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Techniques of Successful Trading!
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Contents
Preface
Technical Analysis
Definition
History, Philosophy & Basic Tenets
Advantages & limitations of Technical Analysis
Chart Construction - Types of Charts
Chapter 2
Dow Theory
Markets discount everything
Definition of Trend - Uptrend, Downtrend, Sideways & Mixed Trend
Retracement & Consolidation
Basic Structure of the Trend - Impulse & Corrective Waves
The Dynamic Impulse
Different Chart durations & their time frame validity
Chapter 4
Continuation Patterns
Triangles
Chapter 7
Moving Averages
Types - Simple / Weighted / Exponential
Signals in respect of Moving Averages
Different Combinations of Moving Averages
Chapter 8
Chapter 9
Trading System
Understanding the Indicators and their strike rate
Choosing between different Tools/Indicators
Combining different Tools/Indicators for optimum results
How to form a Trade Set-up
Ingredients of a Successful Trade setup
Trade Setup II
Trade Setup IV
Trade Setup V
Trade Setup VI
Preface
Stock markets are highly volatile. The sharp movements that occur in stock prices provide us
with great opportunities to make profits if one can time the markets. However, majority of the
traders find themselves on the losing side and end up making huge losses. This is mainly due to
the characteristics of the human mind viz. - Greed, Fear and Hope. Some people never book
profits as they are greedy for more profits whereas some panic and book losses in the fear of
losing heavily only to see the stock move the way they had predicted after they have exited.
The worst affected are those who are on the wrong side of the market trend but still hold on to
a stock in the hope that their price levels will come sooner or later.
Technical Analysis is the art of predicting and forecasting future price trends based on the
current and the historical price data. It is a study of price charts along with volumes and is
based on demand & supply and also depicts the psychology of the masses. The charts take into
account everything that is likely to impact the prices, some of the factors being fundamental
reasons, stock specifics news / results, occurrence of events affecting some sectors / stocks,
political events, natural disasters etc. To summarize Technical Analysis includes everything
that can impact the prices, and the way the prices move indicate the future price trends or the
direction in which the stock prices are likely to move in the future.
The patterns made in the price charts depict the psychology of the masses and will work across
all markets viz. equities, commodities, currency etc. Also patterns will work across all time
horizons i.e. patterns made during the earlier markets highs or lows are likely to be repeated,
may be the price levels of the stocks can differ. Technical Analysis helps in spotting changes in
trends and price patterns based on which one can take timely investment / trading decisions. It
is a very effective tool to time the markets i.e. determine the entry levels, the stop-loss as well
as the target levels. However, a word of caution here is that Technical Analysis is not infallible,
as it is linked to the psychology of the masses and minds of people can be confused, fluctuating
and indecisive at times. At such times Technical Analysis may fail or may not give clear
indications of the direction.
To generate positive returns from the stock markets on a consistent basis, just technical
tools and indicators are not enough. One needs a combination of Technical Indicators, a
proper money management system and most importantly a sound psychological
conditioning of the mind. Also as a trader, one needs a well defined Trade Set-up based
on which one can determine the entry point in a stock, the stop-loss levels, the target
levels (Risk to Reward ratio) and the approximate time horizon. This is an attempt to
understand the age old as well as time tested theories of technical analysis in the context
of our markets & times and practically use it in our investment / trading decisions,
thereby protecting our capital & generating better returns on the same.
The basic difference between Technical Analysis and Fundamental Analysis is that FA
tries to find reasons for a stock to move up or down and based on the reasons predicts
the price movements whereas TA is not concerned with the reasons and it believes that
the way a stock price moves currently tells you where it is heading for in the future.
Chart Construction
The X-axis on a chart plots the periods for which prices are plotted and the Y-axis plots
the value or the price of the share. This could range from a few hours to a few years.
This means that prices can be plotted based on the prices that range from hours to
years. Thus we could have minute charts as well as hourly, daily, weekly, monthly,
quarterly, yearly charts based on the above data.
Short Term Traders trade on the basis of daily charts as they are more interested in the
immediate movement in the stock prices, whereas Medium term to Long term Traders
are more dependent on weekly / monthly charts as they want more returns for which
they are prepared to wait for a longer duration.
There are 3 types of charts which are commonly used by chartists. These are
1. Line charts: The closing prices are plotted on the graph and are joined to form a
line.
2. Bar Charts: The Bar uses open / high / low / close for the session.
3. Candlestick Charts: Also use open / high / low / close for the session.
The 4 quotes that are used to construct a Bar Chart or a Candlestick chart are in the
order of Open / High / Low / Close
Line Chart
High
Open
High
Close
Close
Low
Open
Low
Open
High
Close
Close
Open
Low
Low
High
High
Close
Open
Open
Close
Low
Low
An Uptrend
A Downtrend
A Sideways Trend
In an Uptrend the share prices move in the upward direction making new highs in the
process. Hence the best indication of an Uptrend is the prices making a higher top
higher bottom.
H4
H3
Uptrend
H2
H1
L4
L3
L1
L2
As seen above prices make a higher top as well as a higher bottom and one should try
and buy on every correction in an uptrend.
H1
H2
Down Trend
L1
H3
L2
H4
L3
L4
As seen above prices make a lower high as well as a lower low and one should try and
sell on every rise.
In a Sideways trend the share prices move in a narrow band, neither going upward nor
downward. One should wait for a cleat cut breakout and not trade in a sideways trend.
Sideways Trend
1 to 3 years
6 to 12 months
3 to 6 months
However, a trader should decide his own trading timeframe and accordingly decide
which charts to use.
Period
Seen
Valid For
Daily Charts
Weekly Charts
Monthly Charts
Short term
( 4 - 6 Days)
Medium Term
(4 - 6 Weeks)
Long Term
(4 - 6 Months)
Short Term
(1 - 2 Days)
Intraday Trades
(2 - 3 Hrs)
Importance of Volumes
Volumes lead prices. If prices start moving up on high volumes, there is a very good
chance that this rise will be sustained. However, it very important to understand where
the volumes have occurred and the price movement that that has taken place along with
the volumes.
Broadly one can conclude that:
Price Action
Interpretation
Bullish
Not so Bullish
Bearish
Not so Bearish
Trend line
Support
SUPPORT
RESISTANCE
Trendlines
Retracement Levels
Significant highs and lows are those levels from where the markets have moved up or
have fallen down sharply in the past. When the stock prices test these levels anytime in
the future, they will act as strong support and resistance levels.
A Trend line is another excellent tool which gives us important Support and Resistance
levels. A trendline is a line joining 2 or more significant highs or lows or 2 important
prices, which gives important support and resistance levels.
One should Buy when the price takes support on the Trendline and moves up &
Sell when the price meets with resistance at a Trendline and moves down.
Channel Lines are 2 parallel lines within which the price of a share moves in a
sideways trend. They are very effective in a sideways market and also when the
trend changes from sideways to either direction.
Retracement is the correction that occurs in the price of a share. In a falling market
the retracement will be in the upward direction and in a rising market it will be in the
downward direction.
A
61.8% R
38.2% S
50%R
50%S
38.2% R
61.8% S
Breakout is the phenomenon where the prices move upwards out of a range
breaking an important resistance level in the process. Normally a breakout is to be
supported by high volumes and it indicates a further up move in that stock.
Pullback is the tendency of the share prices to come back towards the Trend line
after a breakout or a breakdown and is a precursor to a big / dynamic move that is
to follow.
Continuation Patterns
Patterns are formations on charts which can be identified by a set of similar
characteristics which occur time and again. Patterns reflect the mindset of the masses at
that point of time and work very well in trended markets.
Continuation Patterns are patterns which occur in continuation of a move. They show
the continuation of the trend. Needless to say that one can get an entry when a part of
the move is already over and not at the beginning of a move. The best thing about
continuation patterns is that, once the pattern is confirmed these patterns give a sense
of the targets in terms of price as well as time and they work accurately most of the
times. Though one gets an entry based on a continuation pattern not exactly at the
beginning of a move, the targets come very fast in most of the continuation patterns.
Rising Wedge: A Wedge is a sloping triangle. In case we have a break down from an
upward sloping triangle it is termed as a rising wedge. All the other properties of
triangles remain the same for a Rising Wedge. A Rising Wedge at or near the market top
is very bearish and a sharp decline in the prices is likely once the prices break down
from the rising wedge.
Rising Wedge Breakdown
The Inverse Head & Shoulder pattern is exactly opposite of the Head & Shoulders
pattern and occurs at market bottoms. The Inverse H & S is an upward reversal
pattern. The Trendline joining the two shoulders and the head is termed as the
neckline.
The target after the breakout and the pullback, in case there is a pull back, is equal to the
length from the neckline to the bottom of the head. The target of price movement of C to
D in the above case is equal to the price movement of A to B. Inverse Head & Shoulders
pattern at significant market bottoms can lead to a trend reversal from bearish to
bullish and as such is also termed as a reversal pattern.
Pennant Breakout
The difference between a flag and a pennant is that, in a flag there is a rectangle and in a
pennant there is a triangle after the flagpole which resembles the sharp rally or the fall
before the consolidation.
The targets for both patterns are measured similarly. The length of the flagpole is
replicated once the breakout or the breakdown occurs and the target measured from
the breakout / breakdown point is equal to the length of the flagpole.
Hanging
Man
Piercing Pattern
Morning
Star
Cutting into 50% or more of the 1st body
Evening
Star
Tweezers Bottoms
Tweezers Tops
Island Reversals
Island Reversals
Gravestone Doji
Harami Cross
Spinning Top
13 / 34 / 55
3 / 8 / 13
1/3/5
Moving Averages theory is a confirmatory theory and is criticized on the count that
many a times it gives late signals but the positive thing is that it gives confirmed signals.
MAs used
13 / 34 / 55
Book
profit
55 Days EMA
Buy II
34 Days EMA
13 Days EMA
Buy I
Signals from MA s.
The 3 MA s should be in the Ascending order i.e. lowest MA at the bottom, and
highest MA at the top.
The first signal to buy (Anticipatory) is when the price cuts the Short term MA
from the bottom.
The second signal to buy (Confirmatory) is when the Short term MA cuts the
Long term MA from the bottom which confirms that the trend is going to
continue.
When the 2nd MA line cuts the third MA line, though the trend continues to
remain up, a good correction normally occurs and one should book profits.
In case the trend changes in between, the Short term or the lowest MA will turn
down. If this happens one should exit the stock.
13 Days EMA
34 Days EMA
Sell I
Sell II
55 Days EMA
MAs used
13 / 34 / 55
Book
Profit
The 3 MA s should be in the order such as the lowest MA at the top, and highest
MA at the bottom.
The first signal to sell (Anticipatory) is when the price cuts the Short term MA
from the top.
The second signal to sell (Confirmatory) is when the Short term MA cuts the
Medium term MA from the top.
When the 2nd MA line cuts the third MA line, though the trend continues to
remain down, a good correction normally occurs and one should book profits.
In case the trend changes in between, the Short term or the lowest MA will turn
up. If this happens one should exit the stock.
8 Days EMA
EMAs used
3/8
Buy
3 Days EMA
Oscillator Analysis
Oscillators or momentum indicators as that are called at times give an advance
indication of change in trend. Oscillators are drawn along with the price to spot signals.
Some commonly used Oscillators are
STOCHASTICS (% K 5, % D 3, E 3)
The most common of the above is the RSI and the Stochastics. Between these two, many
traders prefer the Stochastics as it is smoother and does not turn too often. Also it helps
spot smaller moves. MACD gives good signals but late signals.
STOCHASTICS (% K 5, % D 3, E 3)
The 2 dotted lines are the overbought and oversold zones.
The Oscillator has 2 lines. One is the Oscillator line and the other is the trigger line.
When the Oscillator goes above the overbought zone, it means that a lot of buying has
taken place and that a downward correction may be overdue. Similarly when the
Oscillator goes below the oversold zone, it means that a lot of selling has taken place
and that an upward correction may be overdue.
The overbought and oversold zones are normally 70 and 30 in the RSI and 75 and
25 in the Stochastics. However, they are indicative and can be changed as per the
stock as well as the market conditions.
Negative Divergence
Sell in the overbought zone when there is a Negative Divergence between the
price and the Oscillator. I.e. the price making a higher top but Oscillator making a
lower top.
Positive Divergence
Buy in the oversold zone when there is a Positive Divergence between the price
and the Oscillator. I.e. the price making a lower bottom top but Oscillator making
a higher bottom.
2. Crossover
Sell
Over Sold
Sell
Buy
Oscillator Line
Buy
Trigger Line
Buy in the overbought zone when the Oscillator line cuts the trigger line from
below on the first day.
OR
Sell in the overbought zone when the Oscillator line cuts the trigger line from
above on the first day
An Oscillator gives early signals but it also gives many whipsaws (false
signals). To avoid this it should be used along with patterns and other
indicators and not in isolation.
Stop-Loss
The word Stop-loss means stopping a further loss. It means that one should square of
the deal if it goes against him as it would save a further bigger loss. That means a trader
who has a long position has to keep his stop-loss at a price which is lower than that.
Similarly a trader carrying a short position should have his stop-loss at a higher level.
Stop-losses are ideally meant to protect a trader or an investor from a sudden change of
trend of the markets in general or a stock in particular.
Stop-Loss
Sell
Buy
Stop-Loss
Stop-Loss
Trend line
Buy
Sell
Stop-Loss
Trend line
A reversal pattern at the right place: A right place for a reversal pattern is at a
significant market top or a bottom. This can be identified by a rise of around 8 /
13 or 21 days from an important high or a low. Also if one is buying or selling
after a correction, one must also ensure that the pattern has occurred at the
retracement level of at least 50 %.
Risk to Reward ratio of 1: 3 on every trade spotted: One cannot time the
market to perfection all the time and end up buying at bottoms and selling at
tops. Hence a good strategy has to be formed to supplement the Technical signals
one generates. At times a trader can end up losing money even if his call is right
but is not supported by the right trading strategy and vice versa. One has to buy
or sell in such a way that his R to R ratio is always 1: 2 or more.
Trade Setup II
At Breakouts / Breakdowns
along with a Continuation Pattern giving Price & Time targets
Trade Setup IV
Trade Setup V
Trade Setup VI
Fall in Prices
Rise in Prices
Rise in Volumes
Rise in Prices
Rise in Volumes
Rise in Prices
Rise in Volumes
Rise in Prices
after consolidation
Rise in Volumes
Multiple Resistances
Multiple Supports
Multiple Supports
Resistance 1
Resistance 2
Breakdown
Likely TGT
after
Breakdown
Breakdown
Likely TGT
Likely TGT
Time
TGT
Triangular Formation
Rising Wedge
Breakdown
Symmetrical
Triangular
Breakout
Breakout
V Pattern
Rounding
Bottom
Inverse H&S
Breakout
V Pattern
Breakout
Inverse H&S
Breakout
Fig 6.1 BSE Sensex Weekly Chart - Nov 2007 - Jan 2008
Trend is your Friend Always Trade in the direction of the Trend with
reasonable stop - loss levels and never against it. As a Trader one is
concerned about the Trend for the next 4 to 5 days. If, after a continuous
rise or a fall for a few days some reversal patterns appear, one can take
this as a trading opportunity.
Ride on Profits & cut losses If a trading decision is right one can
partly book profits partly & wait for more gains depending upon in
which phase of the settlement one is in. However, if one is caught one
the wrong side, it is better to square of rather than wait for things to
happen in your favour. However, if one is certain and has decided the
stop loss levels, one should not panic and reverse the decision in haste.
Do not be too Greedy Even though one is one the right side of the
Trend and one should ride the trend one should not get too greedy and
book profits at pre-decided target levels.
Always be Flexible!!
Make use of all the Trading Tools for and do not be over dependent
on any particular tool or be biased towards or against any particular
tool. No one Technique or Tool seen above is more important or less
important than the others. All are equally important. Different Tools
work better than other & give different results at times. Ideally one
should use a combination of Japanese Candlesticks Patterns /
Trendlines as well as previous significant levels for Support &
Resistance Moving Averages / Oscillators / Volume Breakouts and take
a decision when majority of these indicators are favourable.