TA WRKBK

Technical Analysis Module NATIONAL STOCK
EXCHANGE OF INDIA LIMITED
Test Details: No. of

Questions
Sr. Name of Module FeesTest Duration (in Maximum Marks Pass Certifi cate Validity
No. (Rs.) minutes) Marks (%)
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 Offi ce Operations Module 1686 120 60 100 60 5 21 Wealth Management Module 1686 120 60 100 60 5 22 NISM-Series-I: Currency
Derivatives Certifi cation Examination 1000 120 100 100 60 3
23 NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents – Mutual Fund Certifi cation Examination
Corporate Certifi cation Examination 1000 120 100 100 50 3 1000 120 100 100 50 3
24 NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents –
25 NISM-Series-IV: Interest Rate Derivatives Certifi cation Examination 1000 120 100 100 60 3 26 NISM-Series-V-A: Mutual Fund Distributors Certifi
cation Examination * 1000 120 100 100 50 3 27 NISM-Series-VI: Depository Operations Certifi cation Examination 1000 120 100 100 60 3
28 NISM Series VII: Securities Operations and Risk Management 1000 120 100 100 50 3
Certifi cation Examination
29 NISM-Series-VIII: Equity Derivatives Certifi cation Examination 1000 120 100 100 60 3 30 Certifi ed 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 Offi cers
(Brokers) Module 1686 120 60 100 60 5 36 Compliance Offi cers (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 40 FPSB India Exam 1 to 4** 2247 per
exam 120 75 140 60 NA

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 certifi ed as ‘Trainers’. ** Following are the
modules of Financial Planning Standards Board India (Certifi ed Financial Planner Certifi cation) - FPSB India Exam 1 to 4 i.e. (i) Risk Analysis
& Insurance Planning (ii) Retirement Planning & Employee Benefi ts (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 > Certifi cations.
Note: (i) NISM has specifi ed the NISM-Series-VIII-Equity Derivatives Certifi cation 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 engulfi ng
..................................................................26 2.2.2.2 Bearish engulfi ng
................................................................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 benefi ts
.................................................................. 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
Signifi cance 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 Profi t
................................................................... 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
Technical Analysis Module
Curriculum
Chapter No. Title Weightages

Distribution of weights in the
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.
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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 defi ned as an art and science of forecasting future prices based on
an examination of the past price movements. Technical analysis is not astrology for
predicting prices. Technical analysis is based on analyzing current demand-supply of
commodities, stocks, indices, futures or any tradable instrument.
Technical analysis involve putting stock information like prices, volumes and open interest
on a chart and applying various patterns and indicators to it in order to assess the future
price movements. The time frame in which technical analysis is applied may range from
intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily,
weekly or monthly price data to many years.
There are essentially two methods of analyzing investment opportunities in the security
market viz fundamental analysis and technical analysis. You can use fundamental
information like fi nancial and non-fi nancial aspects of the company or technical information
which ignores fundamentals and focuses on actual price movements.
The basis of Technical Analysis
What makes Technical Analysis an effective tool to analyze price behavior is explained by
following theories given by Charles Dow:
• Price discounts everything
• Price movements are not totally random
• What is more important than why
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 refl ects all the possible material
information which could affect the price. The market price refl ects the sum knowledge of all
participants, including traders, investors, portfolio managers, buy-side analysts, sell-side
analysts, market strategist, technical analysts, fundamental analysts and many others. It
would be folly to disagree with the price set by such an impressive array of people with
impeccable credentials. Technical analysis looks at the price and what it has done in the past
and assumes it will perform similarly in future under similar circumstances. Technical
analysis looks at the price and assumes that it will perform in the same way as done in the
past under similar circumstances in future.
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 diffi cult to make money using technical analysis. A
technician believes that it is possible to identify a trend, invest or trade based on the trend
and make money as the trend unfolds. Because technical analysis can be applied to many
different time frames, it is possible to spot both short-term and long-term trends.
“What” is more important than “Why”
It is said that “A technical analyst knows the price of everything, but the value of nothing”.
Technical analysts are mainly concerned with two things:
1. The current price
2. The history of the price movement
All of you will agree that the value of any asset is only what someone is willing to pay for it.
Who needs to know why? By focusing just on price and nothing else, technical analysis
represents a direct approach. The price is the fi nal result of the fi ght between the forces of
supply and demand for any tradable instrument. The objective of analysis is to forecast the
direction of the future price. Fundamentalists are concerned with why the price is what it is.
For technicians, the why portion of the equation is too broad and many times the
fundamental reasons given are highly suspect. Technicians believe it is best to concentrate
on what and never mind why. Why did the price go up? It is simple, more buyers (demand)
than sellers (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, fi xed-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 fi nal cut will depend on the strictness
of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to
choose. These stocks could even be broken down further to fi nd 3-4 best amongst the rest
in the lot.
1.1.3 Technical Analysis: The basic assumptions
The fi eld of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The market discounts everything
Technical analysis is criticized for considering only prices and ignoring the fundamental
analysis of the company, economy etc. Technical analysis assumes that, at any given time, a
stock’s price refl ects everything that has or could affect the company - including
fundamental factors. The market is driven by mass psychology and pulses with the fl ow of
human emotions. Emotions may respond rapidly to extreme events, but normally change
gradually over time. It is believed that the company’s fundamentals, along with broader
economic factors and market psychology, are all priced into the stock, removing the need to
actually consider these factors separately. This only leaves the analysis of price movement,
which technical theory views as a product of the supply and demand for a particular stock in
the market.
2. Price moves in trends
“Trade with the trend” is the basic logic behind technical analysis. Once a trend has been
established, the future price movement is more likely to be in the same direction as the
trend than to be against it. Technical analysts frame strategies based on this assumption
only.
3. History tends to repeat itself
People have been using charts and patterns for several decades to demonstrate patterns in
price movements that often repeat themselves. The repetitive nature of price movements
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 fi nancial instrument -
stocks, futures and commodities, fi xed-income securities, forex, etc
Focus on price
Fundamental developments are followed by price movements. By focusing only on price

action, technicians focus on the future. The price pattern is considered as a leading indicator
and generally leads the economy by 6 to 9 months. To track the market, it makes sense to
look directly at the price movements. More often than not, change is a subtle beast. Even
though the market is prone to sudden unexpected reactions, hints usually develop before
signifi cant movements. You should refer to periods of accumulation as evidence of an
impending advance and periods of distribution as evidence of an impending decline.
Supply, demand, and price action
Technicians make use of high, low and closing prices to analyze the price action of a stock. A
good analysis can be made only when all the above information is present
Separately, these will not be able to tell much. However, taken together, the open, high, low
and close refl ect forces of supply and demand.
Support and resistance
Charting is a technique used in analysis of support and resistance level. These are trading
range in which the prices move for an extended period of time, saying that forces of demand
and supply are deadlocked. When prices move out of the trading range, it signals that either
supply or demand has started to get the upper hand. If prices move above the upper band of
the trading range, then demand is winning. If prices move below the lower band, then supply
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 fl at for those three years, it would appear that market has a
different opinion. If a stock has already advanced signifi cantly, it may be prudent to wait for
a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a
trend 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 refl ected in the analysis. It is important to be aware of these biases when analyzing
a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis.
On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably
have a bearish tilt.
Open to interpretation
Technical analysis is a combination of science and art and is always open to interpretation.
Even though there are standards, many times two technicians will look at the same chart
and paint two different scenarios or see different patterns. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify their position. Is the cup
half-empty or half-full? It is in the eye of the beholder.
Too late
You can criticize the technical analysis for being too late. By the time the trend is identifi ed,
a substantial move has already taken place. After such a large move, the reward to risk
ratio is not great. Lateness is a particular criticism of Dow Theory.
13
Always another level
Technical analysts always wait for another new level. Even after a new trend has been
identifi ed, there is always another “important” level close at hand. Technicians have been
accused of sitting on the fence and never taking an unqualifi ed stance. Even if they are
bullish, there is always some indicator or some level that will qualify their opinion.
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 profi ts!
There is asymmetry between zero and infi nity. What does that mean? Most of us have very
fi nite capital but infi nite opportunities because of thousands of stocks. If we lose an
opportunity, we will have thousands more tomorrow. If we lose our capital, will we get
thousands more tomorrow? It is likely that we will not. We will also lose our opportunities.
Our capital holds more worth to us than our opportunities because we must have capital in
order to take advantage of tomorrow’s opportunities.
It is more important to control risk than to maximize profi ts! Technical Analysis, if practiced
with discipline, gives you specifi c parameters for managing risk. It’s simply supply and
demand. Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your
capital is your opportunity. You can be right a thousand times, become very wealthy and
then get wiped out completely if you manage your risk poorly just once. One last time: That
is why it is more important to control risk than to maximize profi ts!
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 refl ects the sum knowledge of all participants, and
we are not dealing with lightweights here. These participants have considered (discounted)
everything under the sun and settled on a price to buy or sell. These are the forces of
supply and demand at work. By examining price action to determine which force is
prevailing, technical analysis focuses directly on the bottom line: What is the price? Where
has it been? Where is it going?
Even though some principles and rules of technical analysis are universally applicable, it
must be remembered that technical analysis is more an art form than a science. As an art
form, it is subject to interpretation. However, it is also fl exible in its approach and each
investor should use only that which suits his or her style. Developing a style takes time,
effort and dedication, but the rewards can be signifi cant.
*****
15
CHAPTER 2 CANDLE CHARTS
Learning objectives
• 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 specifi c time frames. It’s a graphical method of showing where
stock prices have been in the past.
A chart gives us a complete picture of a stock’s price history over a period of an hour, day,
week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical). Typically,
the x-axis represents time; the y-axis represents price. By plotting a stock’s price over a
period of time, we end up with a pictorial representation of any stock’s trading history.
A chart can also depict the history of the volume of trading in a stock. That is, a chart can
illustrate the number of shares that change hands over a certain time period.
Types of price charts:
1. Line charts
“Line charts” are formed by connecting the closing prices of a specifi c stock or market over
a given period of time. Line chart is particularly useful for providing a clear visual illustration
of the trend of a stock’s price or a market’s movement. It is an extremely valuable analytical
tool which has been used by traders for past many years.
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 fi gure 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 fi lled portion of
the candlestick is called “the body” (also referred to as “the real body”). The long
thin lines above and below the body represent the high/low range and are called
“shadows” (also referred to as “wicks” and “tails”). The high is marked by the top of
the upper shadow and the low by the bottom of the lower shadow. If the stock
closes higher than its opening price, a hollow candlestick is drawn with the
bottom of the body representing the opening price and the top of the body
representing the closing price. If the stock closes lower than its opening price,
a fi lled candlestick is drawn with the top of the body representing the opening price
and the bottom of the body representing the closing price.
Each candlestick provides an easy-to-decipher picture of price action. Immediately a

trader can see and compare the relationship between the open and close as well as
the high and low. The relationship between the open and close is considered vital
information and forms the essence of candlesticks. Hollow candlesticks, where the
close is greater than the open, indicate buying pressure. Filled candlesticks, where
the close is less than the open, indicate selling pressure. Thus, compared to
traditional bar charts, many traders consider candlestick charts more visually
appealing and easier to interpret.
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 identifi ed a number of patterns to determine the continuation
and reversal of trend.
These patterns are the basis for Japanese candlestick chart analysis. This places candlesticks
rightly as a part of technical analysis. Japanese candlesticks offer a quick picture into the
psychology of short term trading, studying the effect, not the cause. Applying candlesticks
means that for short-term, an investor can make confi dent decisions about buying, selling,
or holding an investment.
2.2 Candlestick analysis
One cannot ignore that investor’s psychologically driven forces of fear; greed and hope
greatly infl uence the stock prices. The overall market psychology can be tracked through
candlestick analysis. More than just a method of pattern recognition, candlestick analysis
shows the interaction between buyers and sellers. A white candlestick indicates opening
price of the
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 signifi cance but a white candle shows slightly more bullish implications than the black
body. A positive day i.e. a white candle is required the next day to confi rm this signal.
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 confi rm 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. Confi rmation 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 signifi es a potential top reversal, it requires confi rmation during the next trading
session. The hanging man usually has little or no upper shadow.
Soybean Oil-December, 1990, Daily (Hanging Man and Hammer)
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 identifi ed 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 confi rm 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 confi rmed.
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
identifi ed by the presence of a small body with a shadow at least two times greater than the
body. It is found at the top of an uptrend. The Japanese named this pattern because it looks
like a shooting star falling from the sky with the tail trailing it.
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 confi rm 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 engulfi ng pattern” consists of a large white real body that engulfs a small black
real body during a downtrend. It signifi es that the buyers are overwhelming the sellers
Engulfi ng
Bullish engulfi ng
26
Description
The Engulfi ng pattern is a major reversal pattern comprised of two opposite colored bodies.
This Bullish Pattern is formed after a downtrend. It is formed when a small black candlestick
is followed by a large white candlestick that completely eclipses the previous day candlestick.
It opens lower that the previous day’s close and closes higher than the previous day’s open.
Criteria
1. The candlestick body of the previous day is completely overshadowed by the next day’s
candlestick.
2. Prices have been declining defi nitely, even if it has been in short term. 3. The color of the
fi rst candle is similar to that of the previous one and the body of the second candle is
opposite in color to that fi rst candle. The only exception being an engulfed body which is a
doji.
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 engulfi ng day increases the chances that a blow off day has
occurred.
3. The engulfi ng body engulfs absorbs the body and the shadows of the previous day; the
reversal has a greater probability of working.
4. The probability of a strong reversal increases as the open gaps between the previous and
the current day increases.
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 Engulfi ng signal if used after proper training and at proper locations, can lead to
highly profi table trades and consistent results. This pattern allows an investor to improve
their probabilities of been in a correct trade. The common sense elements conveyed in
candlestick signals makes for a clear and concise trading technique for beginning investors
as well as experienced traders.
27
2.2.2.2 Bearish engulfing
A “bearish engulfi ng 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 Engulfi ng
28
2.2.2.3 Piercing
The bullish counterpart to the dark cloud cover is the “piercing pattern.” The fi rst thing to
look for is to spot the piercing pattern in an existing downtrend, which consists of a long
black candlestick followed by a gap lower open during the next session, but which closes at
least halfway into the prior black candlestick’s real body.
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 fi fteen trading days). The day before the piercing candle appears, the
daily candle should have a fairly large dark real body, signifying a strong down day.
29
Criteria
1. The downtrend has been evident for a good period.
2. The body of the fi rst candle is black; the body of the second candle is white.
3. A long black candle occurs at the end of the trend.
4. The white candle closes more than halfway up the black candle.
5. The second day opens lower than the trading of the prior day.
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 signifi cant confi rmation. 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 fi nish near the high of
the day. The move has almost negated the price decline of the previous day. This now has
the bears concerned. More buying the next day will confi rm the move. Being able to utilize
information that has been used successfully in the past is a much more viable investment
strategy than taking shots in the dark. Keep in mind, when you are given privileged
information about stock market tips, where you are in the food chain. Are you one of those
privileged few that get top-notch pertinent information on a timely manner, or are you one
of the masses that feed into a frenzy and allow the smart money to make the profi ts?
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 fi rst candle is the same color
as that of the current trend. The open and the close occur inside the open and the close of
the previous day. Its presence indicates that the trend is over.
Criteria
1. The fi rst candle is white in color; the body of the second candle is black. 2. The second
day opens lower than the close of the previous day and closes higher than the open of the
prior day.
3. For a reversal signal, confi rmation is needed. The next day should show weakness.
4. The uptrend has been apparent. A long white candle occurs at the end of the trend.
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 profi t taking.
The price for the day ends at a lower level. The bulls are now concerned as the price closes
lower. It is becoming evident that the trend has been violated. A weak day after that would
convince everybody that the trend was reversing. Volume increases due to the profi t taking
and the addition of short sales.
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 signifi es 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 fi rst candle is the same as that of current
trend. The fi rst body in the pattern is longer than the second one. The open and the close
occur inside the open and the close of the previous day. Its presence indicates that the trend
is over.
The Harami (meaning “pregnant” in Japanese) Candlestick Pattern is a reversal pattern. The
pattern consists of two Candlesticks. The fi rst candle is black in color and a continuation of
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 fi rst candle is black in body; the body of the second candle is white. 2. The
downtrend has been evident for a good period. A long black candle occurs at the end of the
trend.
3. The second day opens higher than the close of the previous day and closes lower than
the open of the prior day.
4. Unlike the Western “Inside Day”, just the body needs to remain in the previous day’s
body, where as the “Inside Day” requires both the body and the shadows to remain
inside the previous day’s body.
5. For a reversal signal, further confi rmation is required to indicate that the trend is now
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 fi nishes at a higher level. This gives enough notice to the short sellers that trend
has been violated. A strong day i.e. the next day would convince everybody that the trend
was reversing. Usually the volume is above the recent norm due to the unwinding of short
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 fi rst
real body to form a “star” and a third black candle that closes well into the fi rst 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 fi rst candle is white, continuing the current trend. The second candle has
small trading range showing indecision formation.
3. The third day shows evidence that the bears have stepped in. That candle should close at
least halfway down the white candle.
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 fi rst 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 fi rst 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 profi ts or think
the price is fairly valued. The next day all the buying is being met with the selling, causing
for a small trading range. The bulls get concerned and the bears start taking over. The third
day is a large sell off day. If there is big volume during these days, it shows that the
ownership has dramatically changed hands. The change of direction is immediately seen in
the color of the 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 fi rst real
body to form a star, and a third white candle that closes well into the fi rst session’s black
real body. Its name indicates that it foresees higher prices.
Description
The Morning Star is a bottom reversal signal. Like the planet Mercury, the morning star,
signifi es brighter things – that is sunrise is about to occur, or the prices are going to go
higher. A downtrend has been in place which is assisted by a long black candlestick. There is
little about the downtrend continuing with this type of action. The next day prices gap lower
on the open, trade within a small range and close near their open. This small body shows
the beginning of indecision. The next day prices gap higher on the open and then close
much higher. A signifi cant reversal of trend has occurred.
The make up of the star, an indecision formation, can consist of a number of candle
formations. The important factor is to witness the confi rmation of the bulls taking over the
next day. That
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 fi rst candle is black, continuing the current trend. The second candle is
an indecision formation.
3. The third day is the opposite color of the fi rst day. It shows evidence that the bulls have
stepped in. That candle should close at least halfway up the black candle.
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 fi rst 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 fi rst 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 fi rst 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 signifi cant reversal
indicator.
40
The Importance of the Doji
The perfect doji session has the same opening and closing price, yet there is some fl exibility
to this rule. If the opening and closing price are within a few ticks of each other, the line
could still be viewed as a doji.
How do you decide whether a near-doji day (that is, where the open and close are very
close, but not exact) should be considered a doji? This is subjective and there are no rigid
rules but one way is to look at a near-doji day in relation to recent action. If there are a
series of very small real bodies, the near-doji day would not be viewed as signifi cant since
so many other recent periods had small real bodies. One technique is based on recent
market activity. If the market is at an important mar ket junction, or is at the mature part of
a bull or bear move, or there are other technical signals sending out an alert, the
appearance of a near-doji is treated as a doji. The philosophy is that a doji can be a signifi
cant warning and that it is better to attend to a false warning than to ignore a real one. To
ignore a doji, with all its inherent implications, could be dangerous.
The doji is a distinct trend change signal. However, the likelihood of a reversal increases if
subsequent candlesticks confi rm the doji’s reversal potential. Doji sessions are important
only in markets where there are not many doji. If there are many doji on a particular chart,
one should not view the emergence of a new doji in that particular market as a meaningful
development. That is why candlestick analysis usually should not use intra-day charts of less
than 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or
near doji
Doji at tops
A Doji star at the top is a warning that the uptrend is about to change. This is especially true
after a long white candlestick in an uptrend. The reason for the doji’s negative implications
in uptrend is because a doji repre sents indecision. Indecision among bulls will not maintain
the uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an
extended rally, or is overbought, then formation of a doji could mean the scaffolding of buy
ers’ support will give way.
Doji are also valued for their ability to show reversal potential in downtrends. The reason
may be that a doji refl ects a balance between buying and selling forces. With ambiva lent
market
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 confi rmation
to signal a bottom than they do a top.
*****
New Terms
Bull: An investor who thinks the market, a specifi c security or an industry will rise.
Bear: An investor who believes that a particular security or market is headed downward is
indicative of a bearish trend. Bears attempt to profi t from a decline in prices. Bears are
generally pessimistic about the state of a given market.
Bull market: A fi nancial market of a group of securities in which prices are rising or are
expected to rise. The term “bull market” is most often used to refer to the stock market, but
can be applied to anything that is traded, such as bonds, currencies and commodities.
Bull markets are characterized by optimism, investor confi dence and expectations that
strong results will continue. It’s diffi cult to predict consistently when the trends in the
market will change. Part of the diffi culty is that psychological effects and speculation may
sometimes play a large role in the markets
The use of “bull” and “bear” to describe markets comes from the way the animals attack
their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down.
These actions are metaphors for the movement of a market. If the trend is up, it’s a bull
market. If the trend is down, it’s a bear market.
Bear Market
A market condition in which the prices of securities are falling, and widespread pessimism
causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear
market, selling continues, which then creates further pessimism.
This is not to be confused with a correction which is a short-term trend that has duration
shorter than two months. While corrections are often a great place for a value investor to fi
nd an entry point, bear markets rarely provide great entry points as timing the bottom is
very diffi cult to do. Fighting back can be extremely dangerous because it is quite diffi cult
for an investor to make stellar gains during a bear market unless he or she is a short seller.
Fundamental Analysis: A method of evaluating securities by analyzing statistics generated

by market activity such as past prices and volume is defi ned as ‘Fundamental Analysis’.
Technical analysts do not attempt to measure a security’s intrinsic value, but instead use
charts and other tools to identify patterns that can suggest future activity.
42
Morning star: A bullish candlestick pattern that consists of three candles that have
demonstrated the following characteristics:
• The fi rst bar is a large black candlestick located within a defi ned downtrend.
• The second bar is a small-bodied candle (either black or white) that closes below the fi
rst black bar.
• The last bar is a large white candle that opens above the middle candle and closes near
the center of the fi rst bar’s body.
This pattern is used by traders as an early indication that the downtrend is about to reverse.
Technical Analysis: This is a method of evaluating securities by analyzing statistics

generated by market activity, such as past prices and volume. Technical analysts do not
attempt to measure a security’s intrinsic value, but instead use charts and other tools to
identify patterns that can suggest future activity
*****
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 specifi c 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
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
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 fi rst candle is black and second candle is white in colour d)
there is a gap between the fi rst day and the second day candle
45
CHAPTER 3 PATTERN STUDY
Learning Objectives
• 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 suffi cient amount of demand to stop and possibly, for a time,
turn a downtrend higher. Similarly a resistance line refers to that line beyond which a stock’s
price will not increase. It indicates that price level at which a suffi cient supply of stock is
available to stop and possibly, for a time, head off an uptrend in prices. Trend lines are often
referred to as support and resistance lines on an angle.
3.1.1 Support
A support is a horizontal fl oor where interest in buying a commodity is strong enough to

overcome the pressure to sell. Support level is the price level at which suffi cient demand
exists to, at least temporarily, halt a downward movement in prices. Logically as the price
declines towards support and gets cheaper, buyers become more inclined to buy and sellers
become less inclined to sell. By the time the price reaches the support level, it is believed
that demand will overcome supply and prevent the price from falling below support.
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 suffi cient supply exists to; at least
temporarily, halt an upward movement. Logically as the price advances towards resistance,
sellers become more inclined to sell and buyers become less inclined to buy. By the time the
price reaches the resistance level, it is believed that supply will overcome demand and
prevent the price from rising above resistance.
Resistance does not always hold true and a break above resistance signals that the bears
have lost over the bulls. A break in the resistance level shows more willingness to buy or
lack of incentive to sell. Resistance breaks and new highs indicate that buyer’s expectations
have increased and are ready to buy at even higher prices. In addition, sellers could not be
coerced into selling until prices rose above resistance or above the previous high. Once
resistance is broken, another resistance level will have to be established at a higher level.
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 fi ve ticks above the low and stop yourself out
one tick through the low to manage your risk in the long position. If you wait for a test of
support, you could miss a trading opportunity. The problem is thinking about support and
resistance as a precise price level and this is where most traders err. It is very common for
most people to think of support and resistance levels in terms of absolute price levels. For
instance, if they are looking at Rs 50 as a resistance levels, they mean exactly Rs 50.
In reality, support and resistance levels are not exact prices, but rather price zones. So, if
the resistance level is Rs50, then it is actually the zone around that 50 level that is the
resistance. The stock may hit only 49.87 or it may hit 50.25 and still hold the Rs 50 as price
resistance. One solution is to use price zones for support and resistance instead of price
levels. Support and resistance zones give you a better trading opportunity. A risk taking
investor may buy at top of support zone whereas a cautious investor may want to wait till
the bottom of support 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 specifi c price.
If the prices stay in an area for a longer period than the volume of that spot increases and
that level becomes more important because investors remember it exceptionally well.
Therefore, that level becomes more signifi cant for the technical analyst. According to
experts, previous support and resistance levels can be used as “target” or “limit” prices
when the market have traded away from them. Assume that a year ago a rally ended with a
top price of 120. That price of 120 then becomes a resistance level for the rally occurring in
today’s market.
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 fi
nal confi rmation and completes the head and shoulder formation.
6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in
confi rmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply
by analyzing volume levels. Ideally, but not always, volume during the advance of the left
shoulder should be higher than during the advance of the head. These decreases in volume
along with new highs that form the head serve as a warning sign. The next warning sign
comes when volume increases on the decline from the peak of the head. Final confi rmation
comes when volume further increases during the decline of the right shoulder.
7. Neckline break: The head and shoulders pattern is said to be complete only when the
neckline support is broken. Ideally, this should also occur in a convincing manner with an
expansion in volume.
8. Support turned resistance: Once support is broken, it is common for this same support
level to turn into resistance. Sometimes, but certainly not always, the price will return to the
support break, and offer a second chance to sell.
9. Price target: After breaking neckline support, the projected price decline is found by
measuring the distance from the neckline to the top of the head. Price target is calculated by
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 confi rmation of the formation (by breaking
through the neckline under heavy trading volume). This is equal to the range from top
of the head to neckline.
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 identifi cation are considered to be the most
critical factors. The support break indicates a new willingness to sell at lower prices.
There is an increase in supply combined with lower prices and increasing volume
.The combination can be lethal, and sometimes, there is no second chance return to
the support break.
• Measuring the expected length of the decline after the breakout can be helpful, but
it is not always necessary target. As the pattern unfolds over time, other aspects of
the technical picture are likely to take precedence.
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 fi rst reaction marks the end of the left shoulder and the beginning of the head.
The second reaction marks the end of the head and the beginning of the right shoulder.
Depending on the relationship between the two reaction highs, the neckline can slope up,
slope down, or be horizontal. The slope of the neckline will affect the pattern’s degree of
bullishness: an upward slope is more bullish than downward slope.
6. Volume: Volume plays a very important role in head and shoulders bottom.
Without the proper expansion of volume, the validity of any breakout becomes suspect.
Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing
the absolute levels associated with each peak and trough.
Volume levels during the second half of the pattern are more important than the fi rst half.
The decline of the volume of the left shoulder is usually heavy and selling pressure is also
very intense. The selling continues to be intense even during the decline that forms the low
of the head. After this low, subsequent volume patterns should be watched carefully to look
for expansion during the advances.
The advance from the low of the head should be accompanied by an increase in volume
and/or better indicator readings (e.g. CMF > 0 or strength in OBV). After the formation the
59
second neckline point by the reaction high, there should be a decline in the right shoulder
accompanied with light volume. It is normal to experience profi t-taking after an advance.
Volume analysis helps distinguish between normal profi t-taking and heavy selling pressure.
With light volume on the pullback, indicators like CMF and OBV should remain strong. The
most important moment for volume occurs on the advance from the low of the right
shoulder. For a breakout to be considered valid there needs to be an expansion of volume on
the advance and during the breakout.
1. Neckline break: The head and shoulders pattern is said to be complete only when
neckline resistance is broken. For a head and shoulders bottom, this must occur in a
convincing manner with an expansion of volume.
2. Resistance turned support: The same resistance level can turn into support, if the
resistance is broken. Price will return to the resistance break and provide a second chance to
buy.
3. Price target: Once the neckline resistance is broken, the projected advance is calculated
by measuring the distance from the neckline to the bottom of the head. This distance is
then added to the neckline to reach a price target. Any price target should serve as a rough
guide and other factors should be considered as well. These factors might include previous
resistance levels, Fibonacci retracements or long-term moving averages.
60
CNX IT INDEX Chart Showing Inverse Head and Shoulders Pattern
Once the neckline breaches the prices of index starts rising
Once the resistance is broken at point D the price target will be equal to the bottom of the
head from neckline. It may test the line again at point E therefore the stop should be below
the neckline.
61
Some important points to remember:
• Head and shoulder bottom is one of the most common and reliable reversal formations.
They occur after a downtrend and usually mark a major trend reversal when complete. • It
is preferable but not a necessary requirement that the left and right shoulders be
symmetrical. Shoulders can be of different widths as well as different heights. If you are
looking for the perfect pattern, then it will take a long time to come.
• The major focus of the analysis of the head and shoulders bottom should be the correct
identifi cation of neckline resistance and volume patterns. These are two of the most
important aspects to a successful trade. The neckline resistance breakout combined
with an increase in volume indicates an increase in demand at higher prices. Buyers
are exerting greater force and the price is being affected.
• As seen from the examples, traders do not always have to choose a stock after the
neckline breakout. Many times, the price will return to this new support level and offer a
second chance to buy. Measuring the expected length of the advance after the breakout
can be helpful, but it is not always necessary to achieve the fi nal target. As the pattern
unfolds over time, other aspects of the technical picture are likely to take precedent.
3.3 Double tops and bottoms
These are considered to be among the most familiar of all chart patterns and often signal
turning points, or reversals. The double top resembles the letter “M”. Conversely, the double
bottom resembles a “W” formation; in reverse of the double top.
62
3.3.1 Double top
It is a term used in technical analysis to describe the rise of a stock, a drop and another rise
roughly of the same level as the previous top and fi nally followed by another drop.
A double top is a reversal pattern which occurs following an extended uptrend. This name is
given to the pair of peaks which is formed when price is unable to reach a new high. It is
desirable to sell when the price breaks below the reaction low that is formed between the
two peaks.
Context: The double top must be followed by an extended price rise or uptrend. The two
peaks formed need not be equal in price, but should be same in the area with a minor
reaction low between them. This is a reliable indicator of a potential reversal to the
downside.
Appearance: Price moves higher and forms a new high. This is followed by a downside
retracement, which forms a reaction low before one fi nal low-volume assault is made on the
area of the recent high. In some cases the previous high is never reached, and sometimes it
is briefl y but does not hold. This pattern is said to be complete once price makes the second
peak and then penetrates the lowest point between the highs, called the reaction low. The
sell indication from this topping pattern occurs when price breaks the reaction low to the
downside.
Breakout expectation: When the reaction low is penetrated to the downside, accompanied
by expanding volume the double top pattern becomes offi cial. Downside price target is
calculated by subtracting the distance from the reaction low to the peak from the reaction
low. Often times a double top will mark a lasting top and lead to a signifi cant decline which
exceeds the price target to the downside.
Although there can be variations but if the trend is from bullish to bearish, the classic double
top will mark at least an intermediate change, if not long-term change. Many potential
double tops can form along the way up, but until key support is broken, a reversal cannot
be confi rmed. Let’s look at the key points in the formation.
63
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In
the case of the double top, a signifi cant uptrend of several months should be in place.
2. First peak: The fi rst peak marks the highest point of the current trend.
3. Trough: Once the fi rst peak is reached, a decline takes place that typically ranges from
10-20%. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid
demand.
4. Second peak: The advance off the lows usually occurs with low volume and meets
resistance from the previous high. Resistance from the previous high should be expected and
after the resistance is met, only the possibility of a double top exists. The pattern still needs
to be confi rmed. The time period between peaks can vary from a few weeks to many
months, with the norm being 1-3 months. While exact peaks are preferable, there is some
leeway. Usually a peak within 3% of the previous high is adequate.
5. Decline from peak: Decline in the second peak is witnessed by an expanding volume
and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that
the forces of supply are stronger than the forces of demand and a support test is imminent.
6. Support break: The double top and trend reversal are not complete even when the
trading till the support is done. The double top pattern is said to be complete when the
support breaks from the lowest point between the peaks. This too should occur with an
increase in volume and/or an accelerated descent.
64
7. Support turned resistance: Broken support becomes potential resistance and there is
sometimes a test of this newfound resistance level with a reaction rally
8. Price target: Price target is calculated by subtracting the distance from the support
break to peak from the support break. The larger the potential decline the bigger will be the
formation.
ALEMBIC LTD Chart Showing Double Top
BHEL Chart showing Double Top
• This stock formed a double top after a big price advance. But it fails to breach the
resistance and results in price falls.
Points to be kept in mind:
• Technicians should take proper steps to avoid deceptive double tops. The peaks should be
separated by a time period of at least a month. If the peaks are too close, they could
just represent normal resistance rather than a lasting change in the supply/demand
picture. Ensure that the low between the peaks declines at least 10%. Declines less
than 10% may not be indicative of a signifi cant increase in selling pressure. After the
decline, analyze the trough for clues on the strength of demand. If the trough drags on
a bit and has trouble moving back up, demand could be drying up. When the security
does advance, look for a contraction in volume as a further indication of weakening
demand.
• The most important aspect of a double top is to avoid jumping the gun. The support should
be broken in a convincing manner and with an expansion of volume. A price or time fi
lter
65
can be applied to differentiate between valid and false support breaks. A price fi lter
might require a 3% support break before validation. A time fi lter might require the
support break to hold for 3 days before considering it valid. The trend is in force until
proven otherwise. This applies to the double top as well. Until support is broken in a
convincing manner, the trend remains up.
3.3.2 Double bottom
Double bottom is a charting technique used in technical analysis. It is used to describe a

drop in the value of a stock (index), bounces back and then another drop to the similar level
as the previous low and fi nally rebounds again. A double bottom is a reversal pattern which
occurs following an extended downtrend. The buy signal is when price breaks above the
reaction high which is formed between the two lows.
Context: The double bottom must be followed by an extended decline in prices. The two
lows formed have to be equal in areas with a minor reaction high between them, though
they need not to be equal in price. This is a reliable indicator of a potential reversal to the
upside.
Appearance: Price reduces further to form a new low. This is followed by upside
retracement or minor bounce, which forms a reaction high before one fi nal low-volume
downward push is made to the area of the recent low. In some cases the previous low is
never reached, while in others it is briefl y penetrated to the downside, but price does not
remain below it. This pattern is considered complete once price makes the second low and
then penetrates the highest point between the lows, called the reaction high. The buy
indication from this bottom pattern occurs when price breaks the reaction high to the
upside.
Breakout expectation: A double bottom pattern becomes offi cial when the reaction high is
penetrated to the upside, ideally accompanied by expanding volume. Upside price target is
calculated adding the distance from the reaction high to the low to that of reaction high.
Often times a double bottom will mark a lasting low and lead to a signifi cant price advance
which exceeds the price target to the upside.
There can be many variations that can occur in the double bottom, but the classic double
bottom usually marks an intermediate or a long-term change in trend. Many potential double
bottoms can be formed along the way down, but a reversal cannot be confi rmed until key
resistance is broken. The key points in the formation are as follows:
66
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In
the case of the double bottom, a signifi cant downtrend of several months should be in place.
2. First trough: It marks the lowest point of the current trend. Though it is fairly normal in
appearance and the downtrend remains fi rmly in place.
3. Peak: After the fi rst trough is reached, an advance ranging from 10-20% usually takes
place. An increase in the volume from the fi rst trough signals an early accumulation. The
peaks high is sometimes rounded or drawn out a bit because of the hesitation in going back.
This hesitation is an indication of an increase in demand, but this increase is not strong
enough for a breakout.
4. Second trough: The decline off the reaction high usually occurs with low volume and
meets support from the previous low. Support from the previous low should be expected.
Even after establishing support, only the possibility of a double bottom exists, it still needs
to be confi rmed. The time period between troughs can vary from a few weeks to many
months, with the norm being 1-3 months. While exact troughs are preferable, there is some
room to maneuver and usually a trough within 3% of the previous is considered valid.
5. Advance from trough: Volume gains more importance in the double bottom than in the
double top. The advance of the second trough should be clearly evidenced by the increasing
volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also
indicates a potential change in sentiment.
67
6. Resistance break: The double top and trend reversal are considered incomplete, even
after they trade up to resistance. Breaking resistance from the highest point between the
troughs completes the double bottom. This too should occur with an increase in volume and/
or an accelerated ascent.
7. Resistance turned support: Broken resistance becomes potential support and there is
sometimes a test of this newfound support level with the fi rst correction. Such a test can
offer a second chance to close a short position or initiate a long.
8. Price target: Target is estimated by adding the distance from the resistance breakout to
trough lows on top of the resistance break. This would imply that the bigger the formation
is, the larger the potential advance.
Crude oil chart showing Double Bottom
Points to be kept In Mind
• The double bottom is an intermediate to long-term reversal pattern that will not form in a
few days. Though it can be formed in a time span of few weeks, but it is preferable to
have at least a time of 4 weeks between the two lows. Bottoms usually take more time
than the top. This pattern should be given proper time to develop.
• The advance off of the fi rst trough should be 10-20%. The second trough should form a
low within 3% of the previous low and volume on the ensuing advance should increase.
Signs of buying pressure can be checked by the volume indicators such
68
as Chaikin Money Flow, OBV and Accumulation/Distribution. The formation is not
complete until the previous reaction high is taken out.
3.3.3 Rounded top and bottom

Another shape which a top and bottom can take is one in which the reversal is “rounded”.
The rounded bottom formation forms when the market gradually yet steadily shifts from a
bearish to bullish outlook while in the case of a rounded top, from bullish to bearish. The
Rounded Top formation consists of a gradual change in trend from up to down. The Rounded
Bottom formation consists of a gradual change in trend from down to up. This formation is
the exact opposite of a Rounded Top Formation. The prices take on a bowl shaped pattern
as the market slowly and casually changes from an upward to a downward trend
OMAXE Chart showing Rounded Top
69
It is very (remove) considered very diffi cult to separate a rounded bottom, where the price
continues to decrease from a consolidation pattern and where price stays at a level, but the
clue, as always, is in volume. In a true Rounded Bottom, the volume decreases as the
price decreases, this signifi es a decrease in the selling pressure. A very little trading
activity can be seen when the price movement becomes neutral and goes sideways and the
volumes are also low. Then, as prices start to increase, the volume increases.
3.4 Gap theory
A gap is an area on a price chart in which there were no trades. Normally this occurs after
the close of the market on one day and the next day’s open. Lot’s of things can cause this,
such as an earnings report coming out after the stock market had closed for the day. If the
earnings were signifi cantly higher than expected, this could result in the price opening
higher than the previous day’s close. If the trading that day continues to trade above that
point, a gap will exist in the price chart. Gaps can offer evidence that something important
has happened to the fundamentals or the psychology of the crowd that accompanies this
market movement.
Gaps appear more frequently on daily charts, where every day is an opportunity to create an
opening gap. Gaps can be subdivided into four basic categories:
• Common gap
• Breakaway gap
• Runaway/ Continuation gap
• Exhaustion gap
70
3.4.1 Common gaps
Sometimes referred to as a trading gap or an area gap, the common gap is usually
uneventful. This gap occurs characteristically in nervous markets and is generally closed
within few days. In fact, they can be caused by a stock going ex-dividend when the trading
volume is low. Getting closed means that the price action at a later time (few days to a few
weeks) usually retraces to at the least the last day before the gap. This is also known as fi
lling the gap.
A common gap usually appears in a trading range or congestion area and reinforces the
apparent lack of interest in the stock at that time. Many times this is further exacerbated by
low trading volume. Being aware of these types of gaps is good, but doubtful that they will
produce trading opportunities.
3.4.2 Breakaway gaps
71
Breakaway gaps are the exciting ones. They occur when the price action is breaking out of
their trading range or congestion area. To understand gaps, one has to understand the
nature of congestion areas in the market. A congestion area is just a price range in which
the market has traded for some period of time, usually a few weeks or so. The area near the
top of the congestion area is usually resistance when approached from below. Likewise, the
area near the bottom of the congestion area is support when approached from above. To
break out of these areas requires market enthusiasm and either many more buyers than
sellers for upside breakouts or more sellers than buyers for downside breakouts.
Volume will (should) pick up signifi cantly, for not only the increased enthusiasm, but many
are holding positions on the wrong side of the breakout and need to cover or sell them. It is
better if the volume does not happen until the gap occurs. This means that the new change
in market direction has a chance of continuing. The point of breakout now becomes the new
support (if an upside breakout) or resistance (if a downside breakout). Don’t fall into the trap
of thinking this type of gap, if associated with good volume, will be fi lled soon. It might take
a long time. Go with the fact that a new trend in the direction of the stock has taken place
and trade accordingly.
A good confi rmation for trading gaps is if they are associated with classic chart patterns. For
example, if an ascending triangle all of a sudden has a breakout gap to the upside, this can
be a much better trade than a breakaway gap without a good chart pattern associated with
it.
3.4.3 Runaway gaps
72
Runaway gaps are also called measuring gaps and are best described as gaps that are
caused by increased interest in the stock. For runaway gaps to the upside, it usually
represents traders who did not get in during the initial move of the up trend and while
waiting for a retracement in price, decided it was not going to happen. Increased buying
interest happens all of a sudden and the price gaps above the previous day’s close. This
type of runaway gap represents an almost panic state in traders. Also, a good uptrend can
have runaway gaps caused by signifi cant news events that cause new interest in the stock.
Runaway gaps can also happen in down trends. This usually represents increased liquidation
of that stock by traders and buyers who are standing on the sidelines. These can become
very serious as those who are holding onto the stock will eventually panic and sell, but sell to
whom? The price has to continue to drop and gap down to fi nd buyers. Not a good situation.
The futures market at times will have runaway gaps that are caused by trading limits
imposed by the exchanges. Getting caught on the wrong side of the trend when you have
these limit moves in futures can be horrifying. The good news is that you can also be on the
right side of them. These are not common occurrences in the futures market despite all the
wrong information being touted by those who do not understand it and are only repeating
something they read from an uninformed reporter.
3.4.4 Exhaustion gaps
Exhaustion gaps are those that happen near the end of a good up or down trend. They are
many times the fi rst signal of the end of that move. They are identifi ed by high volume and
73
large price difference between the previous day’s close and the new opening price. They can
easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.
It is almost a state of panic if during a long down move pessimism has set in. Selling all
positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly
fi lled as prices reverse their trend. Likewise if they happen during a bull move, some bullish
euphoria overcomes trades and they cannot get enough of that stock. The prices gap up with
huge volume, then there is great profi t taking and the demand for the stock totally dries up.
Prices drop and a signifi cant change in trend occurs.
Exhaustion gaps are probably the easiest to trade and profi t from. In the chart, notice that
there was one more day of trading to the upside before the stock plunged. The high volume
was the giveaway that this was going to be either an exhaustion gap or a runaway gap.
Because of the size of the gap and an almost doubling of volume, an exhaustion gap was in
the making here.
3.4.5 Island cluster
Island clusters are identifi ed by an exhaustion gap followed by a breakaway gap in

opposite direction. They are powerful reversal signals
Conclusion
There is an old saying that the market abhors a vacuum and all gaps will eventually be fi
lled. While this may have some merit for common and exhaustion gaps, holding positions
waiting for breakout or runaway gaps to be fi lled can be devastating to your portfolio.
Likewise if
74
waiting to get on board a trend by waiting for prices to fi ll a gap just might mean you never
participate in the move. Gaps are a signifi cant technical development in price action and in
chart analysis, and should not be ignored. Japanese candlestick analysis is fi lled with
patterns that rely on gaps to fulfi ll their objectives.
*****
New terms
Breakout: A price movement through an identifi ed level of support or resistance, which is

usually followed by heavy volume and increased volatility, is a ‘breakout’. Traders will buy
the underlying asset when the price breaks above a level of resistance and sell when it
breaks below support. A breakout is the bullish counterpart to a breakdown.
Climax: Following a protracted period of selling or buying, a point wherein market trends
are retarded or discontinued. At a selling climax, the market is characterized by a trend
reversal whereby the market begins to buy stocks and prices rise. For a buying climax, the
opposite occurs, and the market begins to sell, resulting in lower prices. The climax is
merely the highest point of selling or buying and can be followed by many trend reversals
Distribution: Distribution is when trading volume is higher than that of the previous day
without any price appreciation.
Double Top: A term used in technical analysis to describe the rise of a stock, a drop,
another rise to the same level as the original rise, and fi nally another drop.
Double Bottom: A charting pattern used in technical analysis. It describes the drop of a
stock (or index), a rebound, another drop to the same (or similar) level as the original drop,
and fi nally another rebound.
Downtrend: A Downtrend describes the price movement of a fi nancial 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.
Exhaustion: Situation in which a majority of participants trading in the same asset are
either long or short, leaving few investors to take the other side of the transaction when
participants wish to close their positions. Exhaustion signals the reversal of the current
trend because it illustrates excess levels of supply or demand.
Long: The buying of a security such as a stock, commodity, or currency, with the
expectation that the asset will rise in value is called ‘Long’.
Overbought: An asset that has experienced sharp upward movements over a very short
period of time is often deemed to be overbought. Determining the degree in which an asset
is overbought is very subjective and can differ between investors.
75
Oversold: Assets that have experienced sharp declines over a brief period of time are often
deemed to be oversold. Determining the degree to which an asset is oversold is very
subjective and could easily differ between investors.
Peak: The highest point between the end of an economic expansion and the start of a
contraction in a business cycle indicates the ‘Peak’. The peak of the cycle refers to the last
month before several key economic indicators, such as employment and new housing starts,
begin to fall. It is at this point that real GDP spending in an economy is its highest level.
Recession: A signifi cant decline in activity spread across the economy, lasting longer than
a few months. It is visible in industrial production, employment, real income and wholesale
retail trade. The technical indicator of a recession is two consecutive quarters of negative
economic growth as measured by a country’s gross domestic product (GDP).
Recession is a normal (albeit unpleasant) part of the business cycle. A recession generally
lasts from six to 18 months. Interest rates usually fall in recessionary times to stimulate the
economy by offering cheap rates at which to borrow money.
Resistance: The price at which a stock or market can trade, but not exceed, for a certain
period of time. This is often referred to as “resistance level”. The stock or market stops rising
because sellers start to outnumber buyers.
Support: ‘Support’ is the price level which historically, a stock has had diffi culty falling
below. It is thought of as the level at which a lot of buyers tend to enter the stock.
Trough: The stage of the economy’s business cycle that marks the end of a period of
declining business activity and the transition to expansion is the Trough.
*****
76
Model Question
Q1 What does a decline below support level indicate?

a) there is lack of sellers
b) buyers are pushing down the price
c) there is lack of buyers and sellers are willing to sell even at lower prices d)
none of the above
Q2 Bulls bid __ the price by increasing demand, bears take it ____by increasing supply
a) down, up
b) up, down
c) up, up
d) down, down
Q3 In Head & Shoulders pattern, which level is achieved by the second rally?
a) Highest point
b) Lowest point
c) Either highest or lowest point
d) Neither highest nor lowest point
Q4 In top reversal head and shoulders pattern, the decline from peak of __________
should break the neckline.
a) left shoulder
b) right shoulder
c) head
d) neckline
Q5 In an inverted head and shoulders pattern, which of the following represent highest
potential for trend reversal?
a) upward sloping neckline
b) downward sloping neckline
c) horizontal neckline
d) vertical neckline
Q6 A break down the support line shows that the_____ have won out over the ____ a)
bulls; bears
b) bears; bulls
77
Q7 In an uptrend, __________ pattern is identifi ed when the price of an asset creates
three peaks, and all the three peaks are of nearly the same level, at the same price
level.
a) Double Bottom
b) Double Top
c) Triple Bottom
d) Triple Top
Q8 Double top is the name given to a pair of peak which is formed when price is unable to
reach a
a) New high
b) New Low
c) Any of the above
d) None of the above
Q9 Which gaps are also known as measuring gaps ?

a) Common gaps
b) Breakaway gaps
c) Runaway gaps
d) Exhaustion gaps
Q10 The Rounded Top formation consists of a gradual change in trend from:
a) Down to up
b) Up to Down
c) Up to Up
d) Down to Down
78
CHAPTER 4 MAJOR INDICATORS AND
OSCILLATORS
Learning objectives
• What are technical indicators and how to interpret them
• Difference between leading and lagging indicators
• Moving Averages – the trend following indicator
• Oscillators – MACD and RSI

• How to look at divergences
• Using multiple indicators for trading signals
A Technical indicator is a mathematical formula applied to the security’s price, volume or

open interest. The result is a value that is used to anticipate future changes in prices.
A technical indicator is a series of data points derived by applying a formula to the price data
of a security. Price data includes any combination of the open, high, low or close over a
period of time. Some indicators may use only the closing prices, while others incorporate
volume and open interest into their formulas. The price data is entered into the formula and
a data point is produced.
4.1 What Does a Technical indicator offer?
Technical analysts use indicators to look into a different perspective from which stock prices
can be analyzed. Technical indicators provide unique outlook on the strength and direction of
the underlying price action for a given timeframe.
4.1.1 Why use indicators?
Technical Indicators broadly serve three functions: to alert, to confi rm and to predict.
Indicator acts as an alert to study price action, sometimes it also gives a signal to watch for
a break of support. A large positive divergence can act as an alert to watch for a resistance
breakout. Indicators can be used to confi rm other technical analysis tools. Some investors
and traders use indicators to predict the direction of future prices.
4.1.2 Tips for using indicators
There are a large number of Technical Indicators that can be used to assist you in selection
of stocks and in tracking the right entry and exit points. In short, indicators indicate. But it
79
doesn’t mean that traders should ignore the price action of a stock and focus solely on the
indicator. Indicators just fi lter price action with formulas. As such, they are derivatives and
not direct refl ections of the price action. While applying the indicators, the analyst should
consider: What is the indicator saying about the price action of a security? Is the price action
getting stronger? Is it getting weaker?
The buy and sell signals generated by the indicators, should be read in context with other
technical analysis tools like candlesticks, trends, patterns etc. For example, an indicator may
fl ash a buy signal, but if the chart pattern shows a descending triangle with a series of
declining peaks, it may be a false signal.
An indicator should be selected with due care and attention. It would be a futile exercise to
cover more than fi ve indicators. It is best to focus on two or three indicators and learn their
intricacies inside and out. One should always choose indicators that complement each other,
instead of those that move in unison and generate the same signals. For example, it would
be redundant to use two indicators that are good for showing overbought and oversold
levels, such as Stochastic and RSI. Both of these indicators measure momentum and both
have overbought/oversold levels.
4.1.3 Types of indicators
Indicators can broadly be divided into two types “LEADING” and “LAGGING”.
Leading indicators
Leading indicators are designed to lead price movements. Benefi ts of leading indicators are
early signaling for entry and exit, generating more signals and allow more opportunities to
trade. They represent a form of price momentum over a fi xed look-back period, which is
the number of periods used to calculate the indicator. Some of the wellmore popular leading
indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index
(RSI), Stochastic Oscillator and Williams %R.
Lagging Indicators
Lagging Indicators are the indicators that would follow a trend rather then predicting a
reversal. A lagging indicator follows an event. These indicators work well when prices move
in relatively long trends. They don’t warn you of upcoming changes in prices, they simply tell
you what prices are doing (i.e., rising or falling) so that you can invest accordingly. These
trend following indicators makes you buy and sell late and, in exchange for missing the early
opportunities, they greatly reduce your risk by keeping you on the right side of the market.
Moving averages and the MACD are examples of trend following, or “lagging,” indicators.
80

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Technical Analysis Module NATIONAL STOCK

EXCHANGE OF INDIA LIMITED

Test Details: No. of

exam 120 75 140 60 NA

Chapter No. Title Weightages

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

Copyright © 2013 by National Stock Exchange of India Ltd. (NSE)

• The basis of technical analysis

• The strengths and weaknesses of technical analysis

1.1 What is Technical Analysis?

The basis of Technical Analysis

• Price discounts everything

• Price movements are not totally random

• What is more important than why

1.1.1 Price discounts everything

1.1.2 Price movements are not totally random

“What” is more important than “Why”

1. The current price

2. The history of the price movement

1.1.3 Technical Analysis: The basic assumptions

The fi eld 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

2. Price moves in trends

3. History tends to repeat itself

1.1.4 Strengths and weakness of Technical Analysis

Not Just for stocks

Fundamental developments are followed by price movements. By focusing only on price

Supply, demand, and price action

Support and resistance

Pictorial price history

• Past and present volatility

• Historical volume or trading levels

• Relative strength of the stock versus the index.

1.1.4.2 Weaknesses of Technical Analysis

TA is also useful in controlling risk

It is more important to control risk than to maximize profi ts!

• The candlestick analysis

• Pattern Psychology – investors’ psychology behind formation of candlestick pattern

2.1 The charts

Types of price charts:

Each candlestick provides an easy-to-decipher picture of price action. Immediately a

2.2 Candlestick analysis

2.2.1 One candle patterns

Hammer and Hanging Man Hammer Hanging Man Candlesticks

2. There should be no upper shadow or a very small upper shadow.

2.2.1.2 Hanging man

Soybean Oil-December, 1990, Daily (Hanging Man and Hammer)

4. The day after the inverted hammer signal opens higher.

2. Prices gap open after an uptrend.

day after the Shooting Star signal opens lower.