The topic on Fibonacci retracements is quite intriguing.

To fully understand and

appreciate the concept of Fibonacci retracements, one must understand the Fibonacci
series. The origins of the Fibonacci series can be traced back to the ancient Indian
mathematic scripts, with some claims dating back to 200 BC. However, in the
12th century, Leonardo Pisano Bogollo an Italian mathematician from Pisa, known to his
friends as Fibonacci discovered Fibonacci numbers.

The Fibonacci series is a sequence of numbers starting from zero arranged in such a
way that the value of any number in the series is the sum of the previous two numbers.

The Fibonacci sequence is as follows:

0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…

Notice the following:

233 = 144 + 89
144 = 89 + 55
89 = 55 +34

Needless to say the series extends to infinity. There are few interesting properties of the
Fibonacci series.

Divide any number in the series by the previous number; the ratio is always
approximately 1.618.

For example:
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618

The ratio of 1.618 is considered as the Golden Ratio, also referred to as the Phi.
Fibonacci numbers have their connection to nature. The ratio can be found in human
face, flower petals, animal bodies, fruits, vegetables, rock formation, galaxial formations
etc. Of course let us not get into this discussion as we would be digressing from the
main topic. For those interested, I would suggest you search on the internet for golden
ratio examples and you will be pleasantly surprised. Further into the ratio properties, one
can find remarkable consistency when a number is in the Fibonacci series is divided by
its immediate succeeding number.

For example:
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618

At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%.

Similar consistency can be found when any number in the Fibonacci series is divided by
a number two places higher.

For example:
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
0.382 when expressed in percentage terms is 38.2%

Also, there is consistency when a number in the Fibonacci series is divided by a number
3 place higher.

For example:
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236

0.236 when expressed in percentage terms is 23.6%.

16.1 – Relevance to stocks markets

It is believed that the Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% finds its application
in stock charts. Fibonacci analysis can be applied when there is a noticeable up-move or
down-move in prices. Whenever the stock moves either upwards or downwards sharply,
it usually tends to retrace back before its next move. For example if the stock has run up
from Rs.50 to Rs.100, then it is likely to retrace back to probably Rs.70, before it can
move Rs.120.

‘The retracement level forecast’ is a technique using which one can identify upto which
level retracement can happen. These retracement levels provide a good opportunity for
the traders to enter new positions in the direction of the trend. The Fibonacci ratios i.e
61.8%, 38.2%, and 23.6% helps the trader to identify the possible extent of the
retracement. The trader can use these levels to position himself for trade.

Have a look at the chart below:

I’ve encircled two points on the chart, at Rs.380 where the stock started its rally and at
Rs.489, where the stock prices peaked.

I would now define the move of 109 (380 – 489) as the Fibonacci upmove. As per the
Fibonacci retracement theory, after the upmove one can anticipate a correction in the
stock to last up to the Fibonacci ratios. For example, the first level up to which the stock
can correct could be 23.6%. If this stock continues to correct further, the trader can
watch out for the 38.2% and 61.8% levels.
Notice in the example shown below, the stock has retraced up to 61.8%, which
coincides with 421.9, before it resumed the rally.

We can arrive at 421 by using simple math as well –

Total Fibonacci up move = 109

61.8% of Fibonacci up move = 61.8% * 109 = 67.36

Retracement @ 61.8% = 489- 67.36 = 421.6

Likewise, we can calculate for 38.2% and the other ratios. However one need not
manually do this as the software will do this for us.

Here is another example where the chart has rallied from Rs.288 to Rs.338. Therefore
50 points move makes up for the Fibonacci upmove. The stock retraced back 38.2% to
Rs.319 before resuming its up move.

The Fibonacci retracements can also be applied to stocks that are falling, in order to
identify levels upto which the stock can bounce back. In the chart below (DLF Limited),
the stock started to decline from Rs.187 to Rs. 120.6 thus making 67 points as the
Fibonacci down move.

After the down move, the stock attempted to bounce back retracing back to Rs.162,
which is the 61.8% Fibonacci retracement level.

16.2 – Fibonacci Retracement construction

As we now know Fibonacci retracements are movements in the chart that go against the
trend. To use the Fibonacci retracements we should first identify the 100% Fibonacci
move. The 100% move can be an upward rally or a downward rally. To mark the 100%
move, we need to pick the most recent peak and trough on the chart. Once this is
identified, we connect them using a Fibonacci retracement tool. This is available in most

of the technical analysis software packages including Zerodha’s Pi

Here is a step by step guide:

Step 1) Identify the immediate peak and trough. In this case the trough is at 150 and
peak is at 240. The 90 point moves make it 100%.

Step 2) Select the Fibonacci retracement tool from the chart tools
Step 3) Use the Fibonacci retracement tool to connect the trough and the peak.

After selecting the Fibonacci retracement tool from the charts tool, the trader has to click
on trough first, and without un-clicking he has to drag the line till the peak. While doing
this, simultaneously the Fibonacci retracements levels starts getting plotted on the chart.
However, the software completes the retracement identification process only after you
finish selecting both the trough and the peak. This is how the chart looks after selecting
both the points.

You can now see the fibonacci retracement levels are calculated and loaded on the
chart. Use this information to position yourself in the market.
 16.3 – How should you use the Fibonacci retracement
levels?
Think of a situation where you wanted to buy a particular stock but you have not been
able to do so because of a sharp run up in the stock. In such a situation the most
prudent action to take would be to wait for a retracement in the stock. Fibonacci
retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential level upto which
a stock can correct.

By plotting the Fibonacci retracement levels the trader can identify these retracement
levels, and therefore position himself for an opportunity to enter the trade. However
please note like any indicator, use the Fibonacci retracement as a confirmation tool.

I would buy a stock only after it has passed the other checklist items. In other words my
conviction to buy would be higher if the stock has:

1. Formed a recognizable candlestick pattern

2. The stoploss coincides with the S&R level
3. Volumes are above average
Along with the above points, if the stoploss also coincides with the Fibonacci level then I
know the trade setup is well aligned to all the variables and hence I would go in for a
strong buy. The usage of the word ‘strong’ just indicates the level of conviction in the
trade set up. The more confirming factors we use to study the trend and reversal, more
robust is the signal. The same logic can also be applied for the short trade.

Key takeaways from this chapter

1. The Fibonacci series forms the basis for Fibonacci retracement

2. A Fibonacci series has many mathematical properties. These mathematical properties
are prevalent in many aspects of nature
3. Traders believe the Fibonacci series has its application in stock charts as it identified
potential retracement levels
4. Fibonacci retracements are levels (61.8%, 38.2%, and 23.6% ) upto which a stock can
possibly retrace before it resumes the original directional move
5. At the Fibonacci retracement level the trader can look at initiating a new trade. However,
before initiating the trade other points in the checklist should also confirm.
If you look at a stock chart displayed on a trader’s trading terminal, you are most likely to
see lines running all over the chart. These lines are called the ‘Technical Indicators’. A
technical indicator helps a trader analyze the price movement of a security.

Indicators are independent trading systems introduced to the world by successful

traders. Indicators are built on preset logic using which traders can supplement their
technical study (candlesticks, volumes, S&R) to arrive at a trading decision. Indicators
help in buying, selling, confirming trends, and sometimes predicting trends.

Indicators are of two types namely leading and lagging. A leading indicator leads the
price, meaning it usually signals the occurrence of a reversal or a new trend in advance.
While this sounds interesting, you should note, not all leading indicators are accurate.
Leading indicators are notorious for giving false signals. Therefore, the trader should be
highly alert while using leading indicators. In fact the efficiency of using leading
indicators increases with trading experience.

A majority of leading indicators are called oscillators as they oscillate within a bounded
range. Typically an oscillator oscillates between two extreme values – for example 0 to
100. Based on the oscillator’s reading (for example 55, 70 etc) the trading interpretation
varies.

A lagging indicator on the other hand lags the price; meaning it usually signals the
occurrence of a reversal or a new trend after it has occurred. You may think, what would
be the use of getting a signal after the event has occurred? Well, it is better late than
never. One of the most popular lagging indicators is the moving averages.

You might be wondering if the moving average is an indicator in itself, why we discussed
it even before we discussed the indicators formally. The reason is that moving averages
is a core concept on its own. It finds its application within several indicators such as RSI,
MACD, Stochastic etc. Hence, for this reason we discussed moving average as a
standalone topic.

Before we proceed further into understanding individual indicators, I think it is a good

idea to understand what momentum means. Momentum is the rate at which the price
changes. For example if stock price is Rs.100 today and it moves to Rs.105 the next
day, and Rs.115, the day after, we say the momentum is high as the stock price has
changed by 15% in just 3 days. However if the same 15% change happened over let us
say 3 months, we can conclude the momentum is low. So the more rapidly the price
changes, the higher the momentum.

14.1 – Relative Strength Index

Relative strength Index or just RSI, is a very popular indicator developed by J.Welles
Wilder. RSI is a leading momentum indicator which helps in identifying a trend reversal.
RSI indicator oscillates between 0 and 100, and based on the latest indicator reading,
the expectations on the markets are set.

The term “Relative Strength Index” can be a bit misleading as it does not compare the
relative strength of two securities, but instead shows the internal strength of the security.
RSI is the most popular leading indicator, which gives out strongest signals during the
periods of sideways and non trending ranges.

The formula to calculate the RSI is as follows:

Let us understand this indicator with the help of the following example:
Assume the stock is trading at 99 on day 0, with this in perspective; consider the
following data points:

Sl No Closing Price Points Gain Points Lost

01 100 1 0

02 102 2 0

03 105 3 0

04 107 2 0

05 103 0 4

06 100 0 3

07 99 0 1

08 97 0 2

09 100 3 0

10 105 5 0

11 107 2 0

12 110 3 0
 13 114 4 0

14 118 4 0

Total 29 10

In the above table, points gained/lost denote the number of points gained/lost with
respect to the previous day close. For example if today’s close is 104 and yesterday’s
close was 100, points gained would be 4 and points lost would be 0. Similarly, if today’s
close was 104 and previous day’s close was 107, the points gained would be 0 and
points lost would be 3. Please note that, the loses are computed as positive values.

We have used 14 data points for the calculation, which is the default period setting in the
charting software. This is also called the ‘look-back period’. If you are analyzing hourly
charts the default period is 14 hours, and if you are analyzing daily charts, the default
period is 14 days.

The first step is to calculate ‘RS’ also called the RSI factor. RS as you can see in the
formula, is the ratio of average points gained by the average points lost.

Average Points Gained = 29/14

= 2.07

Average Points Lost = 10/14

= 0.714

RS = 2.07/0.714

= 2.8991

Plugging in the value of RS in RSI formula,

= 100 – [100/ (1+2.8991)]

= 100 – [100/3.8991]

= 100 – 25.6469

RSI = 74.3531

As you can see RSI calculation is fairly simple. The objective of using RSI is to help the
trader identify over sold and overbought price areas. Overbought implies that the
positive momentum in the stock is so high that it may not be sustainable for long and
hence there could be a correction. Likewise, an oversold position indicates that the
negative momentum is high leading to a possible reversal.

Take a look at the chart of Cipla Ltd, you will find a lot of interesting developments:
To begin with, the red line below the price chart indicates the 14 period RSI. If you notice
the RSI’s scale you will realize its upper bound to 100, and lower bound to 0. However
100 and 0 are not visible in the chart.

When the RSI reading is between 30 and 0, the security is supposed to be oversold and
ready for an upward correction. When the security reading is between 70 and 100, the
security is supposed to be heavily bought and is ready for a downward correction.

The first vertical line marked from left shows a level where RSI is below 30, in fact RSI is
26.8. Hence RSI suggests that the stock is oversold. In this particular example, the RSI
value of 26.8, also coincides with a bullish engulfing pattern. This gives the trader a
double confirmation to go long! Needless to say, both volumes and S&R should also
confirm to this.

The second vertical line, points to a level where the RSI turns 81, a value which is
considered overbought. Hence, if not for looking at shorting opportunities, the trader
should be careful in his decision to buy the stock. Again, if you notice the candles, they
form a bearish engulfing pattern. So a bearish engulfing pattern, backed by an RSI of 81
is a sign to short the stock. What follows this is a quick and a short correction in the
stock.

The example that I have shown here is quite nice, meaning both the candlestick pattern
and RSI perfectly align to confirm the occurrence of the same event. This may not
always be true. This leads us to another interesting way to interpret RSI. Imagine the
following two scenarios:

Scenario 1) A stock which is in a continuous uptrend (remember the uptrend can last
from few days to few years) the RSI will remain stuck in the overbought region for a long
time, and this is because the RSI is upper bound to 100. It cannot go beyond 100.
Invariably the trader would be looking at shorting opportunities but the stock on the other
hand will be in a different orbit. Example – Eicher motors Limited, the stock has generate
a return of close to 100% year on year.

Scenario 2) A stock which is in a continuous downtrend the RSI will be stuck in the
oversold region since the RSI is lower bound to 0. It cannot go beyond 0. In this case as
well the trader will be looking at buying opportunities but the stock will be going down
lower. Example – Suzlon Energy, the stock has generated a return of negative 34% year
on year.
 This leads us to interpret RSI in many different ways besides the classical interpretation
(which we discussed earlier)

1. If the RSI is fixed in an overbought region for a prolonged period, look for buying
opportunities instead of shorting. The RSI stays in the overbought region for a prolonged
period because of an excess positive momentum
2. If the RSI is fixed in an oversold region for a prolonged period, look for selling
opportunities rather than buying. RSI stays in the oversold region for a prolonged period
because of an excess negative momentum
3. If the RSI value starts moving away from the oversold value after a prolonged period,
look for buying opportunities. For example, the RSI moves above 30 after a long time
may mean that the stock may have bottomed out, hence a case of going long.
4. If the RSI value starts moving away from the overbought value after a prolonged period,
look for selling opportunities. For example, RSI moving below 70 after a long time. This
means the stock may have topped out, hence a case for shorting

14.2 – One last note

None of the parameters used while analyzing RSI should be treated with rigidity. For
example, J.Welles Wilder opted to use a look back period of 14 days simply because
that was the value which gave the best results considering the market conditions in 1978
(which is when RSI was introduced to the world). You may choose to use 5,10,20, or
even 100 days look back period if you wish too. In fact this is how you develop your
edge as a trader. You need to analyze what works for you and adopt the same. Please
note, fewer the days you use to calculate the RSI, the more volatile the indicator would
be.

Also, J.Welles Wilder decided to use 0-30 level to indicate oversold regions and 70-100
level to indicate overbought region. Again this is not set in stone, you can arrive at you
own combination.

I personally prefer to use 0-20 level and 80-100 level to identify oversold and overbought
regions respectively. I use this along with the classical 14 day look back period.

Of course, I urge you to explore parameters that work for you. In fact this is how you
would eventually develop as a successful trader.

Finally, do remember RSI is not used often as a standalone indicator by traders, it is

used along with other candlestick patterns and indicators to study the market.

Key takeaways from this chapter

1. Indicators are independent trading systems developed, and introduced by successful

traders
2. Indicators are leading or lagging. Leading indicators signals the possible occurrence of
an event. Lagging indicators on the other hand confirms an ongoing trend
3. RSI is a momentum oscillator which oscillates between 0 and 100 level
4. A value between 0 and 30 is considered oversold, hence the trader should look at
buying opportunities
5. A value between 70 and 100 is considered overbought, hence the trader should look at
selling opportunities
6. If the RSI value is fixed in a region for a prolonged period, it indicates excess momentum
and hence instead of taking a reversed position, the trader can consider initiating a trade
in the same direction.

15.1 Moving Average Convergence and Divergence

(MACD)
The Moving Average Convergence and Divergence (MACD) indicator was developed by
Gerald Appel in the late seventies. Traders consider MACD as the grand old daddy of
indicators. Though invented in the seventies, MACD is still considered as one of the
most reliable indicators by momentum traders.

As the name suggests, MACD is all about the convergence and divergence of the two
moving averages. Convergence occurs when the two moving averages move towards
each other, and a divergence occurs when the moving averages move away from each
other.

A standard MACD is calculated using a 12 day EMA and a 26 day EMA. Please note,
both the EMA’s are based on the closing prices.We subtract the 26 EMA from the 12 day
EMA, to estimate the convergence and divergence (CD) value. A simple line graph of
this is often referred to as the ‘MACD Line’. Let us go through the math first and then
figure out the applications of MACD.

Date Close 12 Day EMA 26 Day EMA MACD Line

1-Jan-14 6302

2-Jan-14 6221

3-Jan-14 6211

6-Jan-14 6191
7-Jan-14 6162

8-Jan-14 6175

9-Jan-14 6168

10-Jan-14 6171

13-Jan-14 6273

14-Jan-14 6242

15-Jan-14 6321

16-Jan-14 6319

17-Jan-14 6262 6230

20-Jan-14 6304 6226

21-Jan-14 6314 6233

22-Jan-14 6339 6242

23-Jan-14 6346 6254

24-Jan-14 6267 6269

27-Jan-14 6136 6277

28-Jan-14 6126 6274

29-Jan-14 6120 6271

30-Jan-14 6074 6258

31-Jan-14 6090 6244

3-Feb-14 6002 6225

4-Feb-14 6001 6198

5-Feb-14 6022 6176

6-Feb-14 6036 6153 6198 -45

7-Feb-14 6063 6130 6188 -58

10-Feb-14 6053 6107 6182 -75

11-Feb-14 6063 6083 6176 -94

12-Feb-14 6084 6066 6171 -106

13-Feb-14 6001 6061 6168 -107

 Let us go through the table starting from left:

1. We have the dates, starting from 1st Jan 2014

2. Next to the dates we have the closing price of Nifty
3. We leave the first 12 data points (closing price of Nifty) to calculate the 12 day EMA
4. We then leave the first 26 data points to calculate the 26 day EMA
5. Once we have both 12 and 26 day EMA running parallel to each other (6th Feb 2014) we
calculate the MACD value
6. MACD value = [12 day EMA – 26 day EMA]. For example on 6th Feb 2014, 12 day EMA
was 6153, and 26 day EMA was 6198, hence the MACD would be 6153-6198 = – 45
When we calculate the MACD value over a series of 12 and 26 day EMAs and plot it as
a line graph, we get the MACD line, which oscillates above and below the central line.

Date Close 12 Day EMA 26 Day EMA MACD Line

1-Jan-14 6302

2-Jan-14 6221

3-Jan-14 6211

6-Jan-14 6191

7-Jan-14 6162

8-Jan-14 6175

9-Jan-14 6168

10-Jan-14 6171

13-Jan-14 6273
14-Jan-14 6242

15-Jan-14 6321

16-Jan-14 6319

17-Jan-14 6262 6230

20-Jan-14 6304 6226

21-Jan-14 6314 6233

22-Jan-14 6339 6242

23-Jan-14 6346 6254

24-Jan-14 6267 6269

27-Jan-14 6136 6277

28-Jan-14 6126 6274

29-Jan-14 6120 6271

30-Jan-14 6074 6258

31-Jan-14 6090 6244

3-Feb-14 6002 6225

4-Feb-14 6001 6198

5-Feb-14 6022 6176

6-Feb-14 6036 6153 6198 -45

7-Feb-14 6063 6130 6188 -58

10-Feb-14 6053 6107 6182 -75

11-Feb-14 6063 6083 6176 -94

12-Feb-14 6084 6066 6171 -106

13-Feb-14 6001 6061 6168 -107

14-Feb-14 6048 6051 6161 -111

17-Feb-14 6073 6045 6157 -112

18-Feb-14 6127 6045 6153 -108

19-Feb-14 6153 6048 6147 -100

20-Feb-14 6091 6060 6144 -84

21-Feb-14 6155 6068 6135 -67

24-Feb-14 6186 6079 6129 -50

25-Feb-14 6200 6092 6126 -34

26-Feb-14 6239 6103 6122 -19

28-Feb-14 6277 6118 6119 -1

3-Mar-14 6221 6136 6117 20

4-Mar-14 6298 6148 6112 36

5-Mar-14 6329 6172 6113 59

6-Mar-14 6401 6196 6121 75

7-Mar-14 6527 6223 6131 92

10-Mar-14 6537 6256 6147 110

11-Mar-14 6512 6288 6165 124

12-Mar-14 6517 6324 6181 143

13-Mar-14 6493 6354 6201 153

 14-Mar-14 6504 6380 6220 160

Given the MACD value, lets try and find the answer for few obvious questions:

1. What does a negative MACD value indicate?

2. What does a positive MACD value indicate?
3. What does the magnitude of the MACD value actually mean? As in, what information
does a -90 MACD convey versus a – 30 MACD ?
The sign associated with the MACD just indicates the direction of the stock’s move. For
example if the 12 Day EMA is 6380, and 26 Day EMA is 6220 then the MACD value is
+160. Now, under what circumstance do you think the 12 day EMA will be greater than
the 26 day EMA? Well, we had looked into this in the moving average chapter. The
shorter term average will generally be higher than the longer term only when the stock
price is trending upwards. Also, do remember, the shorter term average will always be
more reactive to the current market price than the longer term average. Hence a positive
sign tells us that there is positive momentum in the stock, and the stock is drifting
upwards. The higher the momentum, the higher is the magnitude. For example, +160
indicate a positive trend which is stronger than +120.

However, while dealing with the magnitude, always remember the price of the stock
influences the magnitude. For example, higher the underlying price such as Bank Nifty,
naturally, the higher will be the magnitude of the MACD.

When the MACD is negative, it means the 12 day EMA is lower than the 26 day EMA.
Therefore the momentum is negative. Higher the magnitude of the MACD, the more
strength in the downward trend.

The difference between the two moving averages is called the MACD spread. The
spread decreases when the momentum mellows down and increases when the
momentum increases. To visualize convergence and the divergence traders usually plot
the chart of the MACD value, often referred to as the MACD line.

The following is the MACD line chart of Nifty for data points starting from 1 st Jan 2014 to
18th Aug 2014.
 As you can see the MACD line oscillates over a central zero line. This is also called the
‘Center line’. The basic interpretation of the MACD indicator is that:

1. When the MACD Line crosses the center line from the negative territory to positive
territory, it means there is divergence between the two averages. This is a sign of
increasing bullish momentum; therefore one should look at buying opportunities. From
the chart above, we can see this panning out around 27thFeb
2. When the MACD line crosses the center line from positive territory to the negative
territory it means there is convergence between the two averages. This is a sign of
increasing bearish momentum; therefore one should look at selling opportunities. As you
can see, there were two instance during which the MACD almost turned negative
(8th May, and 24th July) but the MACD just stopped at the zero line and reversed
directions
Traders generally argue that while waiting for the MACD line to crossover the center line
a bulk of the move would already be done and perhaps it would be late to enter a trade.
To overcome this, there is an improvisation over this basic MACD line. The
improvisation comes in the form of an additional MACD component which is the 9 day
signal line. A 9 day signal line is a exponential moving average (EMA) of the MACD line.
If you think about this, we now have two lines:

1. A MACD line
2. A 9 day EMA of the MACD line, also called the signal line
With these two lines, a trader can follow a simple 2 line crossover strategy as discussed
in the moving averages chapter, and no longer wait for the center line cross over.

1. The sentiment is bullish when the MACD line crosses the 9 day EMA wherein MACD
line is greater than the 9 day EMA. When this happens, the trader should look at buying
opportunities
2. The sentiment is bearish when the MACD line crosses below the 9 day EMA wherein the
MACD line is lesser than the 9 day EMA. When this happens, the trader should look at
selling opportunities
The chart below plots the MACD indicator on Asian Paints Limited. You can see the
MACD indicator below the price chart.

The indicator uses standard parameters of MACD:

1. 12 day EMA of closing prices
2. 26 day EMA of closing prices
3. MACD line (12D EMA – 26D EMA) represented by the black line
4. 9 day EMA of the MACD line represented by the red line
The vertical lines on the chart highlight the crossover points on the chart where a signal
to either buy or sell has originated.

For example, the first vertical line starting from left points to a crossover where the
MACD line lies below the signal line (9 day EMA) lies and suggests a short trade.

The 2nd vertical line from left, points to a crossover where the MACD line lies above the
signal line, hence one should look at buying opportunity. So on and so forth.

Please note, at the core of the MACD system, are moving averages. Hence the MACD
indicator has similar properties like that of a moving average system. They work quite
well when there is a strong trend and are not too useful when the markets are moving
sideways. You can notice this between the 1st two line starting from left.

Needless to say, the MACD parameters are not set in stone. One is free to change the
12 day, and 26 day EMA to whatever time frame one prefers. I personally like to use the
MACD in its original form, as introduced by Gerald Appel.

15.2 – The Bollinger Bands

Introduced by John Bollinger in the 1980s, Bollinger bands (BB) is perhaps one of the
most useful indicators used in technical analysis. BB are used to determine overbought
and oversold levels, where a trader will try to sell when the price reaches the top of the
band and will execute a buy when the price reaches the bottom of the band.

The BB has 3 components:

1. Middle line which is The 20 day simple moving average of the closing prices
2. An upper band – this is the +2 standard deviation of the middle line
3. A lower band – this is the -2 standard deviation of the middle line
The standard deviation (SD) is a statistical concept; which measures the variance of a
particular variable from its average. In finance, the standard deviation of the stock price
represents the volatility of a stock. For example, if the standard deviation of a stock is
12%, it is as good as saying that the volatility of the stock is 12%.

In BB, the standard deviation is applied on the 20 day SMA. The upper band indicates
the +2 SD. By using a +2 SD, we simply multiply the SD by 2, and add it to the average.

For example if the 20 day SMA is 7800, and the SD is 75 (or 0.96%), then the +2 SD
would be 7800 + (75*2) = 7950. Likewise, a -2 SD indicates we multiply the SD by 2,
and subtract it from the average. 7800 – (2*75) = 7650.

We now have the components of the BB:

1. 20 day SMA = 7800

2. Upper band = 7950
3. Lower band = 7650
Statistically speaking, the current market price should hover around the average price of
7800. However, if the current market price is around 7950, then it is considered
expensive with respect to the average, hence one should look at shorting opportunities
with an expectation that the price will scale back to its average price.

Therefore the trade would be to sell at 7950, with a target of 7800.

Likewise if the current market price is around 7650, it is considered cheap with respect
to the average prices, and hence one should look at buying opportunities with and
expectation that the prices will scale back to its average price.

Therefore the trade would be to buy at 7650, with a target of 7800.

The upper and lower bands act as a trigger to initiate a trade.

The following is the chart of BPCL Limited,

The central black line is the 20 day SMA. The two red lines placed above and below the
black like are the +2 SD, and -2SD. The idea is to short the stock when the price
touches the upper band with an expectation that it will revert to average. Likewise one
can go long when the price touches the lower band with an expectation it will revert to
the average.

I have highlighted using a down arrow all the sell signals BB generated, while most of
the signals worked quite well, there was a phase when the price stuck to the upper
band. In fact the price continued to drift higher, and therefore even the upper band
expanded. This is called an envelope expansion.

The BB’s upper and lower band together forms an envelope. The envelope expands,
whenever the price drifts in a particular direction indicating a strong momentum. The BB
signal fails when there is an envelope expansion. This leads us to an important
conclusion; BB works well in sideways markets, and fails in a trending market.

Personally whenever, I use BB I expect the trade to start working in my favor almost
immediately. If it does not, I start validating the possibility of an envelope expansion.

15.3 – Other Indicators

 There are numerous other technical indicators, and the list is endless. The question is,
should you know all these indicators to be a successful trader? The answer is a simple
no. Technical indicators are good to know, but they by no means should be your main
tool of analysis.

I have personally met many aspiring traders who spend a lot of time, and energy
learning different indicators, but this in the long run is futile. The working knowledge of
few basic indicators, such as the ones discussed in this module are sufficient.

15.4 – The Checklist

In the previous chapters, we started building a checklist that acts as a guiding force
behind the trader’s decision to buy or sell. It is time to revisit that checklist.

The indicators act as tool which the traders can use to confirm their trading decisions, it
is worthwhile to check what the indicators are conveying before placing a buy or a sell
order. While the dependence on indicators is not as much S&R, volumes or candlestick
patterns, it is always good to know what the basic indicators are suggesting. For this
reason, I would recommend adding indicators in the checklist, but with a twist to it. I will
explain the twist in a bit, but before that let us reproduce the updated checklist.

1. The stock should form a recognizable candlestick pattern

2. S&R should confirm to the trade. The stoploss price should be around S&R
1. For a long trade, the low of the pattern should be around the support
2. For a short trade, the high of the pattern should be around the resistance
3. Volumes should confirm
1. Ensure above average volumes on both buy and sell day
2. Low volumes are not encouraging, hence do feel free to hesitate while taking trade where the
volumes are low
4. Indicators should confirm
1. Scale the size higher if the confirm
2. If they don’t confirm, go ahead with the original plan
The sub bullet points under indicators are where the twist lies.

Now, hypothetically imagine a situation where you are looking at opportunity to buy
shares of Karnataka Bank Limited. On a particular day, Karnataka Bank has formed a
bullish hammer, assume everything ticks on the checklist:

1. Bullish hammer is a recognizable candlestick pattern

2. The low of the bullish hammer also coincides with the support
3. The volumes are above average
4. There is also an MACD crossover (signal line turns greater than the MACD line)
With all four checklist points being ticked off I would be very glad to buy Karnataka Bank.
Hence I place an order to buy, let us say for 500 shares.

However, imagine a situation where the first 3 checklist conditions are met but the
4th condition (indicators should confirm) is not satisfied. What do you think I should do?

I would still go ahead and buy, but instead of 500 shares, I’d probably buy 300 shares.
 This should hopefully convey to you how I tend to (and advocate) the use of indicators.

When Indicators confirm, I increase my bet size, but when Indicators don’t confirm I still
go ahead with my decision to buy, but I scale down my bet size.

However I would not do this with the first three checklist points. For example, if the low of
the bullish hammer does not coincide in and around the support, then I’ll really
reconsider my plan to buy the stock; in fact I may skip the opportunity, and look for
another opportunity.

But I do not treat the indicators with the same conviction. It is always good to know what
indicators convey, but I don’t base my decisions on that. If the indicators confirm, I
increase the bet size, if they don’t, I still go ahead with my original game plan.

Key takeaways from this chapter

1. A MACD is a trend following system

2. MACD consists of a 12 Day, 26 day EMA
3. MACD line is 12d EMA – 26d EMA
4. Signal line is the 9 day SMA of the MACD line
5. A crossover strategy can be applied between MACD Line, and the signal line
6. The Bollinger band captures the volatility. It has a 20 day average, a +2 SD, and a -2 SD
7. One can short when the current price is at +2SD with an expectation that the price
reverts to the average
8. One can go long when the current price is at -2SD with an expectation that the price
reverts to the average
9. BB works well in a sideways market. In a trending market the BB’s envelope expands,
and generates many false signals
10. Indicators are good to know, but it should not be treated as the single source for
decision making.

The Dow Theory (Part 1)

122

The Dow Theory has always been a very integral part of technical analysis. The Dow
Theory was used extensively even before the western world discovered candlesticks. In
fact even today Dow Theory concepts are being used. In fact traders blend the best
practices from Candlesticks and Dow Theory.

The Dow Theory was introduced to the world by Charles H. Dow, who also founded the
Dow-Jones financial news service (Wall Street Journal). During his time, he wrote a
series of articles starting from 1900s which in the later years was referred to as ‘The
Dow Theory’. Much credit goes to William P Hamilton, who compiled these articles with
relevant examples over a period of 27 years. Much has changed since the time of
Charles Dow, and hence there are supporters and critics of the Dow Theory.
17.1 – The Dow Theory Principles
The Dow Theory is built on a few beliefs. These are called the Dow Theory tenets.
These tenets were developed by Charles H Dow over the years of his observation on
the markets. There are 9 tenets that are considered as the guiding force behind the Dow
Theory. They are as follows:

Sl
Tenet What does it mean?
No

The stock market indices discount everything which is known &

unknown in the public domain. If a sudden and unexpected event
01 Indices discounts everything
occurs, the stock market indices quickly recalibrates itself to reflect
the accurate value

Overall there are 3 broad

02 Primary Trend, Secondary Trend, and Minor Trends
market trends

This is the major trend of the market that lasts from a year to
several years. It indicates the broader multiyear direction of the
03 The Primary Trend market. While the long term investor is interested in the primary
trend, an active trader is interested in all trends. The primary trend
could be a primary uptrend or a primary down trend
 These are corrections to the primary trend. Think of this as a minor
counter reaction to the larger movement in the market. Example –
04 The Secondary Trend corrections in the bull market, rallies & recoveries in the bear
market. The counter trend can last anywhere between a few
weeks to several months

Minor Trends/Daily These are daily fluctuations in the market, some traders prefer to
05
fluctuations call them market noise

We cannot confirm a trend based on just one index. For example

the market is said to be bullish only if CNX Nifty, CNX Nifty Midcap,
All Indices must confirm with
06 CNX Nifty Smallcap etc all move in the same upward direction. It
each other
would not be possible to classify markets as bullish, just by the
action of CNX Nifty alone

The volumes must confirm along with price. The trend should be
supported by volume. In an uptrend the volume must increase as
07 Volumes must confirm the price rises and should reduce as the price falls. In a downtrend,
volume must increase when the price falls and decrease when the
price rises. You could refer chapter 12 for more details on volume

Markets may remain sideways (trading between a range) for an

Sideway markets can
extended period. Example:- Reliance Industries between 2010 and
08 substitute secondary
2013 was trading between 860 and 990. The sideways markets can
markets
be a substitute for a secondary trend

Between the open, high, low and close prices, the close is the most
The closing price is the most
09 important price level as it represents the final evaluation of the
sacred
stock during the day

17.2 – The different phases of Market

Dow Theory suggests the markets are made up of three distinct phases, which are self
repeating. These are called the Accumulation phase, the Mark up phase, and the
Distribution phase.

The Accumulation phase usually occurs right after a steep sell off in the market. The
steep sell off in the markets would have frustrated many market participants, losing hope
of any sort of uptrend in prices. The stock prices would have plummeted to rock bottom
valuations, but the buyers would still be hesitant of buying fearing there could be another
sell off. Hence the stock price languishes at low levels. This is when the ‘Smart Money’
enters the market.

Smart money is usually the institutional investors who invest from a long term
perspective. They invariably seek value investments which is available after a steep sell
off. Institutional investors start to acquire shares regularly, in large quantities over an
extended period of time. This is what makes up an accumulation phase. This also
means that the sellers who are trying to sell during the accumulation phase will easily
find buyers, and therefore the prices do not decline further. Hence invariably the
accumulation phase marks the bottom of the markets. More often than not, this is how
the support levels are created. Accumulation phase can last up to several months.

Once the institutional investors (smart money) absorb all the available stocks, short term
traders sense the occurrence of a support. This usually coincides with improved
business sentiment. These factors tend to take the stock price higher. This is called the
mark up phase. During the Mark up phase, the stock price rallies quickly and sharply.
The most important feature of the mark up phase is the speed. Because the rally is
quick, the public at large is left out of the rally. New investors are mesmerized by the
return and everyone from the analysts to the public see higher levels ahead.

Finally when the stock price reaches new highs (52 week high, all time high) everyone
around would be talking about the stock market. The news reports turn optimistic,
business environment suddenly appears vibrant, and everyone one (public) wants to
invest in the markets. The public by and large, wants to get involved in the markets as
there is a positive sentiment. This is when the distribution phase occurs.

The judicious investors (smart investors) who got in early (during the accumulation
phase) will start offloading their shares slowly. The public will absorb all the volumes off
loaded by the institutional investors (smart money) there by giving them the well needed
 price support. The distribution phase has similar price properties as that of the
accumulation phase. In the distribution phase, whenever the prices attempt to go higher,
the smart money off loads their holdings. Over a period of time this action repeats
several times and thus the resistance level is created.

Finally when the institutional investors (smart money) completely sell off their holdings,
there would no further support for prices, and hence what follows after the distribution
phase is a complete sell off in the markets, also known as the mark down of prices. The
selloff in the market leaves the public in an utter state of frustration.

Completing the circle, what follows the selloff phase is a fresh round of accumulation
phase, and the whole cycle repeats again. It is believed that that entire cycle from
accumulation phase to the selloff spans over a few years.

It is important to note that no two market cycles are the same. For example in the Indian
context the bull market of 2006 – 07 is way different from the bull market of 2013-14.
Sometimes the market moves from the accumulation to the distribution phase over a
prolonged multi-year period. On the other hand, the same move from the accumulation
to the distribution can happen over a few months. The market participant needs to tune
himself to the idea of evaluating markets in the context of different phases, as this sets a
stage for developing a view on the market.

17.3 – The Dow Patterns

Like in candlesticks, there are few important patterns in Dow Theory as well. The trader
can use these patterns to identify trading opportunities. Some of the patterns that we will
study are:

1. The Double bottom & Double top formation

2. The Triple Bottom & Triple Top
3. Range formation, and
4. Flag formation
The support and resistance is also a core concept for the Dow Theory, but because of its
importance (in terms of placing targets and stop loss) we have discussed it much earlier
a chapter dedicated to it.

17.4 – The Double bottom and top formation

A double top & double bottom is considered a reversal pattern. A double bottom occurs
when the price of a stock hits a particular low price level and rebounds back with a quick
recovery. Following the price recovery the stock trades at a higher level (relative to the
low price) for at least 2 weeks (well spaced in time). After which the stock attempts to hit
back to the low price previously made. If the stock holds up once again and rebounds,
then a double bottom is formed.

A double bottom formation is considered bullish, and hence one should look at buying
opportunities. Here is a chart that shows a double bottom formation in Cipla Limited:
Notice the time interval between the two bottom formations. It is evident that the price
level was well spaced in time.

Likewise in a double top formation, the stock attempts to hit the same high price twice
but eventually sells off. Of course the time gap between the two attempts of crossing the
high should at least be 2 weeks. In the chart below (Cairn India Ltd), we can notice the
double top at 336 levels. On close observation you will notice the first top was around
Rs.336, and the second top was around Rs.332. With some amount of flexibility a small
difference such as this should be considered alright.

From my own trading experience, I find both double tops and double bottoms very useful
while trading. I always look for opportunities where the double formation coincides with a
recognizable candlesticks formation.

For instance, imagine a situation where in the double top formation, the 2 nd top forms a
bearish pattern such as shooting star. This means, both from the Dow Theory and
candlestick perspective there is consensus to sell; hence the conviction to take the trade
is higher.

17.5 – The triple top and bottom

As you may have guessed, a triple formation is similar to a double formation, except that
the price level is tested thrice as opposed twice in a double bottom. The interpretation of
the triple formation is similar to the double formation.

As a rule of thumb the more number of times the price tests, and reacts to a certain price
level, the more sacred the price level is considered. Therefore by virtue of this, the triple
formation is considered more powerful than the double formation.
 The following chart shows a triple top formation for DLF Limited. Notice the sharp sell off
after testing the price level for the 3rd time, thus completing the triple top.

Key takeaways from this chapter

1. Dow Theory was used in the western world even before candlesticks were formally
introduced
2. Dow Theory works on 9 basic tenets
3. Market can be viewed in 3 basic phases – accumulation, mark up, and distribution
phase
4. The accumulation phase is when the institutional investor (smart money) enters the
market, mark up phase is when traders make an entry, and the final distribution phase is
when the larger public enter the market
5. What follows the distribution phase is the mark down phase, following which the
accumulation phase will complete the circle
6. The Dow theory has a few basic patterns, which are best used in conjunction with
candlesticks
7. The double and triple formations are reversal patterns, which are quite effective
8. The interpretation of double and triple formations are the same