategies
are based on this assumption.
History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive

Note: in the same manner compute the DPO and DIO.

nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent
reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand
trends. Although many of there charts have been used for more than 100 years, they are still believed to be relevant because
they illustrate patterns in price movements that often repeat themselves.
Not Just for Stocks
Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities,
fixed-income securities, forex, etc. In this tutorial, well usually analyze stocks in our examples, but keep in mind that these
concepts can be applied to any type of security. In fact, technical analysis is more frequently associated with commoditized
and forex, where the participants are predominantly traders.

Chapter 4

FUNDAMENTAL ANALYSIS VS. TECHNICAL ANALYSIS


The fundamentalist studies the cause of the market movements while the technicians studies the effect John Murphy
Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. As mentioned earlier,
technical analysis looks at the price movement of a security and used this data to predict its future price movements. Fundamental
analysis, on the other hand, looks at economic factors, known as fundamentals. Lets get into the details of how these two
approaches differ, the criticism against technical analysis and how technical and fundamental analysis can be used together
to analyze securities.

Charts vs. Financial Statements

At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the
financial statements.
By looking at the balance sheet, cash flow statements and income statement, a fundamental analyst tries to determine a
companys value. In future terms, an analyst attempts to measure a companys intrinsic value. In this approach, investment
decisions are fairly easy to make if the price of a stock trades below its intrinsic value, its a good investment.

Technical traders, on the other hand, believe there is no reason to analyze a companys fundamentals because there are all
accounted for in the stocks price. Technicians believe that all the information they need about a stock can be found in its charts.

The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere.
It can take a long time for a company's value to be reflected in the market, so when a fundamental analyst estimates intrinsic
value, a gain is not realized until the stock's market price rises to its "correct" value. This type of investing is called value
investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the
long run. This "long run" can represent a timeframe of as long as several years, in some cases.
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements
are filed quarterly and changes in earnings per share do not emerge on a daily basis like price and volume information. Also
remember that fundamentals are the actual characteristics of a business. New management cannot implement sweeping
changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that
fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much
more slowly than the price and volume data used by technical analysts.
Trading Versus Investing
Not only is technical analysis more short term in nature than fundamental analysis, but the goals of a purchase (or sale) of a
stock are usually different for each approach. In general, technical analysis is used for trading, whereas fundamental analysis
is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe
they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does
characterize a difference between the two schools.

Time Horizon

Fundamental analysis takes a relatively long-term approach in analyzing the market compared to technical analysis. While
technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over
a number of years.

Chapter 5

TECHNICAL ANALYSIS PRE-EMPTS FUNDAMENTAL ANALYSIS

Fundamentalists believe that there is a cause and effect between fundamental factors and price changes. This means that if
the fundamental news is positive, the price should rise, whereas if the news is negative, the price should fall. However, longterm analyses of price changes in financial markets globally show that such a correlation is present only in the short-term
horizon and only to a limited extent. It is non-existent on both the medium-term and long-term basis.
However, the contrary is true. The stock market itself is the best predictor of the future fundamental trend. Most often, prices
start rising in a new bull trend while the economy is still in recession (as depicted by position B on chart shown below), i.e.
while there is no cause for such an uptrend. As against this, prices start falling in a new bear trend while the economy is still
growing (as depicted by position A on the chart below), and not providing fundamental reasons to sell. There is a time-lag of
several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock
market and the economy alone but also for the price trends of individual equities and company earnings. Stock prices peak
ahead of peak earnings while bottoming ahead of peak losses.

Chapter 6

INVESTORS' PSYCHOLOGY

G
R

There are many characteristics and skills required by investors/ traders in order to be successful in the - financial markets. The
ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend
are a few of the key traits needed, but none of these is as important as the ability to contain emotions and maintain discipline.
The psychological aspect of investing / trading is extremely important, and the reason for that is fairly simple. Investors/ traders
often dart in and out of stocks on short notice, and are forced to make quick decisions. To accomplish this, they need a certain
presence of mind. They also, by extension, need discipline, so that they stick to the previously established trading plans and
know when to book profits and losses. Emotions simply cannot get in their way.
G

The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense
if compared to the concurrent fundamental trend.(line repeated from pg 6)

In this context, the following must be made a note of:


Mood is stronger than ratio

E
E
D

"Know yourself and knowledge of the stock market will soon follow" - Ego and emotions determine far more of investors' stock
market decisions than most would be willing to admit. For years, we have dealt with professional money managers and
investment committees and have found that they were as much subject to crowd following and other irrational emotional
mistakes as a novice investor. Despite being well informed, facts alone do not help individuals to make profitable decisions.
The human element, which encompasses a range of emotions from fear to greed, plays a much bigger role in the decision
making process than most investors realize.
On the contrary, most investors act exactly in the opposite manner to the rational wisdom of buying low and selling high based
on very predictable emotional responses to rising or falling prices. Falling prices that at first appear to be bargains generate
fear of loss at much lower prices when opportunities are the greatest. Rising prices that at first appear to be good opportunities
to sell ultimately lead to greed-induced buying at much higher levels. Here, reason is replaced by emotion and respective
rationalization with such cyclical regularity, that those who recognize the symptoms and the trend changes on the charts can
profit very well from this knowledge.

Chapter 7

TREND & TRENDLINES


Optimism and pessimism - greed and fear
People are motivated by greed (optimism) while buying and by fear (pessimism) while selling. They are motivated to buy and
sell by changes in emotion from optimism to pessimism and vice versa. They formulate fundamental scenarios based on their
emotional state (a rationalization of the emotions), which prevents them from realizing that the main drive is emotion.

DEFINITION
A "trend" can be defined as the general direction of a market or of the price of an asset. Trends can vary in length from short,
to intermediate, to long term. If one can identify a trend, it can be highly profitable, because he / she will be able to trade with
the trend.

The chart below shows that if investors buy on the basis of confidence or conviction (optimism), they BUY near or at the TOP.
Likewise, if investors act on concern or capitulation (pessimism), they SELL near or at the BOTTOM. Investors remain under
the bullish impression of the recent uptrend beyond the forming price top and during a large part of the bear trend. As against
this, they remain pessimistic under the bearish impression from the past downtrend through the market bottom and during a
large part of the next bull trend. They adjust their bullish fundamental scenarios to bearish AFTER having become pessimistic
under the pressure of the downtrend or AFTER having become optimistic under the pressure of the uptrend. Once having
turned bearish, investors formulate bearish scenarios, looking for more weakness just when it is about time to buy again. The
same occurs in an uptrend when mood shifts from pessimism to optimism.
Investors formulate bullish scenarios AFTER having turned bullish, which is after a large part of the bull trend is already over.
Emotions are the drawback of fundamental analysis. Investors must learn to buy when they are afraid (pessimistic) and sell
when they feel euphoric (optimistic). This may sound easy (simple contrary opinion), but without charts it is hard to achieve.
The main purpose of technical analysis is to help investors identify turning points which they cannot see because of individual
and group psychological factors.

Figure 7.1

As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should
be very cautious about taking any positions that rely on the trend going in the opposite direction.
A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long term movement
in price or volume.
The Use of Trend
One of the most important concepts in technical analysis is that of trend. The meaning of the term "trend" in finance is quite
similar to its general definition - "a trend is nothing more than the general direction in which a security or market is headed".
Take a look at the chart (Figure 7.2) below:

Figure 6.2

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the general direction in which a security or market is headed". Take a look at the chart (Figure 7.2) below:

There are lots of ups and downs in the chart above (Figure 7.3) but there is no clear indication of which direction this security
is headed.
Unfortunately, trends are not always easy to see. In any given chart, you will probably notice that prices do not tend to move
in a straight line in any direction. They, however, move in a series of highs and lows.
Types of Trends
In technical analysis, it is the movement of the highs and lows that constitutes a trend. The following are the 3 types of trends:
Uptrend
An uptrend is classified as a series of higher highs and higher lows or higher peaks and higher troughs.

6
Figure 7.2

It is not really hard to see that the trend in the chart above is up. However, it's not always this easy to see a trend:

2
3
1

Figure 7.4

Figure 7.4 above is an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from
this point. Point 3 is the low that is established as the price falls from the high. For this to remain an up-trend each successive
low must not fall below the previous lowest point or the trend is deemed a reversal.
Figure 7.3

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Downtrend
A downtrend is classified as a series of lower lows and lower highs or lower peaks and lower troughs. It describes the price
movement of a financial asset when the overall direction is downward. A formal downtrend occurs when each successive peak
and trough is lower than the ones found earlier in the trend.

Trendlines
A trendline can be described as a simple charting technique that adds a line to a chart to represent the trend in the market or
a stock. Drawing a trendline is as simple as drawing a straight line that follows a general trend.
These lines are used to clearly show the trend and are also used in the identification of trend reversals.

1
3

Figure 7.5

Here, note that each successive peak and trough is lower than the previous one. For example, in Figure 7.5 above, the low
at Point 3 is lower than the low at Point 1. The downtrend will be deemed broken once the price closes above the high at
Point 4.
Sideways/ Horizontal Trend / Consolidation

Figure 7.7

Sideways trend, also known as horizontal trend or consolidation, describes the horizontal price movement that occurs when
the forces of supply and demand are nearly equal. A sideways trend is often regarded as a period of consolidation before the
price continues in the direction of the previous move. It is classified as a series of horizontal peaks and horizontal troughs.

As seen in Figure 7.7 above, an upward trendline is drawn at the lows of an upward trend. This line represents the support
the stock has every time it moves from a high to a low. Notice how the price is propped up by this support. This type of trendline
helps traders to anticipate the point at which a stock's price will begin moving upwards again. Similarly, a downward trendline
is drawn at the highs of the downward trend. This line represents the resistance level that a stock faces every time the price
moves from a low to a high.
The trendline can also said to be nothing more than a straight line drawn between at least three points. In an uptrend, the low
points are connected to form an uptrend line (Figure 7.8 below). For a downtrend, the peaks are connected (Figure 7.9 below).
The important point is that it should not be drawn over the price action.

Figure 7.6

Sideways / Horizontal Trend / Consolidation


Sideways trend, also known as horizontal trend or consolidation, describes the horizontal price movement that occurs when
the forces of supply and demand are nearly equal. A sideways trend is often regarded as a period of consolidation before the
price continues in the direction of the previous move. It is classified as a series of horizontal peaks and horizontal troughs.

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Trendlines must incorporate all of the price data, i.e. connect the highs in a downtrend and the lows in an uptrend. The closing
prices are not connected. The trend line becomes more important and gains credibility as the number of price extremes that
can be connected by a single line increases. The validity and viability of a line that connects only two price extremes (for
example the starting point and one price low) is questionable.

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Chapter 8

INVESTMENT HORIZONS
The trend is broken when the price falls below the uptrend line or rises above the downtrend line (as in Figures 7.8 and 7.9
below). Some analysts use a 2-day rule, which means that the trend is only seen as broken if the price closes above/below
the trendline for at least two days. Others use a 1% stop (could be higher depending

HOURS
Long-term trend
(lasts about
12 months)

11

12

10

3
8

4
7

Trendline
is broken

SECONDS
Short-term trend
(lasts about
2-6 weeks)

MINUTES
Intermediate-term
trend
(lasts about
3-6 months)

Figure 7.8 - Uptrend


Figure 8.1 Investment Horizon A Technicians Perspective
Figure 7.8 - Uptrend

on market volatility), which means that the trend is only seen as broken if the price closes over 1% above/below the trend line.

Trendline
is broken

Figure 7.9 - Downtrend

Time Horizon
Fundamental analysis takes a relatively long-term approach in analyzing the market compared to technical analysis. While
technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over
a number of years.

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The charts on the previous pages show that investors require a certain perspective. It is imperative to differentiate between a
short-term, a medium-term and a long-term trend. If someone asks you to buy the US dollar because it is likely to rise, make
sure that you understand whether the dollar is expected to rise over a few days or a few months and if you should buy the dollar
with the intention to hold it for several days, several weeks or several months.
For a technician on the trading floor, the long-term horizon is entirely different from that of institutional investors. For a trader,
long-term can mean several days, while for the investor it can mean 12 to 18 months.
We can compare the charts and indicators to a clock (as shown in Figure 8.1 above). Short-term trends (the seconds) are best
analyzed on daily bar charts. Medium-term trends (the minutes) are best seen on weekly bar charts and long-term trends (the
hours) are best seen on monthly bar charts. Some investors only want to know the hour, some want to know the seconds and
some want to know the exact time.
However, the best investment results are achieved when all three trends on the daily, weekly and monthly charts point in the
same direction.

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Chapter 9

SUPPORT AND RESISTANCE


Trend Lengths
Apart from the above-mentioned 3 trend directions, there are three trend classifications as well. A trend of any direction can
be classified as:

Technical analysts often discuss the ongoing battle between the bulls and the bears, or the struggle between buyers (demand)
and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support).

Long-term trend
In terms of the stock market, a long-term trend is generally categorized as one that lasts for a period longer than a year.
Intermediate trend
An intermediate trend is considered to last between one and three months and a near-term trend is anything less than a month.
A long-term trend is composed of several intermediate trends, which often move against the direction of the major trend. If the
major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the
correction is considered to be an intermediate trend.

Figure 9.1

Short-term trend

As you can see in the Figure 9.1 above, support is the price level below which a stock or market seldom falls (illustrated by
the blue arrows). Resistance, on the other hand, is the price level that a stock or market seldom surpasses (illustrated by the
red arrows).

The short-term trends are components of both major and intermediate trends. Refer to Figure 8.2 below to get a clear picture
of how these three trend lengths might look like.

Resistance lines are horizontal lines that start at a recent extreme price peak with the line pointing horizontally into the future
(Figure 9.2).

Break of resistance

Last peak becomes


resistance

Last peak becomes


resistance

Figure 8.2

While analyzing trends, it is very important that the chart is constructed to reflect the type of trend being analyzed in the best
possible manner. To help identify long-term trends, weekly charts or daily charts spanning a five-year period are used by chartists
to get a better idea of the long-term trend. Daily data charts are best used when analyzing both intermediate and short-term
trends. It is also important to remember that the longer the trend, the more important it is; for example, a one-month trend is
not as significant as a five-year trend.

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Last peak becomes


resistance
Resistance
becomes support

Figure 9.2

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SUPPORT AND RESISTANCE


Support lines are horizontal lines that start at a recent extreme of a correction low and also point towards the future on the
time axis (Figure 9.3)
1

2
3

Support becomes
resisitance

Last low
becomes support
Figure 9.4

Last low
becomes support

Break of support

As you can see in Figure 9.4 above, the dotted line is shown as a level of resistance that has prevented the price from heading
higher on two previous occasions (Points 1 and 2). However, once the resistance is broken, it becomes a level of support
(shown by Points 3 and 4) by propping up the price and preventing it from heading lower again.

Last low
becomes support
Figure 9.3

An uptrend continues as long as the most recent peak is surpassed and new peak levels are reached. A downtrend continues
as long as past lows are broken, sustaining a series of lower lows and lower highs. Notice that the previous support often
becomes resistance and resistance becomes support. A resistance or a support line becomes more important and its break
gains more credibility as the number of price extremes (peaks for resistance; or lows for support) that can be connected by a
single line increases.

Many traders who begin using technical analysis find this concept hard to believe and do not realize that this phenomenon
occurs rather frequently, even with some of the most well-known companies. For example, as you can see in Figure 9.5 below,
this phenomenon is evident on the Wal-Mart Stores Inc. (WMT) chart between 2003 and 2006. Notice how the role of the $51
level changes from a strong level of support to a level of resistance.

Why does it happen?


The support and resistance levels are considered important in terms of market psychology and supply and demand. Support
and resistance levels are the levels at which a lot of traders are willing to buy the stock (in case of a support) or sell it (in case
of resistance). When these trendlines are broken, the supply and demand and the psychology behind the stock's movements
is considered to have shifted, in which case new levels of support and resistance are likely to be established.
Figure 9.5

Role Reversal
Once a resistance or a support level is broken, its role is reversed. If the price falls below a support level, that level will become
resistance. If the price rises above a resistance level, it will often become support. As the price moves past a level of support
or resistance, it is considered that supply and demand have shifted, causing the breached level to reverse its role. For a true
reversal to occur, however, it is important that the prices make a strong move through either the support or resistance.

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In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces
between these levels. This is most often seen when a stock is trading in a generally sideways manner as the price moves
through successive peaks and troughs, testing resistance and support.

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Chapter 10

VOLUME - THE NEGLECTED ESSENTIA


Importance of Support and Resistance

While price is the primary item of concern in technical analysis, volume is also extremely important.

Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify
when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times
but never broken, he or she may decide to take profits as the security moves towards this point because it is unlikely that it
will move past this level.
Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis.
As long as the price of a share remains between these levels of support and resistance, the trend is likely to continue. It is
important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For
example, if prices move above the resistance levels of an upward trending channel, the trend has accelerated, not reversed.
This means that the price appreciation is expected to be faster than it was in the channel.

What is volume?
Volume refers to the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume,
the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that
can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show
trends in the same way that prices do (Figure 10.1).

Being aware of these important support and resistance points should affect the way that you trade a stock. Traders should
avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If you feel confident
about making a trade near a support or resistance level, it is important that you follow this simple rule: do not place orders
directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number,
but flirts with it instead. So if you're bullish on a stock that is moving toward an important support level, do not place the trade
at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing
stops or short selling, set up your trade price at or below the level of support.

Figure 9.1

Importance of Volume
Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement
up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume.
Therefore, if you are looking at a large price movement, you should also examine the volume to see whether it tells the same
story.

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Say, for example, a stock jumps 5% in one trading day after being in a long downtrend. Is this a sign of a trend reversal? This
is where volume helps traders. If volume is high during the day relative to the average daily volume, it is a sign that the reversal
is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true
trend reversal.
Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the
previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend.
For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is
starting to lose its legs and may soon end.
When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators.
The simplest example of divergence is a clear upward trend on declining volume.
Volume and Chart Patterns
The other use of volume is to confirm chart patterns. Patterns such as head and shoulders, triangles, flags, and other price
patterns can be confirmed with volume. In most chart patterns, there are several pivotal points that are vital to what the chart
is able to convey to chartists. Basically, if the volume is not there to confirm the pivotal moments of a chart pattern, the quality
of the signal formed by the pattern is weakened.

Stock market shares are traded for as long as a company stays in the business as a separate unit. On the other hand, futures
and options traders deal in contracts for a future delivery that expires at a pre-defined time.
A futures or options buyer who wants to accept a delivery and a seller who wants to deliver, have to wait until the first notice
day. This waiting period ensures that the numbers of contracts that are long and short are always equal.
However, very few futures and options traders plan to deliver or to accept delivery. They usually close out their positions before
the first notice day.
Open interest rises or falls depending upon whether new traders enter the market or old traders exit it. In this context, the
following points must be noted:
1.
2.
3.
4.

It rises only when a new buyer and a new seller enter the market, thereby creating a new contract.
It falls when a trader who is long, trades with someone who is short. When both of them close out their positions,
open interest falls by one contract because one contract disappears.
If a new bull buys from an old bull that is getting out of his position, open interest remains unchanged.
Open interest also does not change when a new bear sells to an old bear who needs to buy because he is
closing out his short position.

The following table will serve as a ready reckoner for the above:
Volume precedes price
Another important idea in technical analysis is that price is preceded by volume. Volume is closely monitored by technicians
and chartists to form ideas on upcoming trend reversals. If volume starts decreasing in an uptrend, it is usually a sign that the
upward run is about to end.

Buyer

Seller

Open Interest

New Buyer

New seller

Increases

New buyer

Former buyer sells

Unchanged

Now that we have a better understanding of some of the important factors of technical analysis, we can move on to charts,
which help to identify trading opportunities in price movements.

Former seller buys to cover

New seller

Unchanged

Former seller buys to cover

Former buyer sells

Decrease

Open Interest
Open Interest is the number of contracts that are held by buyers or are owned by short sellers in a given market on a given
day. It shows the number of existing contracts. Open interest equals either a total long or a total short position.
Open Interest is also said to be the total number of options and/or futures contracts that are not closed or delivered on a
particular day. Open interest applies primarily to the futures market.

23

Technicians usually plot open interest as a line below the price bars (Figure 10.2 below). Some chart services also plot
average open interest for the past several years. Open interest gives important messages when it deviates from its seasonal
norm. It varies from season to season in many markets because of huge hedging by commercial interests at various stages
in production cycles.

24

Chapter 11

CHART
What is a chart?
In technical analysis, charts are similar to the charts that you see in any business setting. A chart is simply a graphical
representation of a series of prices over a set time frame. It helps to identify trading opportunities in prices movements. For
example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the
closing price for each day the stock is traded.

Figure 10.2 Open Interest

As already discussed, open interest (01) reflects the number of all short and long positions in any futures or options market.
It depends on the intensity of conflict between bulls and bears.
The findings of the above can be enumerated as under:
1.

Rising 01 indicates that the conflict between bulls and bears is becoming more intense and confirms the existing
Figure 11.1

trend.
2.

Rising OI during uptrends show that it is safe to add to long positions (A and D).

Figure11.1 above is an illustration of a basic chart. It is a representation of the price movements of a stock over a one and a

3.

Flat 01 shows that fewer losers are entering the market. This means that a mature trend is nearing its end and

half year period. The bottom of the graph, running horizontally (x-axis) is the date or time scale. On the right hand side, running

it is time to take profits or tighten stops (8 and E).

vertically (y-axis), is the price of the security. By looking at the graph, we cannot ice that in October 2004 (Point # 1), the price

4.

Falling 01 shows that losers are leaving the market and winners are cashing in - that a trend is nearing its end.

of this stock was around $245, whereas in June 2005 (Point# 2), the stock's price was around $265. This tells us that the stock

5.

As a fire cannot continue when fuel is withdrawn, a sharp drop in 01during a trend signals the nearing of a

has risen between October 2004 andJune2005.

reversal (C and F).


6.

25

At the right edge of the chart, cocoa prices have stabilized after falling in October and 01 is flat. It shows that

Properties of Charts

the decline in cocoa has shaken out weak bulls and the uptrend is ready to resume. It is time to go long, with

The following are some of the properties of charts that one should be aware of when looking at a chart, as these factors can

a protective stop below the recent lows.

affect the information that is provided:

26

The Time Scale


The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most
frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually. It should be noted that the shorter the
time frame, the more detailed the chart. Each data point can represent the closing price of the period or show the open, the
high, the low and the close depending on the chart used.
Intraday charts plot price movements within the period of one day. This means that the time scale could be as short as five
minutes or could cover the whole trading day from the opening bell to the closing bell.
Daily charts are comprised of a series of price movements in which each price point on the chart is a full day's trading condensed

Figure 11.2

into one point. Again, each point on the graph can be simply the closing price or can entail the open, high, low and close for
the stock over the day. These data points are spread out over weekly, monthly and even yearly time scales to monitor both

Now refer to the Figure 11.3 below. If a price scale is in logarithmic scale, then the distance between points will be equal in

short-term and intermediate trends in price movement.

terms of percent change. A price change from 10 to 20 is a 100% increase in the price, while a move from 40 to 50 is only a
25% change, even though they are represented by the same distance on a linear scale. On a logarithmic scale, the distance

Weekly, monthly, quarterly and yearly charts are used to analyze long term trends in the movement of a stock's price. Each

of the 100% price change from 10 to 20 will not be the same as the 25% change from 40 to 50. In this case, the move from

data point in these graphs will be a condensed version of what happened over the specified period. So for a weekly chart, each

10 to 20 is represented by a larger space on the chart while the move from 40 to 50, is represented by a smaller space because,

data point will be a representation of the price movement of the week.

percentage-wise, it indicates a smaller move. In Figure 11.2, the logarithmic price scale on the right leaves the same amount
of space between 10 and 20 as it does between 20 and 30 because both represent 100% increase.

Price Scale and Price Point


The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to past data points. This
may seem like a simple concept in that the price scale goes from lower prices to higher prices as you move along the scale
from the bottom to the top. The problem, however, is in the structure of the scale itself. A scale can either be constructed in a
linear (arithmetic) or logarithmic way, and both of these options are available on most charting services.
Refer to the Figure 11.2 below. If a price scale is constructed using a linear scale, the space between each price point (10,
20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a linear scale is the same distance on the chart
as a move from 40 to 50. In other words, the price scale measures moves in absolute terms and does not show the effects of
percent change.
Figure 11.3

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28

Types of Charts

is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means
that it has gained value. A bar that is coloured red signals that the stock has gone down in value over that period. When this

There are four main types of charts that are used by investors and traders depending on the information that they are seeking

is the case, the dash on the right (close) is lower than the dash on the left (open)

to derive and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point
and figure chart. In the following section, we will focus on the S&P 500 Index during the period of January 2006 through May
2006. Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is
different.
Line Charts
The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The
line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading
range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be

Candlestick Charts

Figure 11.5 Bar Charts

the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line
charts.

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart,
the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide
bar on the vertical line, which illustrates the difference between the open and close.

Figure 11.4 Line Chart

Bar Charts
The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made
up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period,

Figure 11.6 Candlestick Charts

along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price
on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented
by the dash on the right. Generally, if the left dash (open)

29

30

Chapter 12

JAPANESE CANDLESTICK PATIERNS


Point and Figure Charts

Candlesticks contain the same data as a normal bar chart but highlight the relationship between opening and
closing prices. In a candlestick, the narrow stick represents the range of prices traded during the period (high

The point and figure chart is not very popular, nor is it widely used by the average investor, but it has had a long history of use

to low) while the broad mid-section represents the opening and closing prices for the period (Figure 12.1

dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and

below).

volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the
stock, which can distort the traders' view of the price trends. These types of charts also try to neutralize the skewing effect that
time has on chart analysis.

If the close is higher than the open the candlesticks mid-section is hollow or shaded

If the open is higher than the close the candlestick mid-section is filled in or shaded red.

blue/green.

Candlesticks
Highest Price

Highest Price

Closing Price

Opening Price

Opening Price

Closing Price

Lowest Price

Lowest Price

The body is filled if the open is higher then the close


Figure 12.1 Candlestick Patterns

The advantage of candlesticks is the ability to highlight trend weakness and reversal signals that may not be
apparent on a normal bar chart.
Figure 11.7 Point & Figure Charts

Since most of the candlestick indicators are reversals in nature, we must emphasise on the subject of reversal
patterns. The following are some of the important groups of these candlestick reversal indicators:
Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being
shown on a chart and the information that it provides.

Reversal Patterns
Hammer Lines
This pattern is a price pattern in candlestick charting that occurs when a security trades significantly lower
than its opening, but rallies later in the day to close either above or close to its opening price. This pattern
forms a hammer-shaped candlestick.

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32

the highest price for the day


Body is black (or red) if
stock closed lower, Body
is white (or green) if it
closed higher

Opening Price
Closing Price

the highest price for the day


closing price
smaller body
opening price

Figure 12.2 Candlestick Reversal Pattern: Hammer Lines

the lowest price for the day

the lowest price for the day

Figure 12.4 Candle Reversal Pattern: Engulfing Pattern Bullish

Figure 12.2 Candlestick Reversal Pattern: Hammer Lines

A hammer occurs after a security has been declining, possibly suggesting that the market is attempting to determine a bottom.

This trend suggests that the bulls have taken control of a security's price movement from the bears. This type of pattern usually

However, it does not mean that the bullish investors have taken full control of a security; it simply indicates that the bulls are

accompanies a declining trend in a security, suggesting that a low or end to a security's decline has occurred. However, as
usual in candlestick analysis, the trader must take the preceding and the following days' prices into account before making

strengthening.

any decisions regarding the security.

Hanging-man Lines

Engulfing Pattern Bearish

This pattern is a bearish candlestick pattern that forms at the end of an uptrend. It is created when there is a significant selloff near the market open price, but buyers are able to push this stock back up so that it closes at or near the opening price.

A chart pattern that consists of a small white candlestick with short shadows or tails followed by a large black candlestick that

Generally the large sell-off is seen as an early indication that the bulls (buyers) are losing control and demand for the asset is

eclipses or "engulfs" the small white one.

waning
the highest price for the day
closing price
smaller body
opening priceFigure 12.2 Candlestick Reversal Pattern: Hammer Lines
the lowest price for the day
Figure 12.3 Candlestick Reversal Pattern: Hanging-man Line

Engulfing Pattern Bullish

A bearish engulfing pattern may provide an indication of a future bearish trend. This type of pattern usually accompanies an

This chart pattern forms when a large white candlestick that completely eclipses or "engulfs" the previous day's candlestick

uptrend in a security, possibly signaling a peak or slowdown in its advancement. However, whenever a trader analyzes any

follows a small black candlestick. The shadows or tails of the small candlestick are short, which enables the body of the large

candlestick pattern, before making any decisions, it is important for him or her to consider the prices of the days that precede

candlestick to cover the entire candlestick from the previous day.

33

Figure 12.5 Candlestick reversal Pattern: Engulfing Pattern Bearish

and follow the formation of the pattern.

34

Dark Cloud Cover

Stars

In candlestick charting, Dark Cloud Cover is a pattern where a black candlestick follows a long white candlestick. It can be an
indication of a future bearish trend.

Another group of fascinating reversal patterns is that which includes stars. A Star is a small real body that gaps away from the
large real body preceding it. It is a warning that the prior trend may be ending. The star is a part of 4 reversal patterns that
include the following:

opening price

the highest price for the day

i.

The Morning Star

Closing price

This is a bullish candlestick pattern that consists of 3 candles that have demonstrated the following characteristics:

Large white candlestick


confirmation

opening price
the lowest price for the day

Figure 12.6 Candlestick Reversal Patterns: Dark Cloud Cover

Essentially, the large black candle is forming a "dark cloud" over the preceding bullish trend. The dark cloud must have a closing
price that is :
1.

Within the price range of the previous day, but

2.

Below the mid-point between open and closing prices of the previous day.

The first bar is a large red candlestick located within a defined downtend

The second bar is a small-bodied candle (either red or white) that closes below the first red bar.

The last bar is a large white candle that opens above the middle candle and closes near the center of the first
bar's body.

Piercing Pattern
This refers to a day's trading activity that often signals the end of a small to moderate downward trend. Following a closing
down day with a good-sized trading range, the next day's trading gap (drops) lowers, but also covers at least half of the upward

As shown by the chart below (Figure 12.8), this pattern is used by traders as an early indication that the downtrend is about
to reverse.

length of the previous day's real body (the range between the opening and closing prices), and then closes up for the day.
A piercing pattern can serve as an indicator that it is time to either buy a stock or close out short positions, because he stock
may be trending upwards soon. It should not, however, be used as a stand-alone indicator, but rather compared against other
bullish and bearish indicators.

Strong
black body

Closing at least
halfway
the prior body
Lower
opening price

Figure 12.8 The Morning Star

A morning star pattern can be useful in determining trend changes, particularly when used in conjunction with other technical
indicators. Many traders also use price oscillators such as the MACD (Moving Average Convergence Divergence) and RSI
(Relative Strength Index), explained later in this tutorial, to confirm the reversal.

Figure 12.7 Candlestick Reversal Pattern: Piercing Pattern

35

36

ii.

The Evening Star

Stars

This is a bearish candlestick pattern consisting of three candles that have demonstrated the following characteristics:

Another group of fascinating reversal patterns is that which includes stars. A Star is a small real body that gaps away from the
large real body preceding it. It is a warning that the prior trend may be ending. The star is a part of 4 reversal patterns that
include the following:

The first bar is large white candlestick located within an uptrend.


The middle bar is a small-bodied candle (red-white) that closes above the first white bar.
The last bar is a large red candle that opens below the middle candle and closes near the center of the first

bar's body.
As shown by the chart below (Figure 12.9), this pattern is used by traders as an early indication that the uptrend is about to
reverse.

Figure 12.9 The Evening Star

i.

The Morning Star

This is a bullish candlestick pattern that consists of 3 candles that have demonstrated the following characteristics:

The first bar is a large red candlestick located within a defined downtend

The second bar is a small-bodied candle (either red or white) that closes below the first red bar.

The last bar is a large white candle that opens above the middle candle and closes near the center of the first
bar's body.

As shown by the chart below (Figure 12.8), this pattern is used by traders as an early indication that the downtrend is about
to reverse.

Evening star formations can be useful in determining trend changes, particularly when used in conjunction with other indicators.
Many traders use price oscillators and trend lines to confirm this candlestick pattern.
iii.

The Morning and Evening Doji Stars

A doji is a candle that lacks a real body, meaning the open and close of the bar are the same or have a very small difference.
It has a strong significance after substantial advances or declines. The lack of direction that the doji illustrates can offer a potent
reversal signal, especially if it is followed by a candle in the anticipated direction. Therefore, when a doji represents the star
of the morning and evening star pattern, you need to take notice. When a doji represents the morning star and evening star,
the formations are known as the morning doji star and evening doji star.

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38

Figure 12.10 The Evening Doji Star and The Morning Star.

An extremely powerful version of the doji star is known as the abandoned baby top or abandoned baby bottom. This pattern
is equivalent to what we heard of through using bar charts, the island reversal. The abandoned baby candlestick has a doji
as the second candle with a gap on both sides.

In order for a candlestick to be considered a shooting star, the formation must be on an upward or bullish trend. Furthermore,
the distance between the highest price for the day and the opening price must be more than twice as large as the shooting
star's body. Finally, the distance between the lowest price for the day and the closing price must be very small or non-existent.
A shooting star shaped candlestick, after a downturn, could be a bullish signal. Such a line is called an Inverted Hammer. Figure
12.13 below illustrates that an inverted hammer looks like a shooting star line with its long upper shadow and small real body
at the lower end of the range. However, while the shooting star is a top reversal line, the inverted hammer is a bottom reversal
line. As with a regular hammer, the inverted hammer is a bullish pattern after a downtrend.

Abandoned Baby
Gap

Gap

Gap

Gap
Figure 12.13 Inverted Hammer

Abandoned Baby

Figure 12.11 The Abandoned Baby Top and The Abandoned Baby Bottom

iv.

Shooting Star and The Inverted Hammer

The Inverted Hammer pattern is a two candle, bottom reversal pattern, but requires a third candle for confirmation, because
of the way the pattern is formed.
More Reversal Patterns

A type of candlestick formation that results when a security's price, at some point during the day, advances well above the
opening price but closes lower than the opening price.

The reversal formations discussed above, namely, reversal patterns and stars, are comparatively strong reversal signals. They
show that the bulls have taken over from the bears (as in the bullish engulfing pattern, a morning star, or a piercing pattern)
or that the bears have wrested control from the bulls (as in the bearish engulfing pattern, the evening star, or the dark-cloud
cover). We shall now discuss more reversal indicators which are usually, but not always, less powerful reversal signals.

the highest price for the day

Harami Pattern
open price
closing price
the lowost price for the day

The harami pattern (see Figure 12.14 below) is a small real body which is contained within a prior relatively long real body.
'Harami' is an old Japanese term which means 'pregnant'. The long candlestick is 'the mother' candlestick and the small
candlestick is the 'baby' or 'foetus'. The harami pattern is the reverse of the engulfing pattern. In the engulfing pattern, a lengthy

Figure 12.12 Shooting Star

39

40

real body engulfs the preceding small real body. For the harami, a small real body follows an unusually long real body.

i.

Bearish Harami Pattern

This is a candlestick pattern which is indicated by a large candlestick followed by a much smaller candlestick where in that
body is located within the vertical range of the larger candle's body. Such a pattern is an indication that the previous upward
trend is coming to an end.

the highest price for the day

smaller body

Closing price
Figure 12.14 The Harami Pattern

i.

body is black (or red) if


stock closed lower. Body
is white (or green) if it
closed higher
opening price

Bullish Harami Pattern

This is a candlestick chart pattern in which a large candlestick is followed by a smaller candlestick whose body is located within
the vertical range of the larger body. In terms of candlestick colors, the bullish harami is a downtrend of negative-colored (black)
candlesticks engulfing a small positive (white) candlestick, giving a sign of a reversal of the downward trend.

the lowest price for the day


Figure 12.16 Bearish Harami Pattern

A bearish harami may be formed from a combination of a large white or black candlestick and a smaller white or black candlestick.
The smaller the second and lestick, the more likely the reversal. When a large white candle stick is followed by a small black
candlestick, it is thought to be a strong sign of a trend ending.
Harami Cross
This candlestick pattern is indicated by a large candlestick followed by a doji that is located within the top and bottom of the
candlestick's body. This indicates that the previous trend is about to reverse.

the highest price for the day


opening price
body is black (or red) if
stock closed lower. Body
is white (or green) if it
closed higher
closing price

Bearish Harami Cross

smaller body

the lowest price for the day

the highest price for the day


closing price
body is black (or red) if
stock closed lower. Body
is white (or green) if it
closed higher
opening price

Doji (cross)

the lowest price for the day

Figure 12.15 Bullish Harami Pattern

Because the bullish harami indicates that the falling trend (bearish trend) may be reversing, it signals that it is a good time to
enter into a long position. The smaller the second (white) candlestick, the more likely the reversal.

Bearish Harami Cross


the highest price for the day
opening price
body is black (or red) if
stock closed lower. Body
is white (or green) if it
closed higher
closing price

Doji (cross)

the lowest price for the day


Figure 12.17 Harami Cross Bearish & Bullish

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42

A Harami cross can be either bullish or bearish, depending on the previous trend (Figure 12.17 above). The appearance of a
Harami Cross, rather than a smaller body, increases the likelihood that the trend will reverse.
Tweezer Tops and Bottoms
The Candlestick theory recognizes both a tweezer top and a tweezer bottom. The tweezers formation always involves two
candles. At a tweezer top, the high price of two nearby sessions is identical. Meanwhile, at a tweezer bottom, the low price of
two sessions that come in close succession is the same.

Windows
A window is a gap between the prior and the current session's price extremes. It can be said to be a break between prices on
a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Such
windows, also referred to as gaps, can be created by factors such as regular buying or selling pressure, earnings announcements,
a change in an analyst's outlook or any other type of news release.

In some instances, the tweezer bottom is formed by two real candlestick bodies that make an identical low. In other instances,
the lower shadows of two nearby candles touch the same price level and the stock then bounces higher. Meanwhile, a third
possibility is that the lower shadow of one day and the real body of a nearby session hit the same bottom level.
Tweezers can also be defined as a pattern found in technical analysis of options trading. Tweezer patterns occur when two or
more candlesticks touch the same bottom for a tweezer bottom pattern or top for a tweezer top pattern. This type of pattern
can be made with candlestick charts of various types.
Figure 12.20 Windows or Gaps

An example of two different gaps can be seen in the chart above (Figure 12.20). Notice how the stock closes the trading session
before the first gap at $50 and opens the next trading day near $46 with no trading occurring between the two prices. Gaps
are a regular occurrence in all financial markets. However, they are rarely seen in the forex market since it is highly liquid and
trades 24 hours a day.
Figure 12.18 Tweezer Top Patterns

Tweezer bottoms are considered to be short-term bullish reversal patterns. Tops are bearish, and either end means that buyers
or sellers were not able to push the top or bottom any further. Both types of patterns require close observation and research
in order to be interpreted and used correctly.
Continuation Pattern
Most candlestick signals are trend reversals. However, there are a group of candlestick patterns which are continuation indicators.
As the Japanese express it, "there are times to buy, times to sell, and times to rest." Many of these patterns imply a time of
rest, a breather, before the market resumes its prior trend.

43

Figure 12.21 below shows an open window that forms in an uptrend. There is a gap between the prior upper shadow and this
session's lower shadow.

Window

Closed Window
But No Selling
Follow Through

Figure 12.21 Window in an uptrend

44

Figure 12.22 below shows a window in a downtrend. It shows no price activity between the previous day's lower shadow and
the current day's upper shadow.

Downward Tasuki Gap


The Downside Tasuki Gap is a three day candlestick continuation pattern. The pattern starts with a red candlestick that has
gapped below the previous red candlestick. The third and final candlestick is a green candlestick that opens inside the body
of the second red candlestick. Traders should go short on the close of the third candlestick. They should trade in the direction
of the Downside Tasuki Gap, which is a defined up downtrend.

Window

Gap Downside

Figure 12.22 Window in a downtrend


Figure 12.24 Downward Tasuki Gap

Upward/ Upside Tasuki Gap

High-price and Low-price Gapping Plays

The Upside Tasuki Gap is a three day candlestick continuation pattern. The pattern starts with a green candlestick that has
gapped above the previous green candlestick. The third and final candlestick is a red candlestick that opens inside the body
of the second green candlestick. Traders should go long on the close of the third candlestick. Traders should trade in the
direction of the Upside Tasuki Gap, which is a defined up
trend.

After a sharp one to two session advance, it is normal for the market to consolidate the gains. Sometimes this consolidation
is by a series of small real bodies. A group of small real bodies after a strong session tells us that the market is undecided.
However, if there is an upside gap on the opening (a window) from these small real bodies, it is time to buy. This is high-price
gapping play pattern (Figure 12.25 below), so called because prices hover near their recent highs and then gaps to the upside.

Window
Gap up

Figure 12.23 Upward Tasuki Gap

45

Figure 12.25 High-price Gapping Play

46

Contrary to the general belief, a low-price gapping play is not the bearish counterpart of the high-price gapping play. The lowprice gapping play (Figure 12.26 below) is a downside window from a low-price congestion band. This congestion band (a
series of small real bodies) initially stabilized a steep one to two session decline. At first, this group of small candlesticks gives
the appearance that a base is forming. The break to the downside via a window dashes these bullish hopes.
Window

Figure 12.28 Gapping Side-by-side White Lines in a Downtrend

Window

Rising and Falling Three Methods


These three methods include the bullish rising three methods and the bearish falling three methods. These are both continuous
patterns.

Figure 12.26 Low price Gapping Play

i. Bullish Rising Three Methods Pattern


Gapping Side-by-side White Lines
In an uptrend, an upward-gapping white candlestick follows the next session by another similar sized white candlestick with
about the same opening is a bullish continuation pattern. This two candlestick pattern is referred to as upgap side-by-side white
lines (Figure 12.27 below). If the market closes above the higher of the side-by-side white candlesticks, another leg up should
unfold.

The Rising Three Methods is a candlestick continuation pattern which indicates the continuation of a bullish trend even after
a temporary halt in trading. It is a multiple candlestick pattern which includes more than three candlesticks (ideally include five
candlesticks) of which the first and last candlesticks are long bullish (white/colorless) candlesticks. The middle candlesticks
may be all bearish (black/colored) or can be a mixture of bullish and bearish candlesticks. Bullish rising three methods is highly
reliable when all middle candlesticks are bearish.
Bullish Rising Three Methods

Window

Figure 12.27 Gapping Side-by-side White Lines in an uptrend

The side-by-side white candlesticks described previously are rare. Even more rare are side-by-side white lines which gap lower.
These are called downgap side-by-side white lines (Figure 12.28 below). In a downtrend, the side-by-side white lines are also
a continuation pattern. That is, prices should continue to lower. The reason this pattern is not bullish (as is the upgap variety)
is because in a falling market, these white lines are viewed as short covering.

47

Figure 12.29 Bullish Rising Three Methods Pattern

This pattern occurs when bears are unable to bring the prices down below first day's range. This boosts the confidence of the
bulls and the prices are then taken to the new highs.

48

This pattern is considered to be a highly reliable trend continuation pattern. Reliability of the pattern increases with shortening
Doji

of real-bodies (doji formations) of middle candlesticks and decrease in trading volumes on middle days. Confirmation is still
suggested with this formation which can be a bullish candlestick on new day.
Long-legged Doji
i. Bearish Falling Three Methods Pattern

Figure 12.31 Common Doji / Doji

A long-legged doji is a far more dramatic candle. It signifies that prices moved far higher on the day, but that profit taking has
kicked in. Typically, it leaves a very large upper shadow. A close below the midpoint of the candle shows a lot of weakness.

The Falling Three Methods is a candlestick pattern which indicates bearish market continuation even after a temporary halt in
trend. This is a multiple candlestick pattern which includes more than three candlesticks, of wt1ich,the first and the last will be
long bearish candlesticks. The middle candlesticks can be all white (bullish or colorless) or a mix of white and black (bearish

Long - Legged
Doji

or colored) candlesticks. Reliability is the highest when all middle candlesticks are bullish.
Falling Three Methods

Gravestone Doji

Figure 12.32 Long legged Doji

A gravestone doji, as the name implies, is probably the most ominous candle of all. On the day this candle is formed, prices
rally, but cannot stand the 'altitude' they achieved. By the end of the day, they come back and close at the opening level.

Gravestone
Doji

Figure 12.30 Bearish Falling Three Methods Pattern

Dragonfly Doji
This formation occurs when the bulls are unable to bring the price to new highs after a significant downtrend. It boosts the
confidence of bears and prices are then taken to new lows.

Figure 12.33 Gravestone Doji

A dragonfly doji depicts a day on which prices opened at a high, sold off, and then returned to the opening price. Dragonflies
are fairly unusual. However, when they do occur, they often resole bullishly (provided the stock is not already overbought).

This is a highly reliable pattern of trend continuation. Reliability increases with shortening of real-body of middle candlesticks
and reduction in trading volume on middle days. Confirmation of trend-continuation is still suggested which can be a new
candlestick with lower closing.
The Magic Doji
A doji is a candlestick in which the opening and closing prices are the same. If prices close very close to the same level (so
that no real body is visible), then that candle is read as a doji. A doji candlestick looks like a cross, inverted cross, or plus sign.
Alone, doji are neutral patterns. There are four types of dojis:
Common Doji
A Common Doji has a relatively small trading range. It reflects indecision in some manner.

49

Dragonfly
Doji

Figure 12.34 _ Dragobfly Doji

The philosophy is that a doji can be a significant warning and that it is better to attend to a false warning than to ignore a real
one. To ignore a doji, with all its inherent implications, could be dangerous.

50

Chapter 13

CHART PATTERNS
What are Chart Patterns?
A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists
use these patterns to identify current trends and trend reversals and to trigger buy and sell signals.
The theory behind chart patterns is based on the assumption that "history repeats itself", as discussed earlier. The idea here
is that certain patterns are seen many times, and that these patterns signal a certain high probability move in a stock. Based
on such historic trend of a chart pattern setting up a certain price movement, chartists look for these patterns to identify trading
opportunities.
Figure 13.2 Head and Shoulders Bottom or Inverse Head and Shoulders

While there are general ideas and components related to every chart pattern, there is no chart pattern that will tell you with
100% certainty where a security is headed. This creates some leeway and debate as to what a good pattern looks like, and

ii. Double Tops and Bottoms - This chart pattern is another well-known pattern that signals a trend reversal - it is considered

is a major reason why charting is often seen as more of an art than a science.

to be one of the most reliable patterns and is commonly used. These patterns are formed after a sustained trend and signal
to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels

Types of Chart Patterns

twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.

Essentially, there are 2 types of patterns within this area of technical analysis. These patterns can be found over charts of any
timeframe: Reversal Patterns
A reversal pattern signals that a prior trend will reverse upon the completion of the pattern.
i. Head and Shoulder This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders
is reversal chart pattern that when formed, signals that the security is likely to move against the previous trend.

Figure 13.3 Double Top Pattern

Figure 13.4 Double Bottom Pattern

Figure 13.1 - Head and shoulders Top Pattern

51

52

iii. Triple Tops and Bottoms - These are another type of reversal chart pattern in chart analysis. These are not as prevalent in

Continuation Patterns

charts as head and shoulders and double tops and bottoms, but they act in a similar fashion. These two chart patterns are
formed when the price movement tests a level of support or resistance three times and is unable to break through; this signals

A continuation pattern signals that a trend will continue once the pattern is complete.

a reversal of the prior trend.


i. Cup and Handle - A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will
continue in an upward direction once the pattern is confirmed.

Figure 13.8 Cup and Handle Pattern

ii. Triangles - Triangles are one of the most well-known chart patterns used in technical analysis. The three types of triangles,
which vary in construct and implications, are symmetrical triangle, ascending triangle and descending triangle. These chart
Figure 13.6 Triple Bottom Pattern

patterns are considered to last anywhere from a couple of weeks to several months.

iv. Rounding Bottom - A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a
shift from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to
several years.

Figure 13.9 Symmetrical Triangle Pattern

Figure 13.7 Rounding Bottom Pattern

53

54

Other Patterns
Figure 13.10 Ascending Triangle Pattern

Figure 13.10 Ascending Triangle Pattern

i. Wedge - The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except
that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways
movement. The other difference is that wedges tend to form over longer periods, usually between three and six months. The
fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at
the most basic level, a falling wedge is bullish and a rising wedge is bearish.

Figure 13.11 Descending Triangle Pattern

iii. Flag and Pennant - These two short-term chart patterns are continuation patterns that are formed when there is a sharp
price movement followed by a generally sideways price movement. This pattern is then completed upon another sharp price
movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three
weeks.

Figure 13.14 Wedge Pattern

ii. Gaps - A gap in a chart is an empty space between a trading period and the following trading period. This occurs when
there is a large difference in prices between two sequential trading periods. Gap price movements can be found on bar charts
and candlestick charts but will not be found on point and figure or basic line charts.
Gaps generally indicate that some event of significance has occurred in relation to a security, such as a better than- expected
earnings announcement.

Figure 13.11 Descending Triangle Pattern

55

56

Chapter 14

There are three main types of gaps - breakaway, runaway (measuring) and exhaustion. A breakaway gap
forms at the start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms
near the end of a trend.
iii. Channels - A channel, or channel lines, can be described as the addition of two parallel trendlines that
act as strong areas of support and resistance. The upper trendline connects a series of highs, while the lower
trend line connects a series of lows. A channel can slope upward, downward or sideways. However, regardless
of the direction, the interpretation still remains the same. Traders will expect a given security to trade between
the two levels of support and resistance until it breaks beyond one of the levels. In this case, traders can
expect a sharp move in the direction of the break. Along with clearly displaying the trend, channels are mainly
used to illustrate important areas of support and resistance.

Day

Close

5-day Total

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

50
55
57
60
65
70
66
60
50
54
45
43
33
40
35
30
25
30
35
33

x
x
x
x
287
307
318
321
311
300
275
252
225
215
196
181
163
160
155
153

5-day Average
x
x
x
x
57.4
61.4
63.6
64.2
62.2
60
55
50.4
45
43
39.2
36.2
32.6
32
31
30.6

Day
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

Close

5-day Total

48
40
43
41
35
39
35
37
25
18
35
50
40
45
50
70
70
60
75
70

271
186
199
205
207
198
193
187
171
154
150
165
168
188
220
255
275
295
325
345

5-day Average
34.2
37.2
39.8
41
41.4
39.6
37.4
37.4
34.2
30.8
30
33
33.6
37.6
44
51
55
59
65
69

Figure 14.1

What are Moving Averages?


Figure 13.10 Ascending Triangle Pattern

Figure 13.15 above illustrates a descending channel on a stock chart; the upper trendline has been placed
on the highs and the lower trend line is on the lows. The price has bounced off these lines several times, and
has remained range-bound for several months. As long as the price does not fall below the lower line or move
beyond the upper resistance, the range-bound downtrend is expected to continue.
It is important to be able to understand and identify trends so that you can trade with them, and not against
them. The following are the two important sayings in technical analysis that illustrate how important trend
analysis is for technical traders:
1.
2.

57

Trend is your friend


Dontt buck the trend

Chart patterns usually show a lot of variation in price movement. This can make it difficult for traders to get
an idea of a security's overall trend. One simple method traders use to combat this is to apply moving averages.
A moving average is the average price of a security over a set period of time. By plotting a security's average
price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better
able to identify the true trend and increase the probability that it will work in their favour.
Example: For a 5-day moving average you simply add the closing prices of the last five closings and divide
this sum by 5. You add each new closing price and skip the oldest. Thus, the number of closing prices
considered always remains constant at 5 days (Figure 14.2).

58

Figure 14.2 Price and 5-day Moving Average

However, whether you choose a 1O-day average or a 40-week average, the calculation is the same; instead
of adding 5 days, you add the closing prices of 10 days or 40 weeks and divide the sum by 10 or 40 respectively.

Figure 14.3 Simple Moving Average

Functions of Moving Averages

Linear Weighted Average

Moving averages are popular for identifying price trends and are versatile in nature. They smooth out
fluctuations in market prices thereby making it easier to determine underlying trends. Their other function is
to signal significant changes in the direction as early as possible.

This moving average indicator is the least common method out of the three and is used to address the problem
of equal weights. The linear weighted moving average is calculated by taking the sum of all the closing prices
over a certain time period and multiplying them with the position of the data point and then dividing the total
by the sum of the number of periods. For example, in a five-day linear weighted average, today's closing
price is multiplied by 5, yesterday's price by 4 and so on until the first day in the period range is reached.
These numbers are then added together and divided by the sum of the multipliers.
Exponential Moving Average (EMA)

Types of Moving Averages


There are different types of moving averages that vary in the way these are calculated, but how each average
is interpreted remains the same. The calculations only differ in regards to the weight placed on the price data,
varying from equal weight applied to each price point to more weight being applied to recent data. The three
most common types of moving averages are:
Simple Moving Average (SMA)
This is the most common method used to calculate the moving average of prices. It simply takes the sum
of all of the past closing prices over a given time period and divides the result by the number of prices used
in the calculation. For example, in a 10-day moving average, the last 10 closing prices are added together
and then divided by 10. As you can see in Figure 14.3 below, a trader is able to make the average less
responsive to changing prices by increasing the number of periods used in the calculation. Increasing the
number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend
and the likelihood that it will reverse.

59

This moving average calculation method uses a smoothing factor to place a higher weight on recent data
points and is regarded as much more efficient method than the linear weighted average. Having an understanding
of the calculation is not generally required for most traders because most charting packages do the calculation
for you. The most important thing to remember about the exponential moving average is that it is more
responsive to new information relative to the simple moving average. This responsiveness is one of the key
factors of why this is the moving average of choice among many technical traders. As you can see in Figure
14.4 below, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesn't seem
like much, but it is an important factor to be aware of since it can affect returns.

60

1. Another method of determining momentum is to look at the order of a pair of moving averages. When a
short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average
above a shorter-term average signals a downward movement in the trend.

Figure 14.4 Exponential Moving Average

2. Moving average trend reversals are interpreted in two main ways: when the price moves through a moving
average and when it moves through moving average cross overs. The first common signal is when the price
moves through an important moving average. For example, when the price of a security that was in an uptrend
falls below a 50-period moving average, like in Figure 14.6 below, it is a sign that the uptrend may be reversing.

Major Uses of Moving Averages


The following are some of the major uses of Moving Averages:
1.
To identify current trends and trend reversals as well as to set support and resistance levels
2.
To quickly identify whether a security is moving in an uptrend or a downtrend depending on the
direction of the moving average. As you can see in Figure 14.5 below, when a moving average is heading
upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving
average with the price below can be used to signal a downtrend.

Figure 14.5

5. Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and
resistance points and are very easy to use. The most common time frames that are used when creating
moving averages are the 200-day, 100-day, 50-day, 20-day and 1O-day.The 200-day average is thought to
be a good measure of a trading year, a 1OO-dayaverage of a half a year, a 50-day average of a quarter of
a year, a 20-day average of a month and 1O-day average of two weeks.
6. Moving averages help technical traders to smooth out some of the noise that is found in day-to-day price

Figure 14.5

movements, giving traders a clearer view of the price trend.


Trends in Moving Averages
The three basic trends that are followed in moving averages to track the various investment horizons are:
Long-term averages

61

62

On the monthly chart shown below (Figure 14.7), the 11-month moving average tracks the long-term trend.

Figure 14.9 Short-term average

Figure 14.7 Long term average

Medium-term averages

However, instead of using three separate charts to illustrate the three basic trends, we often use a daily chart
displaying all three moving averages. On the daily chart (as shown in Figure 14.10 below), the 11-month
moving average equals the 233-day moving average, the 11-week average equals the 55-day average and
the 11-day remains the 11-day moving average.

On the weekly chart above, the 11-week moving average tracks the medium-term trend.
Moving Average Crossover

Figure 14.10 Daily chart displaying all the three moving averages.
Figure 14.8 Medium-term average

Short-term averages
On the daily chart on the right, the 11-day moving average tracks the short-term trend.

63

64

Chapter 15

MOMENTUM
The three moving averages discussed above are shown again here on the daily chart (Figure 14.10) - the
11- day moving average (short-term trend), the 55-day moving average (medium-term trend) and the 233day (long-term trend) moving average which tracks the long-term trend (we also track the more popular 200day moving average). Displaying the three moving averages on one chart provides important signals based
on the moving average crossovers.

What is Momentum?

BUY and SELL signals are given:

Momentum can also be described as the rate of acceleration of a security's price or volume. Once a trader
sees an acceleration in a stock's price, earnings, or revenues, the trader will often take a long or short position
in the stock with the hope that its momentum will continue in either an upwards or downwards direction.

When the price crosses the moving average.


When the moving average itself changes direction and
When the moving averages cross each other

A short-term buy signal (B 1) is given when the price rises above the 11-day moving average. However, the
buy signal is confirmed when the 11-day average itself starts rising. The sell signals (51) are given in the
opposite direction.
A medium-term buy signal (B2) is given when the price rises above the 55-day moving average and is
confirmed when the 55-day average itself starts rising and the 11-day average crosses above the 55-day
average. The sell signals (52) are given in the opposite direction.

In physics, momentum is measured by the rate of increase and decrease in the speed of an object. In financial
markets, it is measured by the speed of the price trend, i.e. whether a trend is accelerating or decelerating,
rather than the actual price level itself.

We have noted that moving averages are lagging indicators and give signals after the price trend has already
turned. On the other hand, momentum indicators lead the price trend. They give signals before the price trend
turns. Once momentum provides a signal, it has to be confirmed by a moving average crossover. Instead of
calculating the moving average of the sum of 5 days, we calculate the difference over a constant 5-day period
for a 5-day rate of change.
This is shown on the chart below (Figure 15.1) together with the zero line. If today's price is higher than that
of five days ago, the indicator is positive, i.e. above the zero line. If the price continues to rise compared to
that of five days earlier, the indicator rises. If the price today is lower than that of five days ago, the indicator
is negative, i.e. below the zero line. The rate of change oscillator is rather volatile. Therefore, we have
smoothed it out (see thick-curved line) so that it provides easy-to-read directional change.

A long-term buy signal (B3) is given when the price rises above the 233-day moving average. However, the
signal is confirmed when the 233-day average itself starts rising and the 55-day average crosses above the
233-day moving average. The sell signals (53) are given in the opposite direction.

Figure 15.1

65

66

Chapter 16

NDICATORS AND OSCILLATORS


What are indicators?
Indicators are calculations based on the price and the volume of a security that measure such factors as
money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual price
movements and add additional information to the analysis of securities.
Uses of indication
Indicators are used in two main ways:
1.
2.

To confirm price movement and the quality of chart patterns


To form buy and sell signals

Types of indicators
There are two main types of indicators:
1.
Leading - A leading indicator precedes price movements, giving them a predictive quality. It is thought
to be the strongest during periods of sideways or non-trending trading ranges.
2.
Lagging - A lagging indicator is a confirmation tool because it follows price movement. It is still useful
during trending periods.
Types of Indicator Constructions
There are also two types of indicator constructions - those that fall in a bounded range and those that do not.
The ones that are bound within a range are called oscillators - these are the most common type of indicators.
Oscillator indicators have a range, for example between zero and 100, and signal periods where the security
is overbought (near 100) or oversold (near zero). Non-bounded indicators still form buy and sell signals along
with displaying strength or weakness, but they vary in the way they do this.
Crossovers and Divergence
The two main ways that indicators are used to form buy and sell signals in technical analysis is through
crossovers and divergence. Crossovers are the most popular and are reflected when either the price moves
through the moving average, or when two different moving averages

67

cross over each other. The second way indicators are used is through divergence, which happens when the
direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This
signals to the indicator users that the direction of the price trend is weakening.
Indicators that are used in technical analysis provide an extremely useful source of additional information.
These indicators help identify momentum, trends, volatility and various other aspects in a security to aid the
technical analysis of trends. It is important to note that while some traders use a single indicator solely for
buy and sell signals, these are best used in conjunction with price movement, chart patterns and other
indicators.
Moving Average Convergence Divergence MACD
Moving average convergence divergence (MACD) is one of the most well known and widely used indicators
in technical analysis. This indicator comprises of two exponential moving averages, which helps to measure
momentum in the security. MACD can simply be defined as the difference between these two moving averages
plotted against a centerline (The centerline is the point at which the two moving averages are equal). Along
with the MACD and the centerline, an exponential moving average of the MACD itself is plotted on the chart.
The idea behind this momentum indicator is to measure short-term momentum compared to longer term
momentum to help signal the current direction of momentum.
MACD = Short-term moving average - Long-term moving average
The findings of the MACD can be enumerated as under:
1.
When the MACD is positive, it signals that the short-term moving average is above the long-term
moving average and suggests an upward momentum.
2.
The opposite holds true when the MACD is negative - this signals that the short-term is below the
long term and suggests a downward momentum.
3.
When the MACD line crosses over the centerline, it signals a crossing in the moving averages.
The most common moving average values used in the calculation are the 26-day and 12-day exponential
moving averages. The signal line is commonly created by using a 9-day exponential moving average of the
MACD values. These values can be adjusted to meet the needs of the technician and the security. For more
volatile securities, short-term averages are used while less volatile securities should have longer averages.

68

MACD Histogram
The MACD histogram is plotted on the centerline and is represented by bars. Each bar is the difference
between the MACD and the signal line or, in most cases, the 9-day exponential moving average. The higher
the bars are in either direction, the more momentum is present behind the direction in which the bars point.

However, the standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet
the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and
will be used for shorter term trades.
On-balance Volume OBV
On-Balance Volume, an indicator developed by Joe Granville, is a method used in technical analysis to detect
momentum, the calculation of which relates volume to price change. OBV provides a running total of volume
and shows whether this volume is flowing in or out of a given security.
The on-balance volume (OBV) indicator is a well-known technical indicator that reflects movements in volume.
It is also one of the simplest volume indicators to compute and understand.

Figure 16.1 Moving Average Convergence Divergence Indicator

Relative Strength Index RSI


The relative strength index (RSI) is another widely used and well-known momentum indicator in technical
analysis. RSI helps to signal the overbought and oversold conditions in a security.
As seen in Figure 16.2 below, the RSI indicator ranges from zero and 100. An asset is deemed to be overbought
once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate
for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold
and therefore likely to become undervalued.

Figure 16.3 On Balance Volume Indicator

OBV attempts to detect when a financial instrument (stock, bond, etc.) is being accumulated by a large number
of buyers or sold by many sellers. Traders will use an upward sloping OBV to confirm an uptrend, while a
downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of
an asset is trending upward can be used to suggest that the "smart" traders have started exiting from their
positions and that a shift in trend may be expected to come.
Stochastic Oscillator

Figure 16.2 Relative Strength Index Indicator

69

Stochastic Oscillator is a technical momentum indicator that compares a security's closing price to its price
range over a given time period. The oscillator's sensitivity to market movements can be reduced by adjusting
the time period or by taking a moving average of the result.

70

Chapter 17

FASCINATING FIBONACCI
The theory behind this indicator is that in an upward-trending market, prices tend to close near their high,
and during a downward-trending market, prices tend to close near their low.
The stochastic oscillator (Figure 16.4 below) is plotted within a range of zero and 100 and signals overbought
conditions above 80 and oversold conditions below 20. Basically, it contains two lines. The first line is the
%K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The
second line is the %0, which is simply a moving average of the %K. The %0 line is considered to be the more
important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the
past 14 trading periods in its calculation but can be adjusted to meet the needs of the user. Transaction
signals occur when the %K crosses through a three-period moving average called the "%D".

Figure 17.1

Figure 16.4 Stochastic Oscillator

This indicator is calculated with the following formula:


%k = 100{(C-l14)/(H14-L14)}

C = the most recent closing price


L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.

What does Fibonacci Numbers / Lines mean?


Leonardo Fibonacci, an Italian mathematician born in the 12th century, is known to have discovered the
Fibonacci numbers - a sequence of numbers where each successive number is the sum of the two previous
numbers.
Example: 0, 1,
144

1,

2,

3,

4,

5,

8,

13,

21,

34,

55,

89,

For reasons unknown, these numbers play an important role in determining relative areas where the prices
of financial assets experience large price moves or change direction. These numbers possess a number of
interrelationships, such as the fact that any given number is approximately 1.618 times the preceding number.

%D = 3 period moving average of %K

71

72

Fibonacci studies
Interpretation of the Fibonacci numbers in technical analysis anticipates changes in trends as prices tend to
be near lines created by the Fibonacci studies. The four popular Fibonacci studies are arcs, fans, retracements
and time zones:
Fibonacci Arc

Fibonacci fans are created by first drawing a trendline through 2 points (usually the high and low in a given
period), and then by dividing the vertical distance between the two points by the key Fibonacci ratios of 38.2%,
50% and 61.8%. The results of these divisions each represent a point within the vertical distance. The three
'fan' lines are then created by drawing a line from the leftmost point to each of the 3 representing a Fibonacci
ratio.
Fibonacci Retracement

This is a charting technique consisting of 3 curved lines that are drawn for the purpose of anticipating key
support and resistance levels, and areas of ranging.

This is a charting technique used in technical analysis that refers to the likelihood that a financial asset's price
will retrace a large portion of an original move and find support or resistance at the key Fibonacci levels before
it continues in the original direction. These levels are created by drawing a trendline between 2 extreme points
and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

Figure 17.2 Fibonacci Arc

Fibonacci arcs are created by first drawing an invisible trendline between two points (usually the high and
low in a given period), and then by drawing 3 curves that intersect this trendline at the key Fibonacci levels
of 38.2%, 50% and 61.8%. Transaction decisions are made when the price of the asset crosses through
these key levels.
Fibonacci Fan
This is a charting technique that consists of 3 diagonal lines that use Fibonacci ratios to help identify key
levels of support and resistance

Figure 17.4 Fibonacci Retracement

Fibonacci retracement is a very popular tool used by many technical traders to help identify strategic places
for transactions to be placed, target prices or stop losses. The notion of retracement is used in many indicators
such as Tirone levels, Gartley patterns, Elliott Wave theory, etc.
Fibonacci Time Zones
This is an indicator used by technical traders to identify periods in which the price of an asset will experience
a significant amount of movement. This charting technique consists of a series of vertical lines that correspond
to the sequence of numbers known as Fibonacci numbers (1, 2, 3, 5,8, 13, 21, 34, etc.). Once a trader
chooses a starting position (most commonly following a major move) on the chart, a vertical line is placed
on every subsequent day that corresponds to the position in the Fibonacci number sequence.

Figure 17.3 Fibonacci Fan

73

74

Additional phenomena relating to the Fibonacci sequence includes:

Figure 17.5 Fibonacci Time Zones

Fibonacci arcs are created by first drawing an invisible trendline between two points (usually the high and
low in a given period), and then by drawing 3 curves that intersect this trendline at the key Fibonacci levels
of 38.2%, 50% and 61.8%. Transaction decisions are made when the price of the asset crosses through
these key levels.
Fibonacci Fan

1.

No two consecutive numbers in the sequence have any common factors.

2.

The sum of any ten numbers in the sequence is divisible by 11.

3.

The sum of all Fibonacci numbers in the sequence +1 equals the Fibonacci number two steps ahead.

4.

The square of a Fibonacci number minus the square of the second number below it in the sequence
is always a Fibonacci number.

There are numerous relationships within this series, but the most important is 1.618 or 0.618. It is known as
the Golden Ratio or Golden Mean and governs nature's growth patterns.

This is a charting technique that consists of 3 diagonal lines that use Fibonacci ratios to help identify key
levels of support and resistance
Properties of Fibonacci Numbers
This sequence of numbers has some very important properties.
1.
The ratio of any number to the next number in the sequence is 0.618 to 1 and to the next lower
number is 1.618.
2.
The ratio between alternative numbers in the sequences is 2.618 or its inverse 0.382.
These numbers have some special relationship of their own such as:
1. 2.618 - 1.618 = 1
2. 1 - 0.618 = 0.382
3. 2.618 x 0.382 = 1
4. 0.618 x 0.618 = 0.382
5. 1.618x1.618=2.618

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Chapter 18

MONEY MANAGEMENT
What is money management?
Money management can be defined as the process of budgeting, saving, investing, spending or otherwise
overseeing the cash usage of an individual or group. The predominant use of the phrase in financial markets
is in relation to an investment professional making investment decisions for large pools of funds, such as
mutual funds or pension plans. While the term is usually used with reference to professional money managers,
everyone practices some form of investment management with their personal finances.
Importance of Money Management
Money management is used in investment management and deals with the question of how much risk a
decision maker should take in situations where uncertainty is present. More precisely, what percentage or
what part of the decision maker's wealth should be put into risk in order to maximize the decision maker's
utility function. However, in the context of an effective money management process, the following points
should necessarily be adhered to:

Survival First
The following are some of the important goals of money management:
a.
b.
c.

To ensure survival risks that can put one out of business should be avoided.
To earn a steady rate of return.
To earn high returns but survival comes first.

It is widely advocated that we should not risk our whole world in trading. Losers violate it by betting too much
on a single trade. They continue to trade on the same or even a bigger size during a losing streak. Often,
losers go bust while trying to trade their way out of a hole. Good money management can keep one out of
the hole in the first place.
We must know in advance how much we can lose - when and at what level can we cut our losses. Professionals
tend to run as soon as they smell trouble and re-enter the market when they think it is fit to do so. Amateurs,
on the other hand, hang on and hope for something better to take place. Get Rich Slowly
An amateur trying to get rich quickly is like a monkey sitting on a thin branch. He reaches for a ripe fruit but
crashes when the branch breaks under his weight.

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Institutional traders, as a group, tend to be more successful than private traders because of their bosses who
enforce a certain (trading) discipline on them. If a trader loses more than his limit on a single trade, he may
be fired for in-subordination. If he loses his monthly limit, his trading privileges may be suspended for the
rest of the month. If similar incidents occur severally in a row, he can also be fired or transferred. Such a
system makes institutional traders avoid losses. Private traders have to be their own enforcers.
Amateurs often ask about the percentage of profit that they can make over a period of time by trading. The
answer depends on their individual skill sets and/ or on market conditions. However, what people never ask
about is the extent of losses that should be enough to stop them from trading further and re-evaluate
themselves, their system and the markets. If we can focus on handling losses, profits will take care of
themselves. One should trade to establish the best track record, with steady gains and small drawdowns.
How much should one risk?
Most traders get killed by one of the 2 bullets - ignorance or emotion. Amateurs act on hunches and stumble
into trades that they should never get into because of negative mathematical expectations. Those who survive
the stage of virginal ignorance graduate to design better systems. When they become more confident, they
lift their heads out of the foxholes - and then, the second bullet (emotion) hits them. Confidence makes them
greedy, they risk too much money on a trade and a short string of losses blows them out of the market.
A professional cannot afford to lose more than a tiny percentage of his equity on a single trade whereas an
amateur has the same tendency towards trading as that of an aicoholic towards drinking. The latter often
gets carried away and sets out to have a good time, but ends up destroying/ damaging his prospective.
Limiting Losses
It is simply not possible for any trader - whether amateur, professional or anywhere in between - to avoid
every single loss. A disciplined trader is fully cognizant of the inevitability of losing hard-earned profits, and
is able to accept losses without an motional upheaval. At the same time, however, there are systematic
methods by which one can ensure that losses are kept to a minimum. The following are some of the most
p r e v a l e n t
m e t h o d s
o f
d o i n g
t h e
s a m e :
Stop-Loss Order
a. Concept of Stop-Loss
Stop-loss is an order that is placed by an investor/ trader with a broker to buy or sell a security (or a part there
of) once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security
position. Setting a stop-loss order for 10% below the

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price at which you bought the stock will limit your loss to 10%.
Example: Let's say you just purchased Microsoft (Nasdaq: MSFT) at $20 per share. Right after buying the
stock, you enter a stop-loss order for $18. This means that if the stock falls below $18, your shares will then
be sold at the prevailing market price.
b. Advantages of the Stop-loss Order
The primary advantage of a stop loss order is that you do not have to monitor how a stock is performing on
a regular basis. This is especially handy when you are on vacation or in a situation that prevents you from
watching your stocks for an extended period of time.
Another use of this tool is to lock in profits, in which case, it is sometimes referred to as a 'trailing stop'. The
stop-loss order is set at a percentage level below, not at the price at
which you bought it, but at the current market price. The price of the stop loss adjusts as the stock price
fluctuates.
The beauty of the stop-loss order is that it costs nothing to implement. The regular commission is charged
once the stop-loss price has been reached and the stock must be sold. It can thus be thought of as a free
insurance policy.
Most importantly, a stop loss order allows decision making to be free from any emotional influences. People
tend to fall in love with certain stocks, believing that if they give a stock another chance, it will come around.
This causes procrastination and delay, giving the stock yet another chance. Meanwhile, the losses may just
mount higher.
c. Disadvantages of the Stop-loss Order
The disadvantage of the stop-loss order is that the stop price could be activated by a short-term fluctuation
in a stock's price. The key here is to pick a stop-loss percentage that allows a stock to fluctuate day to day
while preventing as much downside risk as possible.
Once the stop price is reached, the stop order becomes a market order and the price at which you sell may
be much different from the stop price. This is especially true in a fast-moving market where stock prices can
Change rapidly
A last restriction with the stop-loss order is that many brokers do not allow placing a stop order on certain
securities like OTC Bulletin Board stocks or penny stocks.
A stop-loss order is a simple tool, yet so many investors fail to use it; whether to prevent excessive losses
or to lock in profits, nearly all investing styles can benefit from this trade. A

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stop loss should always be thought of as an insurance policy - you hope you never have to use it, but it's
good to know that you have the protection should you require it.
The 2% Rule
Extensive testing has shown that the maximum amount that a trader may lose on a single trade without
damaging his long-term prospects is 2% of his account. This limit includes both slippage and commissions.
Example: If you have an INR 20,000 account, you may not risk more than INR400 on any trade. If you have
an INR 100,000 account, you may not risk more than INR 2,000 on any trade. Similarly, if you have only an
INR 10,000 account, then you should not risk more than INR 200 on any single trade.
Every trader has a different reaction to the 2% rule of thumb. Many think that a 2% risk limit is too small and
that it stifles their ability to engage in riskier trading decisions with a larger portion of their trading accounts.
On the other hand, most professionals think that 2% is a ridiculously high level of risk and prefer losses to
be limited to around 0.5-0.25% of their portfolios. The pros would naturally be more risk averse than those
with smaller accounts - a 2% loss on a large portfolio is a devastating blow. Irrespective of the size of your
capital, it is advisable to be conservative rather than aggressive when first devising your trading strategy.
The 2% rule puts a solid floor under the amount of damage the market can do to your account. Even a string
of 5 or 6 losing trades will not cripple your prospects. In any case, if you are trading to create the best track
record, you will not want to show more than a 6% or 8% monthly loss. When you hit that limit, stop trading
for the rest of the month. Use this cooling-off period to re-examine yourself, your methods and the markets.
The 2% rule also helps one to stay out of riskier trades. When the system gives an entry signal, one should
check to see where to place a logical stop. If that would expose more than 2% of the account, pass that trade.
It would pay to wait for trades that allow very close stops. Waiting for them reduces the excitement of trading
but enhances profit potential. One must choose which of the two one really wants.
The 2% rule is highly recommended for all traders, especially for those who are prone to the emotional pain
of experienced losses. If you are more risk averse, by all means, adjust the percentage loss to lower numbers
than 2%. However, it is not recommended that you increase your thresholds beyond that - the pros rarely
stray above such potential for losses. So you should think twice before increasing your risk thresholds.

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Chapter 19

CONCLUSION
Re-investing Profits
The term re-investing refers to using dividends, interest and capital gains earned in an investment or mutual
fund to purchase additional shares or units, rather than receiving the distributions in cash. This is a great way
to significantly increase the value of a stock or mutual fund. In the case of stocks, investors can use dividends
to buy additional shares instead of receiving payments in cash. Traders, on the other hand, can use their
earnings, whole or a part thereof, to increase their investable equity/ account in order to earn more profits.
Handling profits is a very important task. Many traders feel torn between a craving for faster and bigger profit
and a fear of losing all. Professional traders carefully sideline a portion of profits from their accounts. On the
other hand, an amateur trader, who grabs some profit rather fearfully and buys something before he can lose
it, is less confident in his ability to make profit.
Re-investing can turn a winning system into a losing one but it cannot turn a losing system into a winning
one. Leaving profits in your account allows you to make money faster by trading more number of contracts
or being able to establish long-term positions using wider stop-loss orders. Removing some of your profits
provides a cash flow.
However, there is no strict rule or guideline to split your profits between re-investment and personal use. It
depends completely on your personal decision and the size of your trading account. One must make sure
that he uses intellect and not his emotions while deciding on such issues.

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This section of technical analysis provides a broad overview of technical analysis. Here's a brief summary
of what we've covered:
1.
Technical analysis is a method of evaluating securities by analyzing the statistics generated by
market activity. It is based on three assumptions:
a.
the market discounts everything,
b.
price movies in trends
c.
history tends to repeat itself.
2.
Technicians believe that all the information they need about a stock can be found in its charts.
3.
Technical traders take a short-term approach to analyzing the market.
4.
Criticism of technical analysis stems from the efficient market hypothesis, which states that the
market price is always the correct one, making any historical analysis useless.
5.
One of the most important concepts in technical analysis is that of a trend - the general direction
that a security is headed in. There are three types of trends: uptrends, downtrends and sideways/horizontal
trends.
6.
A trendline is a simple charting technique that adds a line to a chart to represent the trend in the
market or a stock.
7.
A channel, or channel lines, is the addition of two parallel trend lines that act as strong areas of
support and resistance.
8.
Support is the price level through which a stock or market seldom falls.
9.
Resistance is the price level that a stock or market seldom surpasses.
10.
Volume is the number of shares or contracts that trade over a given period of time, usually a day.
The higher the volume, the more active the security.
11.
A chart is a graphical representation of a series of prices over a set time frame.
The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds.
The most frequently used time scales are intra-day, daily,

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13.

weekly, monthly, quarterly and annually.

14.

The price scale is on the right-hand side of the chart. It shows a stock's current price and compares
it to past data points. It can be either linear or logarithmic.

15.

There are four main types of charts used by investors and traders: line charts, bar charts, candlestick
charts and point and figure charts.

16.

A head and shoulders pattern is a reversal pattern that signals that a security is likely to move against
its previous trend.

18.

twice and is unable to break through.


A triangle is a technical analysis pattern created by drawing trendlines along a price range that gets
narrower over time because of lower tops and higher bottoms. Variations of a triangle include
ascending and descending triangles.
21.

Flags and pennants are short-term continuation patterns that are formed when there is a sharp price
movement followed by a sideways price movement.

22.

29.
30.
31.
32.
33.
34.
35.

A gap in a chart is an empty space between a trading period and the following trading period. This
occurs when there is a large difference in prices between two sequential trading periods.

24.

28.

The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical
triangle except that the wedge pattern slants in an upward or downward direction.

23.

27.

Double tops and double bottoms are formed after a sustained trend and indicates that the trend is
about to reverse. The pattern is created when a price movement tests support or resistance levels

20.

26.

A cup and handle pattern is a bullish continuation pattern in which the upward trend has paused but
will continue in an upward direction once the pattern is confirmed.

19.

25.

A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future
price movements. There are two types: reversal and continuation.

17.

24.

Triple tops and triple bottoms are reversal patterns that are formed when the price movement tests
a level of support or resistance three times and are unable to break through, signalling a trend
reversal.

A rounding bottom (or saucer bottom) is a long-term reversal pattern that signals a shift from a downward

36.

A moving average is the average price of a security over a set period of time. There are three types:
simple, linear and exponential.
Moving averages help technical traders smooth out some of the noise that is found in day-to-day
price movements, giving traders a clearer view of the price trend.
Indicators are calculations based on the price and the volume of a security that measures such
things as money flow, trends, volatility and momentum. Indicators are of the following two types:
leading and lagging.
The accumulation/distribution line is a volume indicator that attempts to measure the ratio of buying
to selling of a security.
The average directional index (ADX) is a trend indicator that is used to measure the strength of a
current trend.
The moving average convergence divergence (MACD)is comprised of two exponential moving
averages, which help to measure a security's momentum.
The relative strength index (RSI) helps to signal overbought and oversold conditions in a security.
The on-balance volume (OBV) indicator is one of the most well-known technical indicators that reflect
movements in volume.
The Stochastic oscillator compares a securitys closing price to its price range over a given time
period.
Fibonacci numbers is a sequence of numbers where each successive number is the sum of two
previous numbers.
Fibonacci Arc is a charting technique consisting of 3 curved lines that are drawn for the purpose of
anticipating key support and resistance levels and areas of ranging.
Fibonacci Fan is a charting technique that consists of 3 diagonal lines that use Fibonacci ratios to
help identify key levels of support and resistance.
Fibonacci Retracement is a charting technique that refers to the likelihood that a financial asset's
price will retrace a large portion of an original move and find support or resistance at the key Fibonacci
levels before it continues in the original direction.
Fibonacci Time Zone is an indicator used by technical traders to identify periods in which the price
of an asset will experience a significant amount of movement.

trend to an upward trend.


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37.

Money management is the process of budgeting, saving, investing, spending or otherwise in


overseeing the cash usage of an individual or group.

38.

Stop-loss is an order that is placed by an investor/ trader with a broker to buy or sell a security (or
a part thereof) once the stock reaches a certain price in order to limit his loss on a security position.

39.

The 2% Rule is a belief that the traders/ investors follow in order to safeguard their losses. The
maximum amount that a trader may lose on a single trade without damaging his long-term prospects
is said to be 2% of his equity / account, including both slippage and commissions.

40.

Re-investing Profits refers to using dividends, interest and capital gains earned in an investment or
mutual fund to purchase additional shares or units, rather than receiving the distribution

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