Technical Analysis Course Book

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Road, Gurgaon - 122002
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What is Technical Analysis
• The word technical comes from the Greek technikos,
relating to art or skillful. Webster’s goes on to define
technical as having special and practical knowledge.
• Technical Analysis is the forecasting of future financial
price movements based on an examination of past
price movements.
• Technical analysis does not result in absolute
predictions about the future. Instead, technical analysis
can help investors anticipate what is "likely" to happen
to prices over time.
• It is an Art more than a Science.
International School of Financial Market (ISFM)
Best Stock Market School - Gurgaon
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Technical analysis can be applied to:-
 Stock market
 Commodities
 Futures Derivatives
 Currencies etc.
What are Charts ?
• A price chart is a sequence of prices plotted over a
specific time frame. In statistical terms, charts are
referred to as time series plots. The word “Securities”
refers to any tradable financial instrument or quantifiable
index such as stocks, bonds, commodities, futures or
market indices. A graphical historical record makes it easy
to spot the effect of key events on a securities’s price, its
performance over a period of time and whether it’s
trading near its highs, near its lows, or in between.
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Types of Charts
• Bar Chart
• Line Chart
• Candle Stick
Line Chart
* The most basic of the four charts is the line chart because it
represents only the closing prices over a set period of time.
* The line is formed by connecting the closing prices over the
time frame.
* Line charts do not provide visual information of the trading
range for the individual points such as the high, low and
opening prices.
* However, the closing price is often considered to be the
most important price in stock data compared to the high and
low for the day and this is why it is the only value used in line
charts.
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Line
Bar Chart
* The bar chart expands on the line chart by adding several more key peices
of information to each data point.
* The chart is made up of a series of vertical lines that represent each data
point.
* This vertical line represents the high and low for the trading period, along
with the closing price. The close and open are represented on the vertical
line by a horizontal dash.
* The opening price on a bar chart is illustrated by the dash that is located on
the left side of the vertical bar. Conversely, the close is represented by the
dash on the right. Generally, if the left dash (open) is lower than the right
dash (close) then the bar will be shaded black, representing an up period for
the stock, which means it has gained value.
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low
high
closing
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Candlestick Chart
• Originated in Japan over 300 years ago.
Candlesticks charts have become quiet
popular in recent years.
• The candlestick chart is similar to a bar chart
but it differs in the way that it is visually
constructed.
• Similar to the bar chart, the candlestick also
has a thin vertical line showing the period's
trading range.
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Properties of Charts
• There are several things that you should be
aware of when looking at a chart, as these
factors can affect the information that is
provided. They include :-
• Time Scale
• Price Scale
• Volume Range
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Time Scale
• The time scale refers to the range of dates at the
bottom of the chart, which can vary from
decades to seconds. The most frequently used
time scales are
• intraday
• daily
• weekly
• monthly
• quarterly
• annually
The Price Scale and Price Point Properties
• The price scale is on the right-hand side of the chart.
It shows a stock's current price and compares it to
past data points. This may seem like a simple concept
in that the price scale goes from lower prices to
higher prices as you move along the scale from the
bottom to the top.
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Price
scale
Time scale
Price Scale
Trends
“A Trend represents a consistent change in prices i.e. a
change in investors’ expectations”.
One of the most important concept is Technical Analysis
is that of trend. A trend is nothing more than the
general direction in which a securities or market is
headed. In other words A Trend represents a consistent
change in prices i.e. a change in investors’ expectations.
Unfortunately, trends are not always easy to see. In
other words defining a trend goes well beyond the
obvious. In any particular given chart, you will probably
notice that price does not tend to move in a straight line
in any direction, but rather in a series of high and lows.
In Technical analysis it is the movement of high and lows
that constitutes a TREND. Trend is your friend.
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Bull (or uptrend)-price rises
• A bull market is indicated by progressively
higher highs and higher lows, also called an
uptrend.
• When the securities price increases more than
20% within two weeks then it is a confirm
‘bullish trend’.
• Volume of the securities increase continues
and everyday closes on a higher price.
Up trend
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Bear (or downtrend)-price falls
A bearish market is indicated by progressively
lower highs and lower lows.
When the securities price moves down more
than 20% within two weeks, then it is a confirm
bearish trend in the market.
Volume of the securities increases but with
selling pressure and make a new low everyday.
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Flat (Sideways)
When the securities price neither move up
side more and neither move downside then its
because some range bound market.
In this trend securities price doesn’t make
new high and low there is less volume as
compared to up & down trend.
Flat Trend
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What is Trend Line
• The trendline is perhaps the simplest and most valuable tool
available to the chartist. An up trendline is a straight line
drawn up and to the right, connecting successive rising
market bottoms. The line is drawn in such a way that all of the
price action.
• Types of Trend lines:
• 1. Down Trend line
• 2. Up Trend line
How to draw a Trendline
• A down trendline is drawn down and to the right, connecting
the successive declining market highs.
The line is drawn in such a way that all of the price action is
below the trendline.
• An up trendline, for example, is drawn
when at least two rising reaction lows (or troughs) are visible.
However, while it takes two points to draw a trendline,a third
point is necessary to identify the line as a valid trend line. If
prices in an uptrend dip back down to the trendline a third
time and bounce off it, a valid up trendline is confirmed
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Uses of Trend lines
• Trendlines have two major uses. They allow identification of
support and resistance levels that can be used, while a market
is trending, to initiate new positions. As a rule, the longer a
trendline has been ain effect and the more times it has been
tested, the more significant it becomes. The violation of a
trendline is often the best warning of a change in trend.
• Price Channels are lines set above and below the price of a
securities. The upper channel is set at the x-period high and
the lower channel is set at the x-period low. For a 20-day Price
Channel, the upper channel would equal the 20-day high and
the lower channel would equal the 20-day low. The dotted
centerline is the midpoint between the two channel lines.
Price Channels can be used to identify upward thrusts that
signal the start of an uptrend or downward plunges that signal
the start of a downtrend. Price Channels can also be used to
identify overbought or oversold levels within a bigger
downtrend or uptrend.
• Calculation
• Upper Channel Line: 20-day high
• Lower Channel Line: 20-day low
• Centerline: (20-day high + 20-day low)/2
What is Price Channels
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•
• Price Channels can be used to identify trend reversals or
overbought/oversold levels that denote pullbacks within a
bigger trend. A surge above the upper channel line shows
extraordinary strength that can signal the start of an uptrend.
Conversely, a plunge below the lower channel line shows
serious weakness that can signal the start of a downtrend.
Once an uptrend has started, chartists can move to a shorter
timeframe to identify pullbacks with oversold readings. A
move below the lower channel line indicates oversold
conditions that can foreshadow an end to the pullback.
Similarly, short-term bounces within a bigger uptrend can be
identified with Price Channels. A move above the upper
channel line signals overbought conditions that can
foreshadow an end to the bounce.
Interpretation
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• Price Channels tells us when a securities reaches an xx-
period high or an xx-period low. 20-day Price Channels mark
the 20-day high-low range, 10-week Price Channels mark the
10-week high-low range. The centerline marks the midpoint.
Securities that continuously exceed the upper channel line
show strength. After all, it takes strong buying pressure to
forge higher highs. Conversely, securities that continuously
break the lower channel line show weakness. Strong selling
pressure is evident with lower lows. Using Price Channels,
chartists can determine the dominant force, buying pressure
or selling pressure. As with all indicators, it is important to use
other analysis techniques to confirm or refute the Price
Channels. Chartists can use chart patterns, indicators or basic
chart analysis to complement Price Channels.
Conclusions
• Price Channels can be used to identify strong moves that may result in
lasting trend reversals. Basically, a move above the 20-day Price
Channel signals a new 20-day high. A move above the 20-week Price
Channel signals a new 20-week high. Obviously, a 20-week high is more
consequential than a 20-day high. The choice of timeframe depends on
your trading timeframe and rationale for using Price Channels. For
example, chartists can use weekly charts with 20-week Price Channels
to determine the big trend and overall trading bias.
• Price Channels are similar to the Stochastic Oscillator when one
considers what the Stochastic Oscillator measures. This momentum
oscillator measures the level of the close relative to the high-low range
over a given period of time, say 20 days. The Stochastic Oscillator is
relatively high when the close is near the high end of its 20-day range
and low when the Stochastic Oscillator is near the low end of this
range. Put in numbers, the Stochastic Oscillator is relatively high above
80 and relatively low below 20.
Trend Identification
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Support
Support is a level below the market where buying pressure exceeds
selling pressure and a decline is halted.
Resistance is marked by a previous market peak. Resistance is a
level above the market where selling pressure exceeds buying
pressure and a rally is halted
Areas of congestion or previous lows below the current price mark
support levels. A break below support would be considered bearish.
When the price of the securities go below the support level then
support become the resistance and when the price go above the
resistance level then resistance become the support level, when the
stock move down from high level.
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• Support and Resistance represent key junctures where the forces of
demand and supply meet. In the financial market, prices are driven
by excessive supply (down) and demand (up). Supply is synonymous
with bearish, bears and selling.
• Demand is synonymous with bullish, bull and buying.
• There are two important cases of demand and supply in support and
resistance levels:-
• (1). As demand increases, prices advance and as supply increases,
prices decline.
• (2). When supply and demand are equal, prices moves sideways as
bulls and bears slug it out of control.
• Where is Support established? Support price are usually below the
current price, but it is not uncommon for a securities to trade at or
near support. Technical analysis is not an exact science and it is
sometimes difficult to set exact support levels. For this reason, some
traders and investors establish support zones.
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Pivots Points
• Pivots Points are significant levels chartists can use to
determine directional movement and potential
support/resistance levels. Pivot Points use the prior period's
high, low, and close to estimate future support and resistance
levels. In this regard, Pivot Points are predictive or leading
indicators. There are at least five different versions of Pivot
Points. This article will focus on
• 1. Standard Pivot Points
• 2. Demark Pivot Points
• 3. Fibonacci Pivot Points
Time Frame
• Pivot Points for 1-, 5-, 10- and 15-minute charts use the prior
day's high, low and close. In other words, Pivot Points for
today's intraday charts would be based solely on yesterday's
high, low and close. Once Pivot Points are set, they do not
change and remain in play throughout the day.
• Pivot Points for 30- 60- and 120-minute charts use the prior
week's high, low, and close. These calculations are based on
calendar weeks. Once the week starts, the Pivot Points for 30-
60- and 120-minute charts remain fixed for the entire
week. They do not change until the week ends and new
Pivots can be calculated.
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Standard Pivot Points
• Standard Pivot Points begin with a base Pivot Point. This is a
simple average of the high, low and close. The middle Pivot
Point is shown as a solid line between the support and
resistance pivots. Keep in mind that the high, low and close
are all from the prior period.
• Pivot Point (P) = (High + Low + Close)/3
• Support 1 (S1) = (P x 2) - High
• Support 2 (S2) = P - (High - Low)
• Resistance 1 (R1) = (P x 2) - Low
• Resistance 2 (R2) = P + (High - Low)
Fibonacci Pivot Points
• Fibonacci Pivot Points start just the same as Standard Pivot
Points. From the base Pivot Point, Fibonacci multiples of the
high-low differential are added to form resistance levels and
subtracted to form support levels.
• Pivot Point (P) = (High + Low + Close)/3
• Support 1 (S1) = P - {.382 * (High - Low)}
• Support 2 (S2) = P - {.618 * (High - Low)}
• Support 3 (S3) = P - {1 * (High - Low)}
• Resistance 1 (R1) = P + {.382 * (High - Low)}
• Resistance 2 (R2) = P + {.618 * (High - Low)}
• Resistance 3 (R3) = P + {1 * (High - Low)}
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Demark Pivot Points
• Demark Pivot Points start with a different base and use
different formulas for support and resistance. These Pivot
Points are conditional on the relationship between the close
and the open.
• If Close < Open, then X = High + (2 x Low) + Close
• If Close > Open, then X = (2 x High) + Low + Close
• If Close = Open, then X = High + Low + (2 x Close)
• Pivot Point (P) = X/4
• Support 1 (S1) = X/2 - High
• Resistance 1 (R1) = X/2 - Low
Moving Average
• In statistics, a moving average is also called rolling
average, rolling mean or running average.
Moving average tells you short-term fluctuations
and highlight longer-term trends.
• Moving average can be used in variety of ways. It
depends on your requirement like if you are a
short term investor then you can use 5-13-21
days and if you are a long term investor then you
can use 100 days or 200 days moving average.
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Types of Moving Average
• Simple Moving Average
• Exponential Moving Average
• Weighted Moving Average
Simple Moving Average
* A simple moving average (SMA) is the unweighted mean of the
previous n data points. For example, a 10-day simple moving
average of closing price is the mean of the previous 10 days'
closing prices.
* In technical analysis there are various popular values for n, like
10 days, 40 days, or 200 days. The period selected depends on
the kind of movement one is concentrating on, such as short,
intermediate, or long term. In any case moving average levels
are interpreted as support in a rising market, or resistance in a
falling market.
* Simple moving average ‘focus on overall price history’ and tell
us about whole past price movement of the securities.
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Exponential Moving Average (EMA)
• EMA’s reduce the lag by applying more weight to
recent prices relative to older prices. The weighting
‘applied to the most recent price depends on the
specified period’ of the moving average. The shorter
the EMA’s period, the more weight that will be applied
to the most recent price. For example: a 10 days period
exponential moving average weighs the most recent
price.
• The important thing to remember is that the
exponential moving average puts more weight on
recent prices. As such, it will react quicker to recent
price changes than a simple moving average.
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Which is better?
• It depends on your trading and investing styles and performances. The
simple moving average obviously has a lag, but the exponential moving
average may be prone to quicker breaks. Some traders prefer to use
exponential moving averages for shorter time periods to capture changes
quicker. Some investors prefer simple moving averages over long time
periods to identify long-terms changes.
• For moving averages, the one dilemma applies. Shorter moving averages
will be more sensitive and generate more signals. The EMA, which is
generally more sensitive than the SMA, will also be likely to generate more
signals.
• These signals will likely prove more reliable, but they also may come late.
Each investor or trader should experiment with different moving average
lengths and types to examine the trade-off between sensitivity and signal
reliability.
Uses of Moving Averages
• There are many uses for moving averages, but
three basic uses stand out:
• Generate buy and sell signal.
• Trend identification/confirmation.
• Support and Resistance level
identification/confirmation.
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Trading Systems
• The first trend identification technique uses the direction of the
moving average to determine the trend. If the moving average is
rising, the trend is considered up. If the moving average is declining,
the trend is considered down. The direction of a moving average
can be determined simply by looking at a plot of the moving
average or by applying an indicator to the moving average.
• This is not a scientific study, but a number of significant turning
points can be spotted just based on visual observation.
• The second technique for trend identification is based on the
location of the shorter moving average relative to the longer
moving average. If the shorter moving average is above the longer
moving average, the trend is considered up. If the shorter moving
average is below the longer moving average, the trend is considered
down.
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Support and Resistance Levels
• Another use of moving average is to identify support
and resistance levels. This is usually accomplished with
one moving average and is based on historical
precedent. As with trend identification, support and
resistance level identification through moving averages
work best in trend markets.
• Moving averages are available as a price overlay feature
on Charts. From the price overlay option, you can
choose either a simple moving average or an
exponential moving average.
• The first parameter is used to set the number of time
periods.
Buy and Sell signal
• When the lower (13 days)moving average cut
the upper ( 21 days) average then you can buy
the securities on that level.
• When the 13 days moving average cut the 21
days average from upper to down then you
can sell the securities.
• Another way you can use 5,13,26 as a
anticipatory buy and sell signal for any
securities.
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Mor Strategy
• Mor Strategy is developed by Mr. Anil Mor on EMA with the
combination of shorter and longer moving average to know
the breakout or breakdown in the market.
• This strategy is mostly help to the options investor to pick the
right time call and put on a reasonable premium so that we
can get the benefits from the movement of the securities.
• Shorter EMA combination should be 2,5,8,12,15,18
• Longer EMA combination should be 25,30,35,40,45,50
• It all about intersection of the moving average where we can
generate the buy and sell signal from the market.
Mor Strategy
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Mor Strategy
Mor Strategy
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Mor Strategy
OSCILLATORS
• Oscillators sold the bottom of the price chart and fluctuates
within a market conditions. The oscillator is plotted on are
used to identify overbought and over horizontal band. When
the oscillator line reaches the upper
limit of the band, a market is said to be overbought and
vulnerable to a short-term setback. When the line is at the
bottom of
the range, the market is oversold and probably due for a rally.
The oscillator helps to measure market extremes and tells the
chartist when a market advance or decline has become
overextended.
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Relative Strength Index (RSI)
* The Relative Strength Index was developed by J. Welles Wilder
and published in a 1978 book, New Concepts in Technical
Trading Systems.
* ‘RSI’ is a trading indicator in the technical analysis of financial
markets. It is intended to indicate the current and historical
strength or weakness of a market based on the closing prices of
completed trading periods. It assumes that prices close higher
in strong market periods, and lower in weaker periods and
computes this as a ratio of the number of incrementally higher
closes to the incrementally lower closes.
* It compares the magnitude of a stock’s recent gains to the
magnitude of its recent losses and turns that information into a
number that ranges from 0 to 100 and average period of using
the RSI is 14 days.
Calculation
•
• To simplify the calculation explanation, RSI has been broken down into its
basic components: RS, Average Gain and Average Loss. This RSI
calculation is based on 14 periods, which is the default suggested by
Wilder in his book. Losses are expressed as positive values, not negative
values.
• The very first calculations for average gain and average loss are simple 14-
period averages.
• First Average Gain = Sum of Gains over the past 14 periods / 14.
• First Average Loss = Sum of Losses over the past 14 periods / 14
• The second, and subsequent, calculations are based on the prior averages
and the current gain loss:
• Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
• Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
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Uses of RSI
• Overbought/Oversold
• If the RSI goes below 30 level it is considered
oversold for the underlying stock. Conversely,
if the RSI rises above 70 it is consider
overbought zone.
• Generally if the RSI rises above 50 it is
considered bullish for the underlying stock.
Conversely, if the RSI falls below 50, it is a
bearish signal.
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Buy and Sell signal
• RSI generates a signal of buy and sell for you. When the RSI
cross the centerline(40), it is a bullish signal and price may
go up. And when the price goes down from the
centerline(40), it means prices are going to decline in near
future.
• But here overbought means not a sell signal and oversold
means not a buy signal because a stock may move in
overbought zone as well as oversold zone respectively but in
the case of index this formula may be weak because Index
can’t stay in overbought and oversold zone for long time as
compare to securities.
• So you should wait for good signal that occurs from the RSI
and other supportive tools like Trend, MACD and Divergences
etc.
Divergence
• Positive divergence --- above 50 scale
• Negative divergence--- below 30 scale
• You should buy and sell mostly on the second
signal generated by the RSI.
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Divergence
Divergence occurs when an indicator and the price of an asset
are heading in opposite directions. Negative divergence
happens when the price of a securities is in an uptrend and a
major indicator—such as the moving average convergence
divergence (MACD), price rate of change (ROC) or relative
strength index (RSI)—heads downward. Conversely, positive
divergence occurs when the price is in a downtrend but an
indicator starts to rise. These are usually reliable signs that the
price of an asset may be reversing. When using divergence to
help make trading decisions, be aware that indicator
divergence can occur over extended periods of time, so tools
such as trend lines and support and resistance levels should
also be used to help confirm the reversal.
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Trend identification
• In Technical Analysis for the Trading Professional, Constance Brown
suggests that oscillators do not travel between 0 and 100. This also
happens to be the name of the first chapter. Brown identifies a bull market
range and a bear market for RSI. RSI tends to fluctuate between 40 and 90
in a bull market (uptrend) with the 40-50 zones acting as support. These
ranges may vary depending on RSI parameters, strength of trend and
volatility of the underlying securities.
• On the flip side, RSI tends to fluctuate between 10 and 60 in a bear market
(downtrend) with the 50-60 zone acting as resistance. The 40-50 zone
subsequently marked resistance until a breakout.
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Conclusions
• RSI is a versatile momentum oscillator that has stood the test of time. Despite
changes in volatility and the markets over the years, RSI remains as relevant
now as it was in Wilder's days. While Wilder's original interpretations are useful
to understanding the indicator, the work of Brown and Cardwell takes RSI
interpretation to a new level. Adjusting to this level takes some rethinking on
the part of the traditionally schooled chartists. Wilder considers overbought
conditions ripe for a reversal, but overbought can also be a sign of strength.
Bearish divergences still produce some good sell signals, but chartists must be
careful in strong trends when bearish divergences are actually normal. Even
though the concept of positive and negative reversals may seem to undermine
Wilder's interpretation, the logic makes sense and Wilder would hardly dismiss
the value of putting more emphasis on price action. Positive and negative
reversals put price action of the underlying securities first and the indicator
second, which is the way it should be. Bearish and bullish divergences place the
indicator first and price action second. By putting more emphasis on price
action, the concept of positive and negative reversals challenges our thinking
towards momentum oscillators.
Stoch RSI
• Developed by Tushar Chande and Stanley Kroll, StochRSI is
an oscillator that measures the level of RSI relative to its high-low range
over a set time period. StochRSI applies the Stochastics formula to RSI
values, instead of price values. This makes it an indicator of an indicator.
The result is an oscillator that fluctuates between 0 and 1.
• In their 1994 book, The New Technical Trader, Chande and Kroll explain
that RSI can oscillate between 80 and 20 for extended periods without
reaching extreme levels. Notice that 80 and 20 are used for overbought
and oversold instead of the more traditional 70 and 30. Traders looking
to enter a stock based on an overbought or oversold reading in RSI
might find themselves continuously on the sidelines. Chande and Kroll
developed StochRSI to increase sensitivity and generate more
overbought/oversold signals.
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Calculation
•
• StochRSI measures the value of RSI relative to its high/low range over a set
number of periods. The number of periods used to calculate StochRSI is
transferred to RSI in the formula. For example, 14-day StochRSI would use the
current value of 14-day RSI and the 14-day high-low range for 14-day RSI.
• 14-day StochRSI equals 0 when RSI is at its lowest point for 14 days.
• 14-day StochRSI equals 1 when RSI is at its highest point for 14 days.
• 14-day StochRSI equals .5 when RSI is in the middle of its 14-day high-low
range.
• 14-day StochRSI equals .2 when RSI is near the low of its 14-day high-low
range.
• 14-day StochRSI equals .80 when RSI is near the high of its 14-day high-low
range.
StochRSI = (RSI - Lowest Low RSI) / (Highest High RSI - Lowest Low RSI)
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Interpretation
• It is important to remember that StochRSI is an indicator of an indicator,
which makes it the second derivative of price. This means it is two steps
(formulas) removed from the price of the underlying securities. Price
has undergone two changes to become StochRSI. Converting prices to
RSI is one change. Converting RSI to the Stochastic Oscillator is the
second change. This is why the end product (StochRSI) looks much
different than the original (price).
• StochRSI has characteristics similar to most bound momentum
oscillators. First, it can be used to identify overbought or oversold
conditions. A move above .80 is considered overbought, while a move
below .20 is considered oversold. Second, it can be used to identify the
short-term trend. As a bound oscillator, the centerline is at .50. StochRSI
reflects an uptrend when consistently above .50 and a downtrend when
consistently below .50. Because this indicator is quite volatile, some
smoothing with a moving average can help for short-term trend
identification.
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Overbought/Oversold
• Trend identification is the key to successfully choosing between
overbought and oversold levels. It is important to look for
oversold conditions when the bigger trend is up and overbought
conditions when the bigger trend is down. In other words, look
for trades in the direction of the bigger trend. 14-day StochRSI
would be considered a short-term indicator. Therefore, it is
important to identify the medium-term trend when looking for
overbought and oversold conditions.
• 14-day RSI did not become oversold during this timeframe
because it is less sensitive. Oversold is not the same as bullish
though. It serves as a warning to watch for a bounce. A catalyst is
still needed to solidify the low and signal an actual upturn. In this
example, chartists could look for prices to break above the 10-day
SMA or for StochRSI to break above .50, its centerline.
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Conclusion
• StochRSI is like RSI on steroids. RSI produces relatively fewer
signals and StochRSI dramatically increases the signal count.
There will be more overbought/oversold readings, more
centerline crosses, more good signals and more bad signals.
Speed comes at a price. This means it is important to use StochRSI
with other aspects of technical analysis for confirmation. The
examples above use gaps, support/resistance breaks, and price
patterns to confirm StochRSI signals. Chartists can also employ
other complementary indicators, such as On Balance Volume
(OBV) or the Accumulation Distribution Line. These volume-based
indicators do not overlap with momentum oscillators. Chartists
should also experiment with various settings and learn the
nuances of StochRSI before using it in the real world.
Stochastic Oscillator
• Developed by George C. Lane in the late 1950s, the
Stochastic Oscillator is a momentum indicator that shows
the location of the close relative to the high-low range over
a set number of periods. According to an interview with
Lane, the Stochastic Oscillator “doesn't follow price, it
doesn't follow volume or anything like that. It follows the
speed or the momentum of price. As a rule, the
momentum changes direction before price.” As such,
bullish and bearish divergences in the Stochastic Oscillator
can be used to foreshadow reversals. This was the first, and
most important, signal that Lane identified. Lane also used
this oscillator to identify bull and bear set-ups to anticipate
a future reversal. Because the Stochastic Oscillator is range
bound, is also useful for identifying overbought and
oversold levels.
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Calculation
• %K = (Current Close - Lowest Low)/(Highest High - Lowest Low) *
100
• %D = 3-day SMA of %K
• Lowest Low = lowest low for the look-back period
• Highest High = highest high for the look-back period
• %K is multiplied by 100 to move the decimal point two places
• The default setting for the Stochastic Oscillator is 14 periods, which
can be days, weeks, months or an intraday timeframe. A 14-period
%K would use the most recent close, the highest high over the last
14 periods and the lowest low over the last 14 periods. %D is a 3-
day simple moving average of %K. This line is plotted alongside %K
to act as a signal or trigger line.
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Interpretation
• The Stochastic Oscillator measures the level of the close
relative to the high-low range over a given period of time.
Assume that the highest high equals 110, the lowest low
equals 100 and the close equals 108. The high-low range is 10,
which is the denominator in the %K formula. The close less
the lowest low equals 8, which is the numerator. 8 divided by
10 equals .80 or 80%. Multiply this number by 100 to find %K
%K would equal 30 if the close was at 103 (.30 x 100). The
Stochastic Oscillator is above 50 when the close is in the
upper half of the range and below 50 when the close is in the
lower half. Low readings (below 20) indicate that price is near
its low for the given time period. High readings (above 80)
indicate that price is near its high for the given time period.
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Fast and Slow
• There are two versions of the Stochastic Oscillator available
on KeyStock The Fast Stochastic Oscillator is based on George
Lane's original formulas for %K and %D. %K in the fast version
that appears rather choppy. %D is the 3-day SMA of %K. In
fact, Lane used %D to generate buy or sell signals based on
bullish and bearish divergences.
• Lane asserts that a %D divergence is the “only signal which
will cause you to buy or sell.” Because %D in the Fast
Stochastic Oscillator is used for signals,
• the Slow Stochastic Oscillator was introduced to reflect this
emphasis. The Slow Stochastic Oscillator smooths %K with a
3-day SMA, which is exactly what %D is in the Fast Stochastic
Oscillator. Notice that %K in the Slow Stochastic Oscillator
equals %D in the Fast Stochastic Oscillator
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Overbought Oversold
• Traditional settings use 80 as the overbought threshold and 20 as the
oversold threshold. These levels can be adjusted to suit analytical needs
and securities characteristics. Readings above 80 for the 20-day Stochastic
Oscillator would indicate that the underlying securities was trading near
the top of its 20-day high-low range. Readings below 20 occur when a
securities is trading at the low end of its high-low range.
• overbought readings are not necessarily bearish. Securities can become
overbought and remain overbought during a strong uptrend. Closing levels
that are consistently near the top of the range indicate sustained buying
pressure. In a similar vein, oversold readings are not necessarily bullish.
Securities can also become oversold and remain oversold during a strong
downtrend. Closing levels consistently near the bottom of the range
indicate sustained selling pressure. It is, therefore, important to identify
the bigger trend and trade in the direction of this trend. Look for
occasional oversold readings in an uptrend and ignore frequent
overbought readings. Similarly, look for occasional overbought readings in
a strong downtrend and ignore frequent oversold readings.
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Bull Bear Divergences
• Divergences form when a new high or low in price is not confirmed by the
Stochastic Oscillator. A bullish divergence forms when price records a lower
low, but the Stochastic Oscillator forms a higher low. This shows less downside
momentum that could foreshadow a bullish reversal. A bearish divergence
forms when price records a higher high, but the Stochastic Oscillator forms a
lower high. This shows less upside momentum that could foreshadow a
bearish reversal. Once a divergence takes hold, chartists should look for a
confirmation to signal an actual reversal. A bearish divergence can be
confirmed with a support break on the price chart or a Stochastic Oscillator
break below 50, which is the centerline. A bullish divergence can be confirmed
with a resistance break on the price chart or a Stochastic Oscillator break
above 50.
• 50 is an important level to watch. The Stochastic Oscillator moves between
zero and one hundred, which makes 50 the centerline. Think of it as the 50-
yard line in football. The offense has a higher chance of scoring when it
crosses the 50-yard line. The defense has an edge as long as it prevents the
offense from crossing the 50-yard line. A Stochastic Oscillator cross above 50
signals that prices are trading in the upper half of their high-low range for the
given look-back period. This suggests that the cup is half full. Conversely, a
cross below 50 means that prices are trading in the bottom half of the given
look-back period. This suggests that the cup is half empty.
Conclusions
• The settings on the Stochastic Oscillator depend on personal
preferences, trading style, and timeframe. A shorter look-back
period will produce a choppy oscillator with many overbought and
oversold readings. A longer look-back period will provide a
smoother oscillator with fewer overbought and oversold readings.
• Like all technical indicators, it is important to use the Stochastic
Oscillator in conjunction with other technical analysis tools.
Volume, support/resistance, and breakouts can be used to confirm
or refute signals produced by the Stochastic Oscillator.
• The indicator can also be used to identify turns near support or
resistance. Should a securities trade near support with an oversold
Stochastic Oscillator, look for a break above 20 to signal an upturn
and successful support test. Conversely, should a securities trade
near resistance with an overbought Stochastic Oscillator, look for a
break below 80 to signal a downturn and resistance failure.
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The Money Flow Index (MFI)
• The Money Flow Index (MFI) is an oscillator that uses both
price and volume to measure buying and selling pressure.
Created by Gene Quong and Avrum Soudack, MFI is also
known as volume-weighted RSI. MFI starts with the typical
price for each period. Money flow is positive when the typical
price rises (buying pressure) and negative when the typical
price declines (selling pressure). A ratio of positive and
negative money flow is then plugged into an RSI formula to
create an oscillator that moves between zero and one
hundred. As a momentum oscillator tied to volume, the
Money Flow Index (MFI) is best suited to identify reversals
and price extremes with a variety of signals.
Calculation
• There are several steps involved in the Money Flow Index
calculation. The example below is based on a 14-period
Money Flow Index, which is the default setting in Key Stock
and the setting recommended by the creators.
• Typical Price = (High + Low + Close)/3
• Raw Money Flow = Typical Price x Volume
• Money Flow Ratio = (14-period Positive Money Flow)/(14-
period Negative Money Flow)
• Money Flow Index = 100 - 100/(1 + Money Flow Ratio)
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Interpretation
• As a volume-weighted version of RSI, the Money Flow Index
(MFI) can be interpreted similarly to RSI. The big difference is,
of course, volume. Because volume is added to the mix, the
Money Flow Index will act a little differently than RSI. Theories
suggest that volume leads prices. RSI is a momentum
oscillator that already leads prices. Incorporating volume can
increase this lead time.
• Quong and Soudack identified three basic signals using the
Money Flow Index. First, chartists can look for overbought or
oversold levels to warn of unsustainable price extremes.
Second, bullish and bearish divergence can be used to
anticipate trend reversals. Third, failure swings at 80 or 20 can
also be used to identify potential price reversals. For this
article, the divergences and failure swings are be combined to
create one signal group and increase robustness.
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Overbought/Oversold
• Overbought and oversold levels can be used to identify
unsustainable price extremes. Typically, MFI above 80 is considered
overbought and MFI below 20 is considered oversold. Strong trends
can present a problem for these classic overbought and oversold
levels. MFI can become overbought (>80) and prices can simply
continue higher when the uptrend is strong. Conversely, MFI can
become oversold (<20) and prices can simply continue lower when
the downtrend is strong. Quong and Soudack recommended
expanding these extremes to further qualify signals. A move above
90 is truly overbought and a move below 10 is truly oversold.
Moves above 90 and below 10 are rare occurrences that suggest a
price move is unsustainable. Admittedly, many stocks will trade for
a long time without reaching the 90/10 extremes. However,
chartists can use the keystock scan engine to find those that do.
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Divergences and Failures
• Failure swings and divergences can be combined to create
more robust signals. A bullish failure swing occurs when MFI
becomes oversold below 20, surges above 20, holds above 20
on a pullback and then breaks above its prior reaction high. A
bullish divergence forms when prices move to a lower low,
but the indicator forms a higher low to show improving
money flow or momentum.
• A bearish failure swing occurs when MFI becomes overbought
above 80, plunges below 80, fails to exceed 80 on a bounce
and then breaks below the prior reaction low. A bearish
divergence forms when the stock forges a higher high and the
indicator forms a lower high, which indicates deteriorating
money flow or momentum
Conclusions
• The Money Flow Index is a rather unique indicator that
combines momentum and volume with an RSI formula. RSI
momentum generally favors the bulls when the indicator is
above 50 and the bears when below 50. Even though MFI is
considered a volume-weighted RSI, using the centerline to
determine a bullish or bearish bias does not work as well.
Instead, MFI is better suited to identify potential reversals
with overbought/oversold levels, bullish/bearish divergences,
and bullish/bearish failure swings. As with all indicators, MFI
should not be used by itself. A pure momentum oscillator,
such as RSI, or pattern analysis can be combined with MFI to
increase signal robustness.
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Bollinger Bands
• Bollinger Bands is technical analysis tool invented by John
Bollinger in the 1980s. Having evolved from the concept of
trading bands, Bollinger Bands can be used to measure the
highness or lowness of the price relative to previous trades
and to find out the support and resistance level of any
financial securities.
• Bollinger Bands® consist of a center line and two price
channels (bands) above and below it. The center line is an
exponential moving average; the price channels are the
standard deviations of the stock being studied. The bands will
expand and contract as the price action of an issue becomes
volatile (expansion) or becomes bound into a tight trading
pattern (contraction)
Bollinger Bands
• When stock prices continually touch the upper Bollinger
Band®, the prices are thought to be overbought; conversely,
when they continually touch the lower band, prices are
thought to be oversold, triggering a buy signal.
• When using Bollinger Bands®, designate the upper and lower
bands as price targets. If the price deflects off the lower band
and crosses above the 20-day average (the middle line), the
upper band comes to represent the upper price target. In a
strong uptrend, prices usually fluctuate between the upper
band and the 20-day moving average. When that happens, a
crossing below the 20-day moving average warns of a trend
reversal to the downside. (For more about gauging an asset's
direction and profiting from it
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Uses
* Bollinger Bands can be combined with price action and
other indicators to generate signals and foreshadow
significant moves.
* Double Bottom Buy: A Double Bottom Buy signal is given
when prices penetrate the lower band and remain above
the lower band after subsequent low forms. Either low can
be higher or lower than other.
* Double Top Sell: A Double Top Sell signal is given when
prices peak above the upper band and a subsequent peak
fails to break above the upper band. The bearish setup is
confirmed when prices decline below the middle band.
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Moving Average Convergence/Divergence
(MACD)
• Developed by Gerald Appel in the late seventies, the Moving
Average Convergence/Divergence oscillator
• (MACD) is one of the simplest and most effective momentum
indicators available.
• Which are lagging indicators, to include some trend-following
characteristics. These lagging indicators are turned into a
momentum oscillator by subtracting the longer moving
average from the shorter moving average.
Calculation
• MACD Line: (12-day EMA - 26-day EMA)
• Signal Line: 9-day EMA of MACD Line
• MACD Histogram: MACD Line - Signal Line
• The MACD Line is the 12-day Exponential Moving Average (EMA) less the
26-day EMA. Closing prices are used for these moving averages. A 9-day
EMA of the MACDLine is plotted with the indicator to act as a signal line
and identify turns. The MACDHistogram represents the difference
between MACD and its 9-day EMA, the Signal line. The histogram is
positive when the MACD Line is above its Signal line and negative when
the MACD Line is below its Signal line.
• The values of 12, 26 and 9 are the typical setting used with the MACD,
however other values can be substituted depending on your trading style
and goals.
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Interpretation
• As its name implies, the MACD is all about the convergence and
divergence of the two moving averages. Convergence occurs when the
moving averages move towards each other. Divergence occurs when the
moving averages move away from each other. The shorter moving average
(12-day) is faster and responsible for most MACD movements. The longer
moving average (26-day) is slower and less reactive to price changes in the
underlying securities.
• The MACD Line oscillates above and below the zero line, which is also
known as the centerline. These crossovers signal that the 12-day EMA has
crossed the 26-day EMA. The direction, of course, depends on the
direction of the moving average cross. Positive MACD indicates that the
12-day EMA is above the 26-day EMA. Positive values increase as the
shorter EMA diverges further from the longer EMA. This means upside
momentum is increasing. Negative MACD values indicate that the 12-day
EMA is below the 26-day EMA. Negative values increase as the shorter
EMA diverges further below the longer EMA.
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Signal Line Crossovers
• Signal line crossovers are the most common MACD signals. The signal line
is a 9-day EMA of the MACD Line. As a moving average of the indicator, it
trails the MACD and makes it easier to spot MACD turns. A bullish
crossover occurs when the MACD turns up and crosses above the signal
line. A bearish crossover occurs when the MACD turns down and crosses
below the signal line. Crossovers can last a few days or a few weeks, it all
depends on the strength of the move.
• Due diligence is required before relying on these common signals. Signal
line crossovers at positive or negative extremes should be viewed with
caution. Even though the MACDdoes not have upper and lower limits,
chartists can estimate historical extremes with a simple visual assessment.
It takes a strong move in the underlying securities to push momentum to
an extreme. Even though the move may continue, momentum is likely to
slow and this will usually produce a signal line crossover at the
extremities. Volatility in the underlying securities can also increase the
number of crossovers.
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Centerline Crossovers
• Centerline crossovers are the next most common MACD signals. A bullish
centerline crossover occurs when the MACD Line moves above the zero
line to turn positive. This happens when the 12-day EMA of the underlying
securities moves above the 26-day EMA. A bearish centerline crossover
occurs when the MACD moves below the zero line to turn negative. This
happens when the 12-day EMA moves below the 26-day EMA.
• Centerline crossovers can last a few days or a few months. It all depends
on the strength of the trend. The MACD will remain positive as long as
there is a sustained uptrend. The MACD will remain negative when there is
a sustained downtrend. The next chart shows Pulte Homes (PHM) with at
least four centerline crosses in nine months. The resulting signals worked
well because strong trends emerged with these centerline crossovers.
Divergences
• Divergences form when the MACD diverges from the price action of the
underlying securities. A bullish divergence forms when a securities records
a lower low and the MACD forms a higher low. The lower low in the
securities affirms the current downtrend, but the higher low in
the MACD shows less downside momentum. Despite less downside
momentum, downside momentum is still outpacing upside momentum as
long as the MACD remains in negative territory. Slowing downside
momentum can sometimes foreshadow a trend reversal or a sizable rally.
• A bearish divergence forms when a securities records a higher high and
the MACD Line forms a lower high. The higher high in the securities is
normal for an uptrend, but the lower high in the MACD shows less upside
momentum. Even though upside momentum may be less, upside
momentum is still outpacing downside momentum as long as the MACD is
positive. Waning upward momentum can sometimes foreshadow a trend
reversal or sizable decline.
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Divergences
• Divergences should be taken with caution. Bearish divergences are
commonplace in a strong uptrend, while bullish divergences occur often in
a strong downtrend. Yes, you read that right. Uptrends often start with a
strong advance that produces a surge in upside momentum (MACD). Even
though the uptrend continues, it continues at a slower pace that causes
the MACD to decline from its highs. Upside momentum may not be as
strong, but upside momentum is still outpacing downside momentum as
long as the MACD Line is above zero. The opposite occurs at the beginning
of a strong downtrend.
• The standard setting for MACD is the difference between the 12 and 26-
period EMAs. Chartists looking for more sensitivity may try a shorter
short-term moving average and a longer long-term moving
average. MACD(5,35,5) is more sensitive than MACD(12,26,9) and might
be better suited for weekly charts. Chartists looking for less sensitivity may
consider lengthening the moving averages. A less sensitive MACD will still
oscillate above/below zero, but the centerline crossovers and signal line
crossovers will be less frequent.
Conclusions
• The MACD indicator is special because it brings together momentum and
trend in one indicator. This unique blend of trend and momentum can be
applied to daily, weekly or monthly charts. The standard setting
for MACD is the difference between the 12 and 26-period EMAs. Chartists
looking for more sensitivity may try a shorter short-term moving average
and a longer long-term moving average.
• MACD(5,35,5) is more sensitive than MACD(12,26,9) and might be better
suited for weekly charts. Chartists looking for less sensitivity may consider
lengthening the moving averages. A less sensitive MACD will still oscillate
above/below zero, but the centerline crossovers and signal line crossovers
will be less frequent.
• Finally, remember that the MACD Line is calculated using the actual
difference between two moving averages. This means MACD values are
dependent on the price of the underlying securities. The MACD values for
a $20 stocks may range from -1.5 to 1.5, while the MACD values for a $100
may range from -10 to +10. It is not possible to compare MACD values for
a group of securities with varying prices. If you want to compare
momentum readings, you should use the Percentage Price Oscillator
(PPO), instead of the MACD.
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MACD Bullish Signals
• MACD generates bullish signals from three
main sources:
• Positive Divergence
• Bullish Moving Average Crossover
• Bullish Centerline Crossover
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Bearish Signals
• MACD generates bearish signals from three
main sources. These signals are mirror
reflections of the bullish signals:
• Negative Divergence
• Bearish Moving Average Crossover
• Bearish centreline Crossover
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MACD-Histogram
Developed by Thomas Aspray in 1986, the MACD-Histogram measures
the distance between MACD and its signal line (the 9-day EMA of
MACD). Like MACD, the MACD-Histogram is also an oscillator that
fluctuates above and below the zero line. Aspray developed the
MACD-Histogram to anticipate signal line crossovers in MACD.
Because MACD uses moving averages and moving averages lag
price, signal line crossovers can come late and affect the reward-to-
risk ratio of a trade. Bullish or bearish divergences in the MACD-
Histogram can alert chartists to an imminent signal line crossover in
MACD.
Calculation:
MACD: (12-day EMA - 26-day EMA)
Signal Line: 9-day EMA of MACD
MACD Histogram: MACD - Signal Line
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Four Steps Process
• The MACD-Histogram is an indicator of an indicator. In fact, MACD
is also an indicator of an indicator. This means that the MACD-
Histogram is four steps removed from the price of the underlying
securities. In other words, it is the fourth derivative of price.
• First derivative: 12-day EMA and 26-day EMA
• Second derivative: MACD (12-day EMA less the 26-day EMA)
• Third derivative: MACD signal line (9-day EMA of MACD)
• Fourth derivative: MACD-Histogram (MACD less MACD signal line)
• The base for this indicator is the securities's price. It takes four
steps to get from the actual price to the MACD-Histogram. Talk
about massaging the data. While not necessarily a bad thing,
chartists should keep this in mind when analyzing the MACD-
Histogram. It is an indicator of an indicator. Therefore, it is designed
to anticipate signals in MACD, which in turn is designed to identify
changes in the price momentum of the underlying securities.
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Interpretation
As with MACD, the MACD-Histogram is also designed to identify
convergence, divergence and crossovers. The MACD-
Histogram, however, is measuring the distance between
MACD and its signal line. The histogram is positive when
MACD is above its signal line. Positive values increase as
MACD diverges further from its signal line (to the upside).
Positive values decrease as MACD and its signal line converge.
The MACD-Histogram crosses the zero line as MACD crosses
below its signal line. The indicator is negative when MACD is
below its signal line. Negative values increase as MACD
diverges further from its signal line (to the downside).
Conversely, negative values decrease as MACD converges on
its signal line.
Conclusions
The MACD-Histogram is an indicator designed to predict signal line
crossovers in MACD. By extension, it is designed as an early warning
system for these signal line crossovers, which are the most frequent
of MACD signals. Divergences in the MACD-Histogram can be used
to filter signal line crossovers, which will reduce the number of
signals. Even with a filter, the robustness of MACD-Histogram
divergences is still an issue. Short and shallow divergences are
much more frequent than long and large divergences. In other
words, divergences that develop over a few days with shallow
movements are generally less robust than divergences that develop
over a few weeks with more pronounced movements. The signal
line crossover provides the ultimate confirmation, but aggressive
traders may try to improve the reward-to-risk ratio by making their
move just before the crossover. This is when the MACD-Histogram
is as close to the zero line as it can be without actually making a
cross, usually between -.20 and +.20.
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On Balance Volume (OBV)
On Balance Volume (OBV) measures buying and selling pressure as a
cumulative indicator that adds volume on up days and subtracts
volume on down days. OBV was developed by Joe Granville and
introduced in his 1963 book, Granville's New Key to Stock Market
Profits. It was one of the first indicators to measure positive and
negative volume flow. Chartists can look for divergences between OBV
and price to predict price movements or use OBV to confirm price
trends.
Calculation :
If the closing price is above the prior close price then:
Current OBV = Previous OBV + Current Volume
If the closing price is below the prior close price then:
Current OBV = Previous OBV - Current Volume
If the closing prices equals the prior close price then:
Current OBV = Previous OBV (no change)
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Interpretation
Granville theorized that volume precedes price. OBV rises when volume on up
days outpaces volume on down days. OBV falls when volume on down
days is stronger. A rising OBV reflects positive volume pressure that can
lead to higher prices. Conversely, falling OBV reflects negative volume
pressure that can foreshadow lower prices. Granville noted in his research
that OBV would often move before price. Expect prices to move higher if
OBV is rising while prices are either flat or moving down. Expect prices to
move lower if OBV is falling while prices are either flat or moving up.
The absolute value of OBV is not important. Chartists should instead focus on
the characteristics of the OBV line. First, define the trend for OBV. Second,
determine if the current trend matches the trend for the underlying
securities. Third, look for potential support or resistance levels. Once
broken, the trend for OBV will change and these breaks can be used to
generate signals. Also, notice that OBV is based on closing prices.
Therefore, closing prices should be considered when looking for
divergences or support/resistance breaks. And finally, volume spikes can
sometimes throw off the indicator by causing a sharp move that will
require a settling period.
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Divergences
Bullish and bearish divergence signals can be used to anticipate a
trend reversal. These signals are truly based on the theory
that volume precedes prices. A bullish divergence forms when
OBV moves higher or forms a higher low even as prices move
lower or forge a lower low. A bearish divergence forms when
OBV moves lower or forms a lower low even as prices move
higher or forge a higher high. The divergence between OBV
and price should alert chartists that a price reversal could be
in the making.
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Conclusions
On Balance Volume (OBV) is a simple indicator that uses volume
and price to measure buying pressure and selling pressure.
Buying pressure is evident when positive volume exceeds
negative volume and the OBV line rises. Selling pressure is
present when negative volume exceeds positive volume and
the OBV line falls. Chartists can use OBV to confirm the
underlying trend or look for divergences that may foreshadow
a price change. As with all indicators, it is important to use
OBV in conjunction with other aspects of technical analysis. It
is not a standalone indicator. OBV can be combined with
basic pattern analysis or to confirm signals from momentum
oscillators.
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Fibonacci Retracement
Fibonacci Retracements are ratios used to identify potential reversal
levels. These ratios are found in the Fibonacci sequence. The most
popular Fibonacci Retracements are 61.8% and
38.2%. Fibonacci Retracements can also be applied after a decline
to forecast the length of a counter-trend bounce.
These retracements can be combined with other indicators
and price patterns to create an overall strategy.
• We will not deeply discuss the mathematical properties behind
the Fibonacci sequence and Golden Ratio. There are plenty of other
sources for this detail. A few basics, however, will provide the
necessary background for the most popular numbers. Leonardo
Pisano Bogollo (1170-1250), an Italian mathematician from Pisa, is
credited with introducing the Fibonacci sequence to the West. It is
as follows:
• 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610……
Sequence of Fibonacci Retracement
• After 0 and 1, each number is the sum of the two prior numbers
(1+2=3, 2+3=5, 5+8=13 8+13=21 etc…).
• A number divided by the previous number approximates 1.618
(21/13=1.6153, 34/21=1.6190, 55/34=1.6176, 89/55=1.6181). The
approximation nears 1.6180 as the numbers increase.
• A number divided by the next highest number approximates .6180
(13/21=.6190, 21/34=.6176, 34/55=.6181, 55/89=.6179 etc….). The
approximation nears .6180 as the numbers increase. This is the
basis for the 61.8% retracement.
• A number divided by another two places higher approximates .3820
(13/34=.382, 21/55=.3818, 34/89=.3820, 55/=144=3819 etc….). The
approximation nears .3820 as the numbers increase. This is the
basis for the 38.2% retracement. Also, note that 1 - .618 = .382
• A number divided by another three places higher approximates
.2360 (13/55=.2363, 21/89=.2359, 34/144=.2361, 55/233=.2361
etc….). The approximation nears .2360 as the numbers increase.
This is the basis for the 23.6% retracement.
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How to take Clue
Retracement levels alert traders or investors of a potential
trend reversal, resistance area or support
area. Retracements are based on the prior move. A bounce
is expected to retrace a portion of the prior decline, while a
correction is expected to retrace a portion of the prior
advance. Once a pullback starts, chartists can identify
specific Fibonacci retracement levels for monitoring. As the
correction approaches these retracements, chartists should
become more alert for a potential bullish reversal.
Keep in mind that these retracement levels are not hard
reversal points. Instead, they serve as alert zones for a
potential reversal. It is at this point that traders should
employ other aspects of technical analysis to identify or
confirm a reversal. These may include candlesticks, price
patterns, momentum oscillators or moving averages.
Retracements Level
• we can consider a 23.6% retracement to be relatively
shallow. Such retracements would be appropriate
for flags or short pullbacks. Retracements in the 38.2%-
50% range would be considered moderate. Even
though deeper, the 61.8% retracement can be referred
to as the golden retracement. It is, after all, based on
the Golden Ratio.
• Shallow retracements occur, but catching these
requires a closer watch and quicker trigger finger. The
examples below use daily charts covering 3-9 months.
Focus will be on moderate retracements (38.2-50%)
and golden retracements (61.8%). In addition, these
examples will show how to combine retracements with
other indicators to confirm a reversal.
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Average Directional Index (ADX)
 ADX is plotted as a single line with values ranging from a low
of zero to a high of 100. ADX is non-directional; it registers
trend strength whether price is trending up or down.
 The Average Directional Index (ADX), Minus Directional
Indicator (-DI) and Plus Directional Indicator (+DI) represent a
group of directional movement indicators that form a trading
system developed by Welles Wilder.
• The Average Directional Index (ADX) measures trend strength
without regard to trend direction. The other two indicators,
Plus Directional Indicator (+DI) and Minus Directional
Indicator (-DI), complement ADX by defining tren direction.
Used together, chartists can determine both the direction and
strength of the trend.
How it works
• 1. ADX system has three components – ADX, +DI, and -DI
• 2. ADX is used to measure the strength/weakness of the trend and not the
actual direction
• 3. ADX above 25 indicates that the present trend is strong, ADX below 20 suggest
that the trend lacks strength. ADX between 20 and 25 is a grey area
• 4. A buy signal is generated when ADX is 25 and the +DI crosses over –DI
• 5. A sell signal is generated when ADX is 25 and the –DI crosses over +DI
• 6. Once the buy or sell signal is generated, take the trade by defining the stop loss
• 7. The stop loss is usually the low of the signal candle (for buy signals) and the high
of the signal candles ( for short signals)
• 8. The trade stays valid till the stop loss is breached (even if the +DI and –DI
reverses the crossover)
• 9. The default look back period for ADX is 14 days
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How to Measure ADX
• ADX values help traders to identify the strongest and most profitable trends to
trade. The values are also important for distinguishing between trending and non-
trending conditions. Many traders will use ADX readings above 25 to suggest that
the trend's strength is strong enough for trend trading strategies. Conversely, when
ADX is below 25, many will avoid trend trading strategies.
• Low ADX is a usually a sign of accumulation or distribution. When ADX is below 25
for more than 30 bars, price enters range conditions and price patterns are often
easier to identify. Price then moves up and down between resistance and support
to find selling and buying interest, respectively. From low ADX conditions, price will
eventually break out into a trend. In Figure 2, price moves from a low ADX price
channel to an uptrend with strong ADX.
ADX Value Trend Strength
0-25 Absent or Weak Trend
25-50 Strong Trend
50-75 Very Strong Trend
75-100 Extremely Strong Trend
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Super trend
A 'Supertrend' indicator is one, which can give you precise buy or sell signal in
a trending market.
As the name suggests, 'Supertrend' is a trend-following indicator just like
moving averages and MACD (moving average convergence divergence). It is
plotted on prices and their placement indicates the current trend.
The indicator is easy to use and gives an accurate reading about an ongoing
trend. It is constructed with two parameters, namely period and multiplier.
"The average true range (ATR) plays an important role in 'Supertrend' as the
indicator uses ATR to calculate its value. The ATR indicator signals the degree
of price volatility,"
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Average True Range
• Developed by J. Welles Wilder, the Average True Range (ATR) is an indicator that
measures volatility. As with most of his indicators, Wilder designed ATR with
commodities and daily prices in mind. Commodities are frequently more volatile
than stocks. They were are often subject to gaps and limit moves, which occur
when a commodity opens up or down its maximum allowed move for the session.
A volatility formula based only on the high-low range would fail to capture
volatility from gap or limit moves. Wilder created Average True Range to capture
this “missing” volatility. It is important to remember that ATR does not provide an
indication of price direction, just volatility.
• How it works:
• 1. Average True Range (ATR) is an extension of True Range concept
• 2. ATR is not upper or lower bound, hence can take any value
• 3. ATR is stock price specific, hence for Stock 1 ATR can be in the range of 1.2 and
Stock 2 ATR could be in the range
• of 150
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• 4. ATR attempts to measure the volatility situation and not really the direction of the
prices
• 5. ATR is used to identify stop loss as well
• 6. If the ATR of a stock is 48, then it means that on average the stock is likely to move 48
points either ways up or
• down. You can add this to the current day’s range to estimate the day’s range. For
example the stock price is 1320,
• then the stock is likely to trade between 1320 – 48 = 1272 and 1320 + 48 = 1368
• 7. If the ATR for the next day decreases to say 40, then it means that the volatility is
decreasing, and so is the expected
• range for the day
• 8. It is best to use ATR to identify the volatility based SL while trading. Assume you have
initiated a long trade on the
• stock at 1325, then your SL should be at least 1272 or below since the ATR is 48
• 9. Likewise if you have initiated a short at 1320, then your stoploss should be at least 1368
or above
• 10. If these SL levels are outside your risk to reward appetite, the its best to avoid such
trade.
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Chart Patterns
• Double Top (Reversal)
• Double Bottom (Reversal)
• Head and Shoulders Top (Reversal)
• Head and Shoulders Bottom (Reversal)
• Three Highs
• Three Lows
• Support Turns Resistance
• Resistance Become Support
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Double Top (Reversal)
• The double top is a major reversal pattern that forms after
an extended uptrend. The pattern is made up of two
consecutive peaks that are roughly equal, with a moderate
trough in-between. Many potential double tops can form
along the way up, but until key support is broken, a reversal
cannot be confirmed. To help clarify, we will look at the key
points in the formation and then walk through an example.
•
• Prior Trend:-
With any reversal pattern, there must be an
existing trend to reverse. In the case of the double top, a
significant uptrend of several months should be in place.
First Peak:-
The first peak should mark the highest point of the
current trend. As such, the first peak is fairly normal and the
uptrend is not in jeopardy (or in question) at this time.
Trough:-
After the first peak, a decline takes place that typically
ranges from 10 to 20%. Volume on the decline from the first peak is
usually inconsequential. The lows are sometimes rounded or drawn
out a bit, which can be a sign of tepid demand.
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.
Decline from Peak:-
The subsequent decline from the second peak
should witness an expansion in volume and/or an accelerated
descent, perhaps marked with a gap.International School of Financial Market (ISFM)
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1st top
2nd top
Second
top
First top
Support breakout
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Double Bottom (Reversal)
The double bottom is a major reversal pattern that
forms after an extended downtrend. As its name
implies, the pattern is made up of two consecutive
troughs that are roughly equal, with a moderate
peak in-between. The classic double bottom usually
marks an intermediate or long-term change in trend.
Many potential double bottoms can form along the
way down, but until key resistance is broken, a
reversal cannot be confirmed.
1st low 2nd low (buying)
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Key points should be considered
• First Trough: The first trough should mark the lowest point of the
current trend. As such, the first trough is fairly normal in
appearance and the downtrend remains firmly in place.
• Peak: After the first trough, an advance takes place that typically
ranges from 10 to 20%. Volume on the advance from the first
trough is usually inconsequential, but an increase could signal early
accumulation.
• 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 confirmed .
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* Advance from Trough: Volume is more important for the double
bottom than the double top. There should be clear evidence that
volume and buying pressure are accelerating during the advance
off of the second trough. An accelerated ascent, perhaps marked
with a gap or two.
* Resistance Break: Even after trading up to resistance, the double
top and trend reversal are still not complete. 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.
* Resistance Turned Support: Broken resistance becomes potential
support and there is sometimes a test of this newfound support
level with the first correction. Such a test can offer a second chance
to close a short position or initiate a long.
• Price Target: The distance from the resistance breakout to trough
lows can be added on top of the resistance break to estimate a
target. This would imply that the bigger the formation is, the larger
the potential advance.
It is important to remember that the double bottom is an
intermediate to long-term reversal pattern that will not form in a
few days. Even though formation in a few weeks is possible, it is
preferable to have at least 4 weeks between lows. Bottoms usually
take longer than tops to form and patience can often be a virtue.
Give the pattern time to develop and look for the proper clues. The
advance off of the first 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.
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Head and Shoulders Top (Reversal)
• A Head and Shoulders reversal pattern forms after an
uptrend, 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, a head, a right
shoulder and a neckline. Other parts playing a role in
the pattern are volume, the breakout, price target and
support turned resistance.
Left
shoulders
head
neckline
Right Neckline breakout
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Left shoulders Right shoulders
Neckline
Neckline breakout
head
Key points should be considered
• 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).
• Left Shoulder: While in an uptrend, the left shoulder forms a peak
that marks the high point of the current trend. After making this
peak, a decline ensues to complete the formation of the shoulder
(1). The low of the decline usually remains above the trend line,
keeping the uptrend intact.
• Head: From the low of the left shoulder, an advance begins that
exceeds the previous high and marks the top of the head. After
peaking, the low of the subsequent decline marks the second point
of the neckline (2). The low of the decline usually breaks the
uptrend line, putting the uptrend in jeopardy.International School of Financial Market (ISFM)
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• Right Shoulder: The advance from the low of the head forms the
right shoulder. This peak is lower than the head (a lower high) and
usually in line with the high of the left shoulder. 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.
• Neckline: The neckline forms by connecting low points 1 and 2. Low
point 1 marks the end of the left shoulder and the beginning of the
head. Low point 2 marks the end of the head and the beginning of
the right shoulder. Depending on the relationship between the two
low points, the neckline can slope up, slope down or be horizontal.
The slope of the neckline will affect the pattern's degree of
bearishness: a downward slope is more bearish than an upward
slope. Sometimes more than one low point can be used to form the
neckline.
• Volume: As the Head and Shoulders pattern unfolds, volume plays
an important role in confirmation. Volume can be measured as an
indicator 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. This decrease in
volume and the new high of the head, together, serve as a warning
sign. The next warning sign comes when volume increases on the
decline from the peak of the head. Final confirmation comes when
volume further increases during the decline of the right shoulder.
• Neckline Break: The head and shoulders pattern is not complete
and the uptrend is not reversed until neckline support is broken.
Ideally, this should also occur in a convincing manner, with an
expansion in volume.
Contact : 0124-2200689, 9540008689, 9953147497, 9911878442
WWW.ISFM.CO.IN
www.isfm.co.in

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