NCFM Technical Analysis Module PDF

Technical Analysis Module NATIONAL STOCK EXCHANGE OF INDIA LIMITED Test Details: Sr. Name of Module Fees Test Duration No. of Maximum Pass Certiﬁcate No....

Technical Analysis Module NATIONAL STOCK EXCHANGE OF INDIA LIMITED Test Details: Sr. Name of Module Fees Test Duration No. of Maximum Pass Certiﬁcate No. (Rs.) (in minutes) Questions Marks Marks (%) Validity 1 Financial Markets: A Beginners’ Module * 1686 120 60 100 50 5 2 Mutual Funds : A Beginners' Module 1686 120 60 100 50 5 3 Currency Derivatives: A Beginner’s Module 1686 120 60 100 50 5 4 Equity Derivatives: A Beginner’s Module 1686 120 60 100 50 5 5 Interest Rate Derivatives: A Beginner’s Module 1686 120 60 100 50 5 6 Commercial Banking in India: A Beginner’s Module 1686 120 60 100 50 5 7 Securities Market (Basic) Module 1686 120 60 100 60 5 8 Capital Market (Dealers) Module * 1686 105 60 100 50 5 9 Derivatives Market (Dealers) Module * [Please refer to footnote no. (i) ] 1686 120 60 100 60 3 10 FIMMDA-NSE Debt Market (Basic) Module 1686 120 60 100 60 5 11 Investment Analysis and Portfolio Management Module 1686 120 60 100 60 5 12 Fundamental Analysis Module 1686 120 60 100 60 5 13 Financial Markets (Advanced) Module 1686 120 60 100 60 5 14 Securities Markets (Advanced) Module 1686 120 60 100 60 5 15 Mutual Funds (Advanced) Module 1686 120 60 100 60 5 16 Banking Sector Module 1686 120 60 100 60 5 17 Insurance Module 1686 120 60 100 60 5 18 Macroeconomics for Financial Markets Module 1686 120 60 100 60 5 19 Mergers and Acquisitions Module 1686 120 60 100 60 5 20 Back Ofﬁce Operations Module 1686 120 60 100 60 5 21 Wealth Management Module 1686 120 60 100 60 5 22 NISM-Series-I: Currency Derivatives Certiﬁcation Examination 1000 120 100 100 60 3 23 NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents – 1000 120 100 100 50 3 Corporate Certiﬁcation Examination 24 NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents – 1000 120 100 100 50 3 Mutual Fund Certiﬁcation Examination 25 NISM-Series-IV: Interest Rate Derivatives Certiﬁcation Examination 1000 120 100 100 60 3 26 NISM-Series-V-A: Mutual Fund Distributors Certiﬁcation Examination * 1000 120 100 100 50 3 27 NISM-Series-VI: Depository Operations Certiﬁcation Examination 1000 120 100 100 60 3 28 NISM Series VII: Securities Operations and Risk Management 1000 120 100 100 50 3 Certiﬁcation Examination 29 NISM-Series-VIII: Equity Derivatives Certiﬁcation Examination 1000 120 100 100 60 3 30 Certiﬁed Personal Financial Advisor (CPFA) Examination 4495 120 80 100 60 3 31 NSDL–Depository Operations Module 1686 75 60 100 60 # 5 32 Commodities Market Module 2022 120 60 100 50 3 33 Surveillance in Stock Exchanges Module 1686 120 50 100 60 5 34 Corporate Governance Module 1686 90 100 100 60 5 35 Compliance Ofﬁcers (Brokers) Module 1686 120 60 100 60 5 36 Compliance Ofﬁcers (Corporates) Module 1686 120 60 100 60 5 37 Information Security Auditors Module (Part-1) 2528 120 90 100 60 2 Information Security Auditors Module (Part-2) 2528 120 90 100 60 38 Options Trading Strategies Module 1686 120 60 100 60 5 39 Options Trading (Advanced) Module 1686 120 35 100 60 5 2247 per 40 FPSB India Exam 1 to 4** 120 75 140 60 NA exam 41 Examination 5/Advanced Financial Planning ** 5618 240 30 100 50 NA 42 Equity Research Module ## 1686 120 65 100 55 2 43 Issue Management Module ## 1686 120 80 100 55 2 44 Market Risk Module ## 1686 120 50 100 55 2 45 Financial Modeling Module ### 1123 120 30 100 50 NA 46 Financial Services Foundation Module ### 1123 120 45 100 50 NA * Candidates have the option to take the tests in English, Gujarati or Hindi languages. # Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certiﬁed as ‘Trainers’. ** Following are the modules of Financial Planning Standards Board India (Certiﬁed Financial Planner Certiﬁcation) - FPSB India Exam 1 to 4 i.e. (i) Risk Analysis & Insurance Planning (ii) Retirement Planning & Employee Beneﬁts (iii) Investment Planning and (iv) Tax Planning & Estate Planning - Examination 5/Advanced Financial Planning ## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP) ### Module of IMS Proschool The curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives Learning India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com > Education > Certiﬁcations. Note: (i) NISM has speciﬁed the NISM-Series-VIII-Equity Derivatives Certiﬁcation Examination as the requisite standard for associated persons functioning as approved users and sales personnel of the trading member of an equity derivatives exchange or equity derivative segment of a recognized stock exchange. Contents CHAPTER 1............................................................................................................ 9 INTRODUCTION TO TECHNICAL ANALYSIS............................................................ 9 1.1 What is technical analysis?...............................................................................9 1.1.1 Price discounts everything....................................................................9 1.1.2 Price movements are not totally random.............................................. 10 1.1.3 Technical Analysis: the basic assumption.............................................. 11 1.1.4 Strengths and weakness of technical analysis....................................... 12 1.1.4.1 Importance of technical analysis............................................ 12 1.1.4.2 Weaknesses of technical analysis........................................... 13 CHAPTER 2.......................................................................................................... 16 CANDLE CHARTS.................................................................................................. 16 2.1 The charts................................................................................................... 16 2.2 Candlestick analysis...................................................................................... 20 2.2.1 One candle pattern............................................................................ 21 2.2.1.1 Hammer............................................................................ 21 2.2.1.2 Hanging man...................................................................... 22 2.2.1.3 Shooting star and inverted hammer....................................... 23 2.2.2 Two candle pattern............................................................................ 26 2.2.2.1 Bullish engulﬁng.................................................................. 26 2.2.2.2 Bearish engulﬁng................................................................ 28 2.2.2.3 Piercing............................................................................. 29 2.2.2.4 Bearish harami.................................................................... 31 2.2.2.5 Bullish harami..................................................................... 33 2.2.3 Three candle pattern......................................................................... 35 2.2.3.1 Evening star....................................................................... 35 2.2.3.2 Morning star....................................................................... 38 2.2.3.3 Doji................................................................................... 40 CHAPTER 3.......................................................................................................... 46 PATTERN STUDY.................................................................................................. 46 3.1 What are support and resistance lines?............................................................ 46 3.1.1 Support........................................................................................ 46 3.1.2 Resistance....................................................................................... 48 3.1.3 Why do support and resistance lines occurs?......................................... 49 3.1.4 Support and resistance zone............................................................... 49 3.1.5 Change of support to resistance and vice versa..................................... 51 3 3.1.6 Why are support and resistance lines important?................................... 52 3.2 Head and shoulders...................................................................................... 52 3.2.1 Head and shoulders top reversal......................................................... 53 3.2.2 Inverted head and shoulders.............................................................. 57 3.2.3 Head and shoulders bottom................................................................ 58 3.3 Double top and double bottom....................................................................... 62 3.3.1 Double top....................................................................................... 63 3.3.2 Double bottom.................................................................................. 66 3.3.3 Rounded top and bottom.................................................................... 69 3.4 Gap theory.................................................................................................. 70 3.4.1 Common gaps.................................................................................. 71 3.4.2 Breakaway gaps................................................................................ 71 3.4.3 Runaway/continuation gap................................................................. 72 3.4.4 Exhaustion gap................................................................................. 73 3.4.5 Island cluster................................................................................... 74 CHAPTER 4........................................................................................................ 79 MAJOR INDICATORS & OSCILLATORS................................................................. 79 4.1 What does a technical indicator offer?............................................................. 79 4.1.1 Why use indicator?............................................................................ 79 4.1.2 Tips for using indicators..................................................................... 79 4.1.3 Types of indicators............................................................................ 80 4.1.4 Simple moving average...................................................................... 81 4.1.5 Exponential moving average............................................................... 81 4.1.6 Which is better?................................................................................ 83 4.2 Trend following indicator................................................................................ 84 4.2.1 When to use?................................................................................... 84 4.2.2 Moving average settings.................................................................... 84 4.2.3 Uses of moving average..................................................................... 85 4.2.4 Signals - moving average price crossover............................................. 87 4.2.5 Signals - multiple moving averages..................................................... 88 4.3 Oscillators................................................................................................... 89 4.3.1 Relative strength index...................................................................... 89 4.3.1.1 What is momentum?............................................................ 89 4.3.1.2 Applications of RSI.............................................................. 90 4.3.1.3 Overbought and oversold..................................................... 90 4.3.1.4 Divergence......................................................................... 91 4.3.1.5 Stochastic.......................................................................... 93 4 4.3.1.6 William %R....................................................................... 97 4.3.1.7 Real life problems in use of RSI............................................. 99 4.3.1.8 Advanced concepts.............................................................. 99 4.3.2 Moving average convergence/divergence(MACD)................................. 102 4.3.2.1 What is the macd and how is it calculated............................. 102 4.3.2.2 MACD beneﬁts.................................................................. 103 4.3.2.3 uses of MACD................................................................... 104 4.3.2.4 Money Flow Index............................................................. 107 4.3.2.5 Bollinger Bands................................................................. 109 4.4 Using multiple indicators for trading signals.................................................... 110 4.4.1 Price sensitive techniques................................................................. 110 4.4.2 Volume sensitive techniques............................................................. 111 4.4.3 Composite methods......................................................................... 111 4.4.4 How to use tool kit of trading techniques............................................ 111 4.4.5 Trading market tool kit applications................................................... 112 4.4.6 Bull market tool kit application.......................................................... 112 4.4.7 Bear market tool kit application......................................................... 112 4.4.8 Trading market changing to bull market tool kit application................... 113 4.4.9 Trading market changing to bear market tool kit application.................. 113 4.4.10 Bull market changing to trading market tool kit application................... 114 4.4.11 Bear market changing to trading market tool kit application.................. 114 Chapter 5.......................................................................................................... 120 Trading Strategies............................................................................................. 120 5.1 day trading................................................................................................ 120 5.1.1 advantages of day trading................................................................ 120 5.1.2 risks associated with risk trading....................................................... 121 5.2 strategies.................................................................................................. 123 5.2.1 strategies for day trading................................................................. 123 5.2.2 momentum trading strategies........................................................... 123 Chapter 6.......................................................................................................... 127 Dow Theory and Elliott Wave Theory................................................................. 127 6.1 Introduction............................................................................................... 127 6.2 Principles of Dow Theory............................................................................. 127 6.3 Signiﬁcance of Dow Theory.......................................................................... 133 6.4 Problems with Dow Theory........................................................................... 133 6.5 Elliot Wave................................................................................................ 133 6.5.1 Introduction................................................................................... 133 6.5.2 Fundamental Concept...................................................................... 133 5 6.5.3 After Elliott..................................................................................... 149 Chapter 7......................................................................................................... 159 Trading psychology and risk management........................................................ 159 7.1 Introduction............................................................................................... 159 7.2 Risk Management....................................................................................... 160 7.2.1 Components of risk management...................................................... 161 7.2.1.1 Stop loss.......................................................................... 161 7.2.1.2 Analyze reward risk ratio.................................................... 161 7.2.1.3 Trail stop loss.................................................................... 161 7.2.1.4 Booking Proﬁt................................................................... 161 7.2.1.5 uses of stop loss............................................................... 161 7.2.1.6 qualities of successful traders............................................. 161 7.2.1.7 golden rules of traders....................................................... 162 7.2.1.8 do’s and don’ts in trading................................................... 162 7.3 rules to stop losing money........................................................................... 163 7.4 choosing the right market to trade................................................................ 167 7.4.1 importance of discipline in trading..................................................... 167 6 Distribution of weights in the Technical Analysis Module Curriculum Chapter Title Weightages No. 1 INTRODUCTION TO TECHNICAL ANALYSIS 12 2 CANDLE CHARTS 13 3 PATTERN STUDY 20 4 MAJOR INDICATORS & OSCILLATORS 20 5 TRADING STRATEGIES 12 6 DOW THEORY AND ELLIOT WAVE THEORY 12 7 TRADING PSYCHOLOGY AND RISK MANAGEMENT 11 Total 100 Note: Candidates are advised to refer to NSE’s website: www.nseindia.com, click on ‘Education’ link and then go to ‘Updates & Announcements’ link, regarding revisions/updations in NCFM modules or launch of new modules, if any. Copyright © 2013 by National Stock Exchange of India Ltd. (NSE) Exchange Plaza, BandraKurla Complex, Bandra (East), Mumbai 400 051 INDIA All content included in this book, such as text, graphics, logos, images, data compilation etc. are the property of NSE. This book or any part thereof should not be copied, reproduced, duplicated, sold, resold or exploited for any commercial purposes. Furthermore, the book in its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise. 7 8 CHAPTER 1 INTRODUCTION TO TECHNICAL ANALYSIS Learning objectives After studying this chapter the student should be able to understand: The basis of technical analysis The strengths and weaknesses of technical analysis 1.1 What is Technical Analysis? Technical Analysis can be deﬁned as an art and science of forecasting future prices based on an examination of the past price movements. Technical analysis is not astrology for predicting prices. Technical analysis is based on analyzing current demand-supply of commodities, stocks, indices, futures or any tradable instrument. Technical analysis involve putting stock information like prices, volumes and open interest on a chart and applying various patterns and indicators to it in order to assess the future price movements. The time frame in which technical analysis is applied may range from intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data to many years. There are essentially two methods of analyzing investment opportunities in the security market viz fundamental analysis and technical analysis. You can use fundamental information like ﬁnancial and non-ﬁnancial aspects of the company or technical information which ignores fundamentals and focuses on actual price movements. The basis of Technical Analysis What makes Technical Analysis an effective tool to analyze price behavior is explained by following theories given by Charles Dow: Price discounts everything Price movements are not totally random What is more important than why 1.1.1 Price discounts everything “Each price represents a momentary consensus of value of all market participants – large commercial interests and small speculators, fundamental researchers, technicians and gamblers- at the moment of transaction” – Dr Alexander Elder 9 Technical analysts believe that the current price fully reﬂects all the possible material information which could affect the price. The market price reﬂects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis looks at the price and what it has done in the past and assumes it will perform similarly in future under similar circumstances. Technical analysis looks at the price and assumes that it will perform in the same way as done in the past under similar circumstances in future. 1.1.2 Price movements are not totally random Technical analysis is a trend following system. Most technicians acknowledge that hundreds of years of price charts have shown us one basic truth – prices move in trends. If prices were always random, it would be extremely difﬁcult to make money using technical analysis. A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. “What” is more important than “Why” It is said that “A technical analyst knows the price of everything, but the value of nothing”. Technical analysts are mainly concerned with two things: 1. The current price 2. The history of the price movement All of you will agree that the value of any asset is only what someone is willing to pay for it. Who needs to know why? By focusing just on price and nothing else, technical analysis represents a direct approach. The price is the ﬁnal result of the ﬁght between the forces of supply and demand for any tradable instrument. The objective of analysis is to forecast the direction of the future price. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). The principles of technical analysis are universally applicable. The principles of support, resistance, trend, trading range and other aspects can be applied to any chart. Technical analysis can be used for any time horizon; for any marketable instrument like stocks, futures and commodities, ﬁxed-income securities, forex, etc 10 Top-down Technical Analysis Technical analysis uses top-down approach for investing. For each stock, an investor would analyze long-term and short-term charts. First of all you will consider the overall market, most probably the index. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-5 most promising stocks in each group can be made. How many stocks or industry groups make the ﬁnal cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to ﬁnd 3-4 best amongst the rest in the lot. 1.1.3 Technical Analysis: The basic assumptions The ﬁeld of technical analysis is based on three assumptions: 1. The market discounts everything. 2. Price moves in trends. 3. History tends to repeat itself. 1. The market discounts everything Technical analysis is criticized for considering only prices and ignoring the fundamental analysis of the company, economy etc. Technical analysis assumes that, at any given time, a stock’s price reﬂects everything that has or could affect the company - including fundamental factors. The market is driven by mass psychology and pulses with the ﬂow of human emotions. Emotions may respond rapidly to extreme events, but normally change gradually over time. It is believed that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market. 2. Price moves in trends “Trade with the trend” is the basic logic behind technical analysis. Once a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Technical analysts frame strategies based on this assumption only. 3. History tends to repeat itself People have been using charts and patterns for several decades to demonstrate patterns in price movements that often repeat themselves. The repetitive nature of price movements 11 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. 1.1.4 Strengths and weakness of Technical Analysis 1.1.4.1 Importance of Technical Analysis Not Just for stocks Technical analysis has universal applicability. It can be applied to any ﬁnancial instrument - stocks, futures and commodities, ﬁxed-income securities, forex, etc Focus on price Fundamental developments are followed by price movements. By focusing only on price action, technicians focus on the future. The price pattern is considered as a leading indicator and generally leads the economy by 6 to 9 months. To track the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden unexpected reactions, hints usually develop before signiﬁcant movements. You should refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline. Supply, demand, and price action Technicians make use of high, low and closing prices to analyze the price action of a stock. A good analysis can be made only when all the above information is present Separately, these will not be able to tell much. However, taken together, the open, high, low and close reﬂect forces of supply and demand. Support and resistance Charting is a technique used in analysis of support and resistance level. These are trading range in which the prices move for an extended period of time, saying that forces of demand and supply are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning. Pictorial price history A price chart offers most valuable information that facilitates reading historical account of a security’s price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following: 12 Market reactions before and after important events Past and present volatility Historical volume or trading levels Relative strength of the stock versus the index. Assist with entry point Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to decide what to buy and technical analysis is used to decide when to buy. Timings in this context play a very important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Checking out for a breakout above resistance or buying near support levels can improve returns. First of all you should analyze stock’s price history. If a stock selected by you was great for the last three years has traded ﬂat for those three years, it would appear that market has a different opinion. If a stock has already advanced signiﬁcantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal. 1.1.4.2 Weaknesses of Technical Analysis Analyst bias Technical analysis is not hard core science. It is subjective in nature and your personal biases can be reﬂected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt. Open to interpretation Technical analysis is a combination of science and art and is always open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. Is the cup half-empty or half-full? It is in the eye of the beholder. Too late You can criticize the technical analysis for being too late. By the time the trend is identiﬁed, a substantial move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory. 13 Always another level Technical analysts always wait for another new level. Even after a new trend has been identiﬁed, there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualiﬁed stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion. Trader’s remorse An array of pattern and indicators arises while studying technical analysis. Not all the signals work. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for Infosys, but a 70-day moving average may work better for Reliance. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies. TA is also useful in controlling risk It is Technical Analysis only that can provide you the discipline to get out when you’re on the wrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a trade and to get stubborn. That is also potentially the worst thing you can do. You think that if you ride it out you’ll be okay. However, there will also be occasions when you won’t be okay. The stock will move against you in ways and to an extent that you previously found virtually unimaginable. It is more important to control risk than to maximize proﬁts! There is asymmetry between zero and inﬁnity. What does that mean? Most of us have very ﬁnite capital but inﬁnite opportunities because of thousands of stocks. If we lose an opportunity, we will have thousands more tomorrow. If we lose our capital, will we get thousands more tomorrow? It is likely that we will not. We will also lose our opportunities. Our capital holds more worth to us than our opportunities because we must have capital in order to take advantage of tomorrow’s opportunities. It is more important to control risk than to maximize proﬁts! Technical Analysis, if practiced with discipline, gives you speciﬁc parameters for managing risk. It’s simply supply and demand. Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your capital is your opportunity. You can be right a thousand times, become very wealthy and then get wiped out completely if you manage your risk poorly just once. One last time: That is why it is more important to control risk than to maximize proﬁts! 14 How to know what to look for? How to organize your thinking in a market of thousands of stock trading millions of shares per day? How to learn your way around? Technical Analysis answers all these questions. Conclusions Technical analysis works on Pareto principle. It considers the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reﬂects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going? Even though some principles and rules of technical analysis are universally applicable, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also ﬂexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be signiﬁcant. ***** 15 CHAPTER 2 CANDLE CHARTS Learning objectives After studying this chapter the student should be able to understand: Types of charts The candlestick analysis Pattern Psychology – investors’ psychology behind formation of candlestick pattern 2.1 The charts What is a chart? Charts are the working tools of technical analysts. They use charts to plot the price movements of a stock over speciﬁc time frames. It’s a graphical method of showing where stock prices have been in the past. A chart gives us a complete picture of a stock’s price history over a period of an hour, day, week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical). Typically, the x-axis represents time; the y-axis represents price. By plotting a stock’s price over a period of time, we end up with a pictorial representation of any stock’s trading history. A chart can also depict the history of the volume of trading in a stock. That is, a chart can illustrate the number of shares that change hands over a certain time period. Types of price charts: 1. Line charts “Line charts” are formed by connecting the closing prices of a speciﬁc stock or market over a given period of time. Line chart is particularly useful for providing a clear visual illustration of the trend of a stock’s price or a market’s movement. It is an extremely valuable analytical tool which has been used by traders for past many years. 16 NIFTY (Daily) Line Chart 2. Bar chart Bar chart is the most popular method traders use to see price action in a stock over a given period of time. Such visual representation of price activity helps in spotting trends and patterns. Although daily bar charts are best known, bar charts can be created for any time period - weekly and monthly, for example. A bar shows the high price for the period at the top and the lowest price at the bottom of the bar. Small lines on either side of the vertical bar serve to mark the opening and closing prices. The opening price is marked by a small tick to the left of the bar; the closing price is shown by a similar tick to the right of the bar. Many investors work with bar charts created over a matter of minutes during a day’s trading. 17 NIFTY (Daily) Bar Chart 3. Candlesticks Formation Candlestick charts provide visual insight to current market psychology. A candlestick displays the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that extenuates the relationship between the opening and closing prices. Candlesticks don’t involve any calculations. Each candlestick represents one period (e.g., day) of data. The ﬁgure given below displays the elements of a candle. 18 A candlestick chart can be created using the data of high, low, open and closing prices for each time period that you want to display. The hollow or ﬁlled portion of the candlestick is called “the body” (also referred to as “the real body”). The long thin lines above and below the body represent the high/low range and are called “shadows” (also referred to as “wicks” and “tails”). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a ﬁlled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price. Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader can see and compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks. Hollow candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure. Thus, compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to interpret. 19 NIFTY (Daily) Candlestick Chart Why candlestick charts? What does candlestick charting offer that typical Western high-low bar charts do not? Instead of vertical line having horizontal ticks to identify open and close, candlesticks represent two dimensional bodies to depict open to close range and shadows to mark day’s high and low. For several years, the Japanese traders have been using candlestick charts to track market activity. Eastern analysts have identiﬁed a number of patterns to determine the continuation and reversal of trend. These patterns are the basis for Japanese candlestick chart analysis. This places candlesticks rightly as a part of technical analysis. Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Applying candlesticks means that for short-term, an investor can make conﬁdent decisions about buying, selling, or holding an investment. 2.2 Candlestick analysis One cannot ignore that investor’s psychologically driven forces of fear; greed and hope greatly inﬂuence the stock prices. The overall market psychology can be tracked through candlestick analysis. More than just a method of pattern recognition, candlestick analysis shows the interaction between buyers and sellers. A white candlestick indicates opening price of the 20 session being below the closing price; and a black candlestick shows opening price of the session being above the closing price. The shadow at top and bottom indicates the high and low for the session. Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Therefore if you combine candlestick analysis with other technical analysis tools, candlestick pattern analysis can be a very useful way to select entry and exit points. 2.2.1 One candle patterns In the terminology of Japanese candlesticks, one candle patterns are known as “Umbrella lines”. There are two types of umbrella lines - the hanging man and the hammer. They have long lower shadows and small real bodies that are at top of the trading range for the session. They are the simplest lines because they do not necessarily have to be spotted in combination with other candles to have some validity. Hammer and Hanging Man Hammer Hanging Man Candlesticks 2.2.1.1 Hammer Hammer is a one candle pattern that occurs in a downtrend when bulls make a start to step into the rally. It is so named because it hammers out the bottom. The lower shadow of hammer is minimum of twice the length of body. Although, the color of the body is not of much signiﬁcance but a white candle shows slightly more bullish implications than the black body. A positive day i.e. a white candle is required the next day to conﬁrm this signal. Criteria 1. The lower shadow should be at least two times the length of the body. 2. There should be no upper shadow or a very small upper shadow. 3. The real body is at the upper end of the trading range. The color of the body is not important although a white body should have slightly more bullish implications. 4. The following day needs to conﬁrm the Hammer signal with a strong bullish day. 21 Signal enhancements 1. The longer the lower shadow, the higher the potential of a reversal occurring. 2. Large volume on the Hammer day increases the chances that a blow off day has occurred. 3. A gap down from the previous day’s close sets up for a stronger reversal move provided the day after the Hammer signal opens higher. Pattern psychology The market has been in a downtrend, so there is an air of bearishness. The price opens and starts to trade lower. However the sell-off is abated and market returns to high for the day as the bulls have stepped in. They start bringing the price back up towards the top of the trading range. This creates a small body with a large lower shadow. This represents that the bears could not maintain control. The long lower shadow now has the bears questioning whether the decline is still intact. Conﬁrmation would be a higher open with yet a still higher close on the next trading day. 2.2.1.2 Hanging man The hanging man appears during an uptrend, and its real body can be either black or white. While it signiﬁes a potential top reversal, it requires conﬁrmation during the next trading session. The hanging man usually has little or no upper shadow. Soybean Oil-December, 1990, Daily (Hanging Man and Hammer) 22 Dow Jones Industrials-1990, Daily (Hanging Man and Hammer) 2.2.1.3 Shooting star and inverted hammer Other candles similar to the hanging man and hammer are the “shooting star,” and the “inverted hammer.” Both have small real bodies and can be either black or white but they both have long upper shadows, and have very little or no lower shadows. Inverted Hammer Description Inverted hammer is one candle pattern with a shadow at least two times greater than the body. This pattern is identiﬁed by the small body. They are found at the bottom of the decline 23 which is evidence that bulls are stepping in but still selling is going on. The color of the small body is not important but the white body has more bullish indications than a black body. A positive day is required the following day to conﬁrm this signal. Signal enhancements 1. The longer the upper shadow, the higher the potential of a reversal occurring. 2. A gap down from the previous day’s close sets up for a stronger reversal move. 3. Large volume on the day of the inverted hammer signal increases the chances that a blow off day has occurred 4. The day after the inverted hammer signal opens higher. Pattern psychology After a downtrend has been in effect, the atmosphere is bearish. The price opens and starts to trade higher. The Bulls have stepped in, but they cannot maintain the strength. The existing sellers knock the price back down to the lower end of the trading range. The Bears are still in control. But the next day, the Bulls step in and take the price back up without major resistance from the Bears. If the price maintains strong after the Inverted Hammer day, the signal is conﬁrmed. Stars A small real body that gaps away from the large real body preceding it is known as star. It’s still a star as long as the small real body does not overlap the preceding real body. The color of the star is not important. Stars can occur at tops or bottoms. Shooting star Description The Shooting Star is a single line pattern that indicates an end to the uptrend. It is easily identiﬁed by the presence of a small body with a shadow at least two times greater than the body. It is found at the top of an uptrend. The Japanese named this pattern because it looks like a shooting star falling from the sky with the tail trailing it. 24 Criteria 1. The upper shadow should be at least two times the length of the body. 2. Prices gap open after an uptrend. 3. A small real body is formed near the lower part of the price range. The color of the body is not important although a black body should have slightly more bearish implications. 4. The lower shadow is virtually non-existent. 5. The following day needs to conﬁrm the Shooting Star signal with a black candle or better yet, a gap down with a lower close. Signal enhancements 1. The longer the upper shadow, the higher the potential of a reversal occurring. 2. A gap up from the previous day’s close sets up for a stronger reversal move provided. 3. The day after the Shooting Star signal opens lower. 4. Large volume on the Shooting Star day increases the chances that a blow-off day has occurred although it is not a necessity. Pattern psychology During an uptrend, the market gaps open and rallies to a new high. The price opens and trades higher. The bulls are in control. But before the close of the day, the bears step in and take the price back down to the lower end of the trading range, creating a small body for the day. 25 This could indicate that the bulls still have control if analyzing a Western bar chart. However, the long upper shadow represents that sellers had started stepping in at these levels. Even though the bulls may have been able to keep the price positive by the end of the day, the evidence of the selling was apparent. A lower open or a black candle the next day reinforces the fact that selling is going on. 2.2.2 Two candles pattern 2.2.2.1 Bullish engulfing A “bullish engulﬁng pattern” consists of a large white real body that engulfs a small black real body during a downtrend. It signiﬁes that the buyers are overwhelming the sellers Engulﬁng Bullish engulﬁng 26 Description The Engulﬁng pattern is a major reversal pattern comprised of two opposite colored bodies. This Bullish Pattern is formed after a downtrend. It is formed when a small black candlestick is followed by a large white candlestick that completely eclipses the previous day candlestick. It opens lower that the previous day’s close and closes higher than the previous day’s open. Criteria 1. The candlestick body of the previous day is completely overshadowed by the next day’s candlestick. 2. Prices have been declining deﬁnitely, even if it has been in short term. 3. The color of the ﬁrst candle is similar to that of the previous one and the body of the second candle is opposite in color to that ﬁrst candle. The only exception being an engulfed body which is a doji. Signal enhancements 1. A small body being covered by the larger one. The previous day shows the trend was running out of steam. The large body shows that the new direction has started with good force. 2. Large volume on the engulﬁng day increases the chances that a blow off day has occurred. 3. The engulﬁng body engulfs absorbs the body and the shadows of the previous day; the reversal has a greater probability of working. 4. The probability of a strong reversal increases as the open gaps between the previous and the current day increases. Pattern psychology After a decline has taken place, the price opens at a lower level than its previous day closing price. Before the close of the day, the buyers have taken over and have led to an increase in the price above the opening price of the previous day. The emotional psychology of the trend has now been altered. When investors are learning the stock market they should utilize information that has worked with high probability in the past. Bullish Engulﬁng signal if used after proper training and at proper locations, can lead to highly proﬁtable trades and consistent results. This pattern allows an investor to improve their probabilities of been in a correct trade. The common sense elements conveyed in candlestick signals makes for a clear and concise trading technique for beginning investors as well as experienced traders. 27 2.2.2.2 Bearish engulfing A “bearish engulﬁng pattern,” on the other hand, occurs when the sellers are overwhelming the buyers. This pattern consists of a small white candlestick with short shadows or tails followed by a large black candlestick that eclipses or “engulfs” the small white one. Bearish Engulﬁng 28 2.2.2.3 Piercing The bullish counterpart to the dark cloud cover is the “piercing pattern.” The ﬁrst thing to look for is to spot the piercing pattern in an existing downtrend, which consists of a long black candlestick followed by a gap lower open during the next session, but which closes at least halfway into the prior black candlestick’s real body. Description The Piercing Pattern is composed of a two-candle formation in a down trending market. With daily candles, the piercing pattern will often end a minor downtrend (a downtrend that lasts between six and ﬁfteen trading days). The day before the piercing candle appears, the daily candle should have a fairly large dark real body, signifying a strong down day. 29 Criteria 1. The downtrend has been evident for a good period. 2. The body of the ﬁrst candle is black; the body of the second candle is white. 3. A long black candle occurs at the end of the trend. 4. The white candle closes more than halfway up the black candle. 5. The second day opens lower than the trading of the prior day. Signal enhancements 1. The reversal will be more pronounced, if the gap down the previous day close is more. 2. The longer the black candle and the white candle, the more forceful the reversal. 3. The higher the white candle closes into the black candle, the stronger the reversal. 4. Large volume during these two trading days is a signiﬁcant conﬁrmation. Pattern psychology The atmosphere becomes bearish once a strong downtrend has been in effect. The price goes down. Bears may move the price even further but before the day ends the bulls enters and bring a dramatic change in price in the opposite direction. They ﬁnish near the high of the day. The move has almost negated the price decline of the previous day. This now has the bears concerned. More buying the next day will conﬁrm the move. Being able to utilize information that has been used successfully in the past is a much more viable investment strategy than taking shots in the dark. Keep in mind, when you are given privileged information about stock market tips, where you are in the food chain. Are you one of those privileged few that get top-notch pertinent information on a timely manner, or are you one of the masses that feed into a frenzy and allow the smart money to make the proﬁts? 30 Harami 2.2.2.4 Bearish Harami In up trends, the harami consists of a large white candle followed by a small white or black candle (usually black) that is within the previous session’s large real body. 31 Bearish Harami Description Bearish Harami is a two candlestick pattern composed of small black real body contained within a prior relatively long white real body. The body of the ﬁrst candle is the same color as that of the current trend. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over. Criteria 1. The ﬁrst candle is white in color; the body of the second candle is black. 2. The second day opens lower than the close of the previous day and closes higher than the open of the prior day. 3. For a reversal signal, conﬁrmation is needed. The next day should show weakness. 4. The uptrend has been apparent. A long white candle occurs at the end of the trend. Signal enhancements 1. The reversal will be more forceful, if the white and the black candle are longer. 2. The lower the black candle closes down on the white candle, the more convincing that a reversal has occurred, despite the size of the black candle. Pattern psychology The bears open the price lower than the previous close, after a strong uptrend has been in effect and after a long white candle day. The longs get concerned and start proﬁt taking. The price for the day ends at a lower level. The bulls are now concerned as the price closes lower. It is becoming evident that the trend has been violated. A weak day after that would convince everybody that the trend was reversing. Volume increases due to the proﬁt taking and the addition of short sales. 32 2.2.2.5 Bullish Harami A candlestick chart pattern in which a large candlestick is followed by a smaller candlestick whose body is located within the vertical range of the larger body. In downtrends, the harami consists of a large black candle followed by a small white or black candle (usually white) that is within the previous session’s large real body. This pattern signiﬁes that the immediately preceding trend may be concluding, and that the bulls and bears have called a truce. Bullish Harami Description The Harami is a commonly observed phenomenon. The pattern is composed of a two candle formation in a down-trending market. The color ﬁrst candle is the same as that of current trend. The ﬁrst body in the pattern is longer than the second one. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over. The Harami (meaning “pregnant” in Japanese) Candlestick Pattern is a reversal pattern. The pattern consists of two Candlesticks. The ﬁrst candle is black in color and a continuation of 33 the existing trend. The second candle, the little belly sticking out, is usually white in color but that is not always the case. Magnitude of the reversal is affected by the location and size of the candles. Criteria 1. The ﬁrst candle is black in body; the body of the second candle is white. 2. The downtrend has been evident for a good period. A long black candle occurs at the end of the trend. 3. The second day opens higher than the close of the previous day and closes lower than the open of the prior day. 4. Unlike the Western “Inside Day”, just the body needs to remain in the previous day’s body, where as the “Inside Day” requires both the body and the shadows to remain inside the previous day’s body. 5. For a reversal signal, further conﬁrmation is required to indicate that the trend is now moving up. Signal enhancements 1. The reversal will be more forceful if the black candle and the white candle are longer. 2. If the white candle closes up on the black candle then the reversal has occurred in a convincing manner despite the size of the white candle. Pattern psychology After a strong down-trend has been in effect and after a selling day, the bulls open at a price higher than the previous close. The short’s get concerned and start covering. The price for the day ﬁnishes at a higher level. This gives enough notice to the short sellers that trend has been violated. A strong day i.e. the next day would convince everybody that the trend was reversing. Usually the volume is above the recent norm due to the unwinding of short positions. When the second candle is a doji, which is a candle with an almost non-existent real body, these patterns are called “harami crosses.” They are however less reliable as reversal patterns as more indecision is indicated. 34 2.2.3 Three candle pattern 2.2.3.1 Evening star The Evening Star is a top reversal pattern that occurs at the top of an uptrend. It is formed by a tall white body candle, a second candle with a small real body that gaps above the ﬁrst real body to form a “star” and a third black candle that closes well into the ﬁrst session’s white real body. Description The Evening Star pattern is a bearish reversal signal. Like the planet Venus, the evening star represents that darkness is about to set or prices are going to decline. An uptrend has been in place which is assisted by a long white candlestick. The following day gaps up, yet the trading 35 range remain small for the day. Again, this is the star of the formation. The third day is a black candle day and represents the fact that the bears have now seized control. That candle should consist of a closing that is at least halfway down the white candle of two days prior. The optimal Evening Star signal would have a gap before and after the star day. Criteria 1. The uptrend should be apparent. 2. The body of the ﬁrst candle is white, continuing the current trend. The second candle has small trading range showing indecision formation. 3. The third day shows evidence that the bears have stepped in. That candle should close at least halfway down the white candle. Signal enhancements 1. Long length of the white candle and the black candle indicates more forceful reversal. 2. The more indecision the middle day portrays, the better probabilities that a reversal will occur. 3. A gap between the ﬁrst day and the second day adds to the probability of occurrence of reversal. 4. A gap before and after the star day is even more desirable. The magnitude, that the third day comes down into the white candle of the ﬁrst day, indicates the strength of the reversal. Pattern psychology The psychology behind this pattern is that a strong uptrend has been in effect. Buyers have been piling up the stock. However, it is the level where sellers start taking proﬁts or think the price is fairly valued. The next day all the buying is being met with the selling, causing for a small trading range. The bulls get concerned and the bears start taking over. The third day is a large sell off day. If there is big volume during these days, it shows that the ownership has dramatically changed hands. The change of direction is immediately seen in the color of the bodies. 36 37 2.2.3.2 Morning star Morning star is the reverse of evening star. It is a bullish reversal pattern formed by a tall black body candle, a second candle with a small real body that gaps below the ﬁrst real body to form a star, and a third white candle that closes well into the ﬁrst session’s black real body. Its name indicates that it foresees higher prices. Description The Morning Star is a bottom reversal signal. Like the planet Mercury, the morning star, signiﬁes brighter things – that is sunrise is about to occur, or the prices are going to go higher. A downtrend has been in place which is assisted by a long black candlestick. There is little about the downtrend continuing with this type of action. The next day prices gap lower on the open, trade within a small range and close near their open. This small body shows the beginning of indecision. The next day prices gap higher on the open and then close much higher. A signiﬁcant reversal of trend has occurred. The make up of the star, an indecision formation, can consist of a number of candle formations. The important factor is to witness the conﬁrmation of the bulls taking over the next day. That 38 candle should consist of a closing that is at least halfway up the black candle of two days prior. Criteria 1. Downtrend should be there. 2. The body of the ﬁrst candle is black, continuing the current trend. The second candle is an indecision formation. 3. The third day is the opposite color of the ﬁrst day. It shows evidence that the bulls have stepped in. That candle should close at least halfway up the black candle. Signal enhancements 1. Long length of the black candle and the white candle indicates more forceful reversal. 2. The more indecision that the star day illustrates, the better probabilities that a reversal will occur. 3. A Gap between the ﬁrst day and the second day adds to the probability of occurrence of reversal. 4. A gap before and after the star day is even more desirable. 5. The magnitude, that the third day comes up into the black candle of the ﬁrst day, indicates the strength of the reversal. Pattern psychology While a strong downtrend has been in effect, there is a large sell-off day. The selling continues and bulls continue to step in at low prices. Big volume on this day shows that the ownership has dramatically changed. The second day does not have a large trading range. The third day, the bears start to lose conviction as the bull increase their buying. When the price starts moving back into the trading range of the ﬁrst day, the sellers diminish and the buyers seize control. 39 2.2.3.3 Doji Doji lines are patterns with the same open and close price. It’s a signiﬁcant reversal indicator. 40 The Importance of the Doji The perfect doji session has the same opening and closing price, yet there is some ﬂexibility to this rule. If the opening and closing price are within a few ticks of each other, the line could still be viewed as a doji. How do you decide whether a near-doji day (that is, where the open and close are very close, but not exact) should be considered a doji? This is subjective and there are no rigid rules but one way is to look at a near-doji day in relation to recent action. If there are a series of very small real bodies, the near-doji day would not be viewed as signiﬁcant since so many other recent periods had small real bodies. One technique is based on recent market activity. If the market is at an important market junction, or is at the mature part of a bull or bear move, or there are other technical signals sending out an alert, the appearance of a near-doji is treated as a doji. The philosophy is that a doji can be a 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. The doji is a distinct trend change signal. However, the likelihood of a reversal increases if subsequent candlesticks conﬁrm the doji’s reversal potential. Doji sessions are important only in markets where there are not many doji. If there are many doji on a particular chart, one should not view the emergence of a new doji in that particular market as a meaningful development. That is why candlestick analysis usually should not use intra-day charts of less than 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or near doji Doji at tops A Doji star at the top is a warning that the uptrend is about to change. This is especially true after a long white candlestick in an uptrend. The reason for the doji’s negative implications in uptrend is because a doji represents indecision. Indecision among bulls will not maintain the uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an extended rally, or is overbought, then formation of a doji could mean the scaffolding of buyers’ support will give way. Doji are also valued for their ability to show reversal potential in downtrends. The reason may be that a doji reﬂects a balance between buying and selling forces. With ambivalent market 41 participants, the market could fall due to its own weight. Thus, an uptrend should reverse but a falling market may continue its descent. Because of this, doji need more conﬁrmation to signal a bottom than they do a top. ***** New Terms Bull: An investor who thinks the market, a speciﬁc security or an industry will rise. Bear: An investor who believes that a particular security or market is headed downward is indicative of a bearish trend. Bears attempt to proﬁt from a decline in prices. Bears are generally pessimistic about the state of a given market. Bull market: A ﬁnancial market of a group of securities in which prices are rising or are expected to rise. The term “bull market” is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities. Bull markets are characterized by optimism, investor conﬁdence and expectations that strong results will continue. It’s difﬁcult to predict consistently when the trends in the market will change. Part of the difﬁculty is that psychological effects and speculation may sometimes play a large role in the markets The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market. Bear Market A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market, selling continues, which then creates further pessimism. This is not to be confused with a correction which is a short-term trend that has duration shorter than two months. While corrections are often a great place for a value investor to ﬁnd an entry point, bear markets rarely provide great entry points as timing the bottom is very difﬁcult to do. Fighting back can be extremely dangerous because it is quite difﬁcult for an investor to make stellar gains during a bear market unless he or she is a short seller. Fundamental Analysis: A method of evaluating securities by analyzing statistics generated by market activity such as past prices and volume is deﬁned as ‘Fundamental Analysis’. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. 42 Morning star: A bullish candlestick pattern that consists of three candles that have demonstrated the following characteristics: The ﬁrst bar is a large black candlestick located within a deﬁned downtrend. The second bar is a small-bodied candle (either black or white) that closes below the ﬁrst black 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. This pattern is used by traders as an early indication that the downtrend is about to reverse. Technical Analysis: This is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity ***** 43 Model Questions Q1 Technical analysis can help investors anticipate what is “likely” to happen to ________ over time. a) prices b) volumes c) economy d) fair value of stock Q2 The study of technical analysis is based on which of the following elements: a) price b) volume c) open interest (in case of derivatives) d) all of the above Q3 A technician will refer to periods of accumulation as evidence of an upcoming a) rise in prices b) fall in prices c) range-bound prices d) none of the above Q4 Which of the following statements is true about price? a) Price movements succeed fundamental developments b) Price movements are totally random c) Price discounts everything d) Price never move in trend Q5 _________ movements are typically referred to as bull and bear markets. a) Secondary b) Daily c) Major d) Primary Q6 Which of the following is not true about chart? a) it plot the price movements of a stock over speciﬁc time frames b) x-axis represents price and y-axis represents time c) it gives pictorial representation of any stock’s trading history d) it can give a complete picture of a stock’s price history over a period of an hour, day, week, month or many years. 44 Q7 Which of the following best reveal psychology of the market at a certain point in time? a) Line Chart b) Candlestick chart c) Bar Chart d) None of the above Q8 A higher open on next trading day of hammer indicates that: a) bears are intact b) bulls have taken control c) there is no possibility of trend reversal d) none of the above Q9 Which of the following candlestick pattern look like star falling from sky with a tail trailing it? a) morning star b) shooting star c) dark cloud cover d) none of the above Q10 Which of the following is not a feature of bearish kicking pattern? a) it is a three candle pattern b) it is a top reversal signal c) the body of ﬁrst candle is black and second candle is white in colour d) there is a gap between the ﬁrst day and the second day candle 45 CHAPTER 3 PATTERN STUDY Learning Objectives After studying this chapter the student should be able to understand: Formation of support and resistance lines Change of support to resistance and vice versa How to trade head and shoulders pattern Volume study in head and shoulders pattern Double top and double bottom The gap analysis 3.1 What are support and resistance lines? Support and resistance represent key junctures where the forces of supply and demand meet. These lines appear as thresholds to price patterns. They are the respective lines which stops the prices from decreasing or increasing. A support line refers to that level beyond which a stock’s price will not fall. It denotes that price level at which there is a sufﬁcient amount of demand to stop and possibly, for a time, turn a downtrend higher. Similarly a resistance line refers to that line beyond which a stock’s price will not increase. It indicates that price level at which a sufﬁcient supply of stock is available to stop and possibly, for a time, head off an uptrend in prices. Trend lines are often referred to as support and resistance lines on an angle. 3.1.1 Support A support is a horizontal ﬂoor where interest in buying a commodity is strong enough to overcome the pressure to sell. Support level is the price level at which sufﬁcient demand exists to, at least temporarily, halt a downward movement in prices. Logically as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support. 46 Support does not always hold true and a break below support signals that the bulls have lost over the bears. A fall below support level indicates more willingness to sell and a lack of willingness to buy. A break in the levels of support indicates that the expectations of sellers are reducing and they are ready to sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level ACC chart showing the support level at 720 47 3.1.2 Resistance A resistance is a horizontal ceiling where the pressure to sell is greater than the pressure to buy. Thus a Resistance level is a price at which sufﬁcient supply exists to; at least temporarily, halt an upward movement. Logically as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance. Resistance does not always hold true and a break above resistance signals that the bears have lost over the bulls. A break in the resistance level shows more willingness to buy or lack of incentive to sell. Resistance breaks and new highs indicate that buyer’s expectations have increased and are ready to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level. 48 Euro showing resistance around 1.4930 and then 1.5896 3.1.3 Why do support and resistance lines occur? A stock’s price is determined by supply and demand. Bulls buy when the stock’s is prices are too low and bears sell when the price reaches its maximum. Bulls increase the prices by increasing the demand and bears decrease it by increasing the supply. The market reaches a balance when bulls and bears agree on a price. When prices are increasing upward, there exists a point at which the bears become more aggressive the bulls begin to pull back - the market balances along the resistance line. When prices are going downwards, the market balances along the support line. As prices starts to decline toward the support line, buyers become more inclined to buy and sellers start holding on to their stocks. The support line marks the point where demand takes precedence over supply and prices will not decrease below that support line. The reverse holds true for a resistance line. Prices often break through support and resistance lines. A break through a resistance line shows that the buyers have won out over the sellers. The price of the stock is bid higher than the previous levels by the Bulls. Once the resistance line is broken, another will be created at a higher level. The reverse holds true for a support line. 3.1.4 Support and resistance zones Support and resistance is often thought of as a price level. For example, analysts and traders might discuss support for Nifty futures contract is at 4850. As a trader, if you are looking for 49 a place to go long would you wait for the market to actually trade at 4850 before taking a position? Should you buy one, two or maybe ﬁve ticks above the low and stop yourself out one tick through the low to manage your risk in the long position. If you wait for a test of support, you could miss a trading opportunity. The problem is thinking about support and resistance as a precise price level and this is where most traders err. It is very common for most people to think of support and resistance levels in terms of absolute price levels. For instance, if they are looking at Rs 50 as a resistance levels, they mean exactly Rs 50. In reality, support and resistance levels are not exact prices, but rather price zones. So, if the resistance level is Rs50, then it is actually the zone around that 50 level that is the resistance. The stock may hit only 49.87 or it may hit 50.25 and still hold the Rs 50 as price resistance. One solution is to use price zones for support and resistance instead of price levels. Support and resistance zones give you a better trading opportunity. A risk taking investor may buy at top of support zone whereas a cautious investor may want to wait till the bottom of support zone. The main factor in determining exactly how much the exact prices are tested by is how quickly or slowly the prices move into that resistance zone. For instance, if the zone hits very quickly on a large momentum surge, then it is more likely to hit that 50.25 level. This is also the case if the stock is a rather volatile one with a wide price range intraday. If the security spikes higher and does not quite hit the price resistance, such as a spike into 49.70, then it may round off into 50 with slightly higher highs and never exactly touch the Rs 50 price resistance zone before turning over due to the slowdown in momentum into that resistance. The larger the time frame, the greater the price zone is as well. A resistance zone at 50 on a weekly time frame may have a range of 1 Rs on each side of 50. Where traders tend to run into trouble 50 is in thinking that because the stock has traded over 50 therefore the Rs 50 resistance has been broken, so we often hear of people “buying the highs” or “shorting the lows” in the case of support. Resistance levels can transform into support levels and vice versa. After prices break through a support level, investors may try to limit their losses by selling the stock, pushing prices back up to the line which now becomes a resistance level. 3.1.5 Change of support to resistance and vice versa Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price penetrates below the support level, the earlier or the broken support level can turn into resistance. The break of support level signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance Wipro chart showing change of support around 440 to resistance Another aspect of technical analysis is resistance turning into support. As the price increases above resistance, it signals changes in demand and supply. The breakout above resistance proves that the forces of demand have overcome the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support can be established at this point 51 Crude oil chart showing change of resistance to support around 100$ 3.1.6 Why are support and resistance lines important? Technical analysts often say that the market has a memory. Support and resistance lines are a key component of that memory. Investors “tend” to remember previous area levels and thus make them important. When a price of a stock is changing rapidly each day the buying and selling will be done at a divergent level and there will not exist any unanimity or pattern in price changing. But when prices trade within a narrow range for a period of time an area is formed and investors begin to remember that speciﬁc price. If the prices stay in an area for a longer period than the volume of that spot increases and that level becomes more important because investors remember it exceptionally well. Therefore, that level becomes more signiﬁcant for the technical analyst. According to experts, previous support and resistance levels can be used as “target” or “limit” prices when the market have traded away from them. Assume that a year ago a rally ended with a top price of 120. That price of 120 then becomes a resistance level for the rally occurring in today’s market. 3.2 Head and Shoulders The head and shoulders pattern can be either head and shoulders, top or head and shoulders bottom. The Charts are a picture of a head and shoulders movement, which portrays three successive rallies and reactions with the second one making the highest/lowest point. 52 3.2.1 Head and Shoulders (Top reversal) A Head and Shoulders (Top) is a reversal pattern which occurs following an extended uptrend forms and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder, and neckline. Other parts playing a role in the pattern are volume, the 53 breakout, price target and support turned resistance. Lets look at each part individually, and then put them together with some example 1. Prior trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders reversal pattern, or any reversal pattern for that matter. 2. Left shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. It is formed usually at the end of an extensive advance during which volume is quite heavy. At the end of the left shoulder there is usually a dip or recession which typically occurs on low volume. 3. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. At this point, in order conform to proper form, prices must come down somewhere near the low of the left shoulder –somewhat lower perhaps or somewhat higher but in any case, below the top of the left shoulder. 4. Right shoulder: The right shoulder is formed when the low of the head advances again. The peak of the right shoulder is almost equal in height to that of the left shoulder but lower than the head. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline. 5. Neckline: A neckline can be drawn across the bottoms of the left shoulder, the head and the right shoulder. A breaking of this neckline on a decline from the right shoulder is the ﬁnal conﬁrmation and completes the head and shoulder formation. 6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in conﬁrmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. These decreases in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final conﬁrmation comes when volume further increases during the decline of the right shoulder. 7. Neckline break: The head and shoulders pattern is said to be complete only when the neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume. 8. Support turned resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell. 9. Price target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. Price target is calculated by 54 subtracting the above distance from the neckline. Any price target should serve as a rough guide, and other factors such as previous support levels should be considered as well. ABHISHEK IND chart showing the Head and Shoulders pattern Potato futures (MCX) showing H&S Pattern 55 Signals generated by head and shoulder pattern The support line is based on points B and C. The resistance line. After giving in at point D, the market may retest the neckline at point E. The price direction. If the neckline holds the buying pressure at point E, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish). The price target D to F. This is provided by the conﬁrmation of the formation (by breaking through the neckline under heavy trading volume). This is equal to the range from top of the head to neckline. Volume study 56 Some important points to remember The head and shoulders pattern is one of the most common reversal formations. It occurs after an uptrend and usually marks a major trend reversal when complete. It is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. Volume support and neckline support identiﬁcation are considered to be the most critical factors. The support break indicates a new willingness to sell at lower prices. There is an increase in supply combined with lower prices and increasing volume.The combination can be lethal, and sometimes, there is no second chance return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but it is not always necessary target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedence. 3.2.2 Inverted head and shoulders The head and shoulders bottom is the inverse of the H&S Top. In the chart below, after a period, the downward trend reaches a climax, which is followed by a rally that tends to carry the share back approximately to the neckline. After a decline below the previous low followed by a rally, the head is formed. This is followed by the third decline which fails to reach the previous low. The advance from this point continues across the neckline and constitutes the breakthrough. 57 The main difference between this and the Head and Shoulders Top is in the volume pattern associated with the share price movements. The volume should increase with the increase in the price from the bottom of the head and then it should start increasing even more on the rally which is followed by the right shoulder. If the neckline is broken but volume is low, you should be skeptical about the validity of the formation. As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three troughs in successive manner with the two outside troughs namely the right and the shoulder being lower in height than the middle trough (head) which is the deepest. Ideally, the two shoulders i.e. the right and the left shoulder should be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance, or a neckline. 3.2.3 Head and shoulders bottom The price action remains roughly the same for both the head and shoulders top and bottom, but in a reversed manner. The biggest difference between the two is played by the volume. While an increase in volume on the neckline breakout for a head and shoulders top is welcomed, it 58 is absolutely required for a bottom. Lets look at each part of the pattern individually, keeping volume in mind: 1. Prior trend: For this to be a reversal pattern it is important to establish the existence of a prior downtrend for this to be a reversal pattern. There cannot be a head and shoulders bottom formation, without a prior downtrend to reverse. 2. Left shoulder: It is formed after an extensive increase in price, usually supported by high volume. While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder. The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact. 3. Head: After the formation of the left shoulder, a decline begins that exceeds the previous low and forms a point at an even lower point. After making a bottom, the high of the subsequent advance forms the second point of the neckline. 4. Right shoulder: Right shoulder is formed when the high of the head begins to decline. The height of the right shoulder is always less than the head and is usually in line with the left shoulder, though it can be narrower or wider. When the advance from the low of the right shoulder breaks the neckline, the head and shoulders reversal is complete. 5. Neckline: The neckline is drawn through the highest points of the two intervening troughs and may slope upward or downward. The neckline forms by connecting two reaction highs. The ﬁrst reaction marks the end of the left shoulder and the beginning of the head. The second reaction marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern’s degree of bullishness: an upward slope is more bullish than downward slope. 6. Volume: Volume plays a very important rol

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