TECHNICAL ANALYSIS TYBFM

TYBFM – Technical Analysis

Content Index
No. Particulars

Module 1: Introduction to Technical Analysis

1 Introduction To Technical Analysis:
Meaning of Technical Analysis, Basics Assumptions of Technical Analysis,
Advantages & Disadvantages of Technical Analysis, Types of Charts
2 Candlestick Formation:
Introduction to Candlestick Patterns, One Candle Patterns, Two Candle Patterns,
Three Candle Patterns, Meaning of Support & Resistance, Role Reversal of Support
& Resistance, Importance of Support & Resistance
3 Chart Patterns:
Head and Shoulders, Inverted Head and Shoulders, Double Tops, Double Bottoms,
Triple Tops, Triple Bottoms, Channels, Rounded Top, Rounded Bottom, Cup and
Handle, Triangles, Flag and Pennant, Wedges, Gap Theory, Island Cluster

Module 2: Major Indicators and Oscillators

1 Indicators and Oscillators
Introduction to Indicators, Types of Indicators, Moving Averages – Simple &
Exponential, Relative Strength Index (RSI), Problems in RSI, Moving Average
Convergence and Divergence (MACD), Money Flow Index (MFI), Bollinger Bands

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Chapter
Introduction to Technical Analysis
1

Content:
1.1 Meaning of Technical Analysis
1.2 Basics Assumptions of Technical Analysis
1.3 Advantages of Technical Analysis
1.4 Disadvantages of Technical Analysis
1.5 Types of Charts

1.1 Meaning of Technical Analysis:

Investors need to analyse many factors

relating to investment avenues before investing.
The investor has to consider various aspects of
investment such as safety, returns, liquidity,
capital appreciation, tax benefit, etc. thus,
investment analysis is a precondition of investment.
The methods used to analyse securities and make
investment decisions fall into two broad
categories:
• Fundamental analysis and
• Technical analysis.

Technical analysis is the forecasting of future price movements on an examination of

past price movement. Like weather forecasting, technical analysis does not result in absolute
predictions about the future. Instead, help investors anticipate what is "likely" to happen to
price over time. Technical analysis uses a wide variety of charts that shows price over time. It
involves evaluation of a particular share/security on the basis of various aspects such as past
prices of the share, volume of trading, etc. by using various statistical tools and techniques.

Technical analysis studies supply and demand in a market in an attempt to determine

what direction or trend will continue in the future. In other words, technical analysis attempts
to understand the emotions in the market by studying the market itself. Technical analysis
looks backward as it analyses past price movements and volume of trading. Technical analysis
takes short term point of view. The past price movements are plotted on various graphs and
charts to identify history of price movements. This past trend helps to predict future trends in
share prices.

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1.2 Basics Assumptions of Technical Analysis:

What makes technical analysis an effective tool to analyse

price behaviour is explained by price theories by Charles Dow.
They key assumptions of technical analysis are a part of
Charles Dow theory. These assumptions are:

1. The market discounts everything: Technical analysis

assumes that at any given time a stock's price reflects
everything that has or could affect the company including
fundamental factors. It means the current supply/demand
situation has already taken all publicly available information
into account, therefore nothing that is currently known,
should affect the price.
The technician believes that anything that can possible affect the price-fundamentally,
politically, psychologically, or otherwise-is actually reflected in the price of that market.

2. Price moves in trends: The concept of trend is absolutely essential to the technical
approach. The whole purpose of charting the price action of a market is to identify trends in
early stages of their development for the purpose of trading in the direction of those
trends. In fact, most of the techniques used in this approach are trend-following in nature,
meaning, that their intent is to identify and follow existing trends.
In technical analysis, price movements are believed to follow trends. This means that after a
trend has been established, the future price movement is more likely to be in the same
direction as the trend rather than to be against it. Hence Technicians often says “Trend is
your Friend”.

3. History tends to repeat itself: Another important idea in technical analysis is that history
tends to repeat itself, mainly in terms of price movements.
Technical analysts believe that history tends to repeat itself. The repetitive nature of price
movements is often attributed to market psychology, which tends to be very predictable
based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze
these emotions and subsequent market movements to understand trends. While many forms
of technical analysis have been used for more than 100 years, they are still believed to be
relevant because they illustrate patterns in price movements that often repeat themselves

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1.3 Advantages of Technical Analysis:

1. Universal Applicability: Technical Analysis has universal applicability. Its use is not
restricted to stocks only. It can be used for trading in all assets like Stocks, Commodities,
Currencies, Derivatives, Etc. A strategy that works well in one market can also be tried in
other markets. Trying a successful strategy in other markets is good for risk diversification.
Expanding profit growth opportunities can also be a significant advantage.

2. Easy to understand: In Technical Analysis one is not require to know and study lengthy
Financial Reports of the company. No need to check the fundamentals. Trader is supposed to
look only Charts, Volume and relevant data hence it is easy to understand. Many traders use
technical analysis because it provides clear trading rules. For example, buying when the price
breaks above a moving average. By displaying indicators on a chart and using technical
analysis to understand the relationship between the price and the indicator, it can be clear
where to buy and sell.

3. Quick execution: Technical analysis can be done very quickly. Compare this with fundamental
analysis, which requires time-consuming reading of news and reports. You can take trades in
seconds and minutes by just looking the charts and Indicators. Constructing automated
trading systems based on technical analysis rules and algorithms is also possible.

4. Clear entry signals: Technical analysis provides a clear numerical indication of where to buy
and sell. Good technical analysis successfully captures recurring market patterns and enables
repeatable trades with relatively simple rules. Bad technical analysis produces complex
trading signals which can be too confusing to make good trading decisions.

5. Strategy Optimisation: As technical analysis focuses on price movement patterns, the

effectiveness of strategies can be back-tested using historical data. You can also test
different strategies and determine which gives you the best chance. The same strategy can
then be optimised for that particular market by changing the parameters and trying it out.
You can do it all in a short period of time.

6. Support & Resistance: Technical Analysis Provides 2 Price levels, Support & Resistance.
Support can be a price level on the chart or a price zone. In any event, support is an area on
a price chart that shows buyers’ willingness to buy. It is at this level that demand will usually
overwhelm supply, causing the price decline to halt and reverse. Resistance is the opposite of
support. As prices move higher, there will come a point when selling will overwhelm the desire
to buy. On a price chart a level at which supply begins to overwhelm demand. This is
resistance. Like support, it can be a level or a zone.

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1.4 Disadvantages of Technical Analysis:

1. Baisness: Technical analysis is not hard core science. It is Subjective in Nature and your
personal biases can be reflected in the analysis. It is important to be aware of these baises
when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow
the analysis. On the other hand, if the analyst is a bear, then a bearish bias will overshadow
the analysis.

2. Ever-changing chart patterns: Markets repeat patterns, but these patterns are constantly
changing, making it difficult to make money in the long term by always making the same
trades. For example, suppose you can make large profits using simple moving averages in a
strong trending market. However, if you use the same simple moving average strategy when
the market enters a range, you will lose a lot of money.

3. The myth of the perfect indicator: Traders who experience only losses assume that if
they use the right indicators they will be able to make money and reduce their losses.
However, most traders' losses are due to poor risk management and missed trades caused by
the stress of losing while trading. There is no perfect indicator that can make profits in any
market.

4. Indicators showing opposite signals: Many traders assume that the best indicator for long-
term profits is seemingly difficult to find and that combining multiple indicators is optimal.
They also feel that if they can understand complex theories using advanced mathematics,
and they can become an evergreen trader. In reality, however, strategies that take a lot of
time and effort to construct do not always work. When multiple indicators are displayed on a
single chart, it is difficult to decide which one to look at and trade. For example, if the
moving average is a sell signal, but the RSI shows a buy signal, you will not know how to
trade, leading to losses.

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1.5 Types of Charts:

1. Line chart
One of the most basic charts used in technical analysis, the line chart is used to depict the
trends in the price of a particular stock or index over a certain period of time. This kind of
chart is very useful when it comes to determining the overall trend of a stock. With one look at
a line chart, you can identify the price or volume movements of that stock.

Firstly, to plot a line chart, the prices of a stock at different points in time are marked by dots
along the horizontal and vertical axis. Here, the horizontal axis represents the time frame and
the vertical axis represents the price of the stock. Once that is done, the dots are then
connected using a line.

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2. Bar chart
A bar chart is more useful to a trader involved in
technical analysis. It depicts these four price points of a
stock for a particular period of time easily.
• The opening price
• The lowest price
• The highest price
• The closing price

A bar chart is generally depicted as a thin central

vertical line with two horizontal lines emerging from it,
one on the left and one on the right. Here’s how it looks
and what the lines mean.

When the closing price of the stock is above the opening price, the stock is said to have moved
positively. And, the bar is represented either in green. When the stock moved negatively, the
bar is depicted in red.

Another point to note when reading through a bar chart is that the length of the bar changes
according to the price range. The difference between the lowest price and the highest price of
the stock is the price range. Therefore, the longer the line, the larger the range.

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3. Candlestick chart

The candlestick charts, which first

originated in Japan, are what traders
involved in technical analysis primarily use.
It is the most popular form of charting
technique used by technical Analysts.

The structure of a candlestick is quite

similar to that of a bar chart. The only
difference is that the candlestick uses a
rectangular body to depict the opening and
closing prices of a stock instead of the two
horizontal protrusions.

The shadows, also known as tails or wicks, signify the price range of the stock. The longer the
shadows, the larger the price range.

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Chapter
Candlestick Formations
2

Content:
2.1 Introduction to Candlestick Patterns
2.2 One Candle Patterns
2.3 Two Candle Patterns
2.4 Three Candle Patterns
2.5 Meaning of Support & Resistance
2.6 Role Reversal of Support & Resistance
2.7 Importance of Support & Resistance

2.1 Introduction to Candlestick Patterns:

One cannot ignore that investor's

psychologically driven forces of fear; greed and
hope greatly influence the stock prices. The
overall market psychology can be tracked
through candlestick analysis. More than just a
method of pattern recognition, candlestick
analysis shows the interaction between buyers
and sellers. A white/green candlestick indicates
opening price of the session being below the
closing price; and a black/red candlestick shows
opening price of the session being above the
closing price. The shadow at top and bottom
indicates the high and low for the session.

Japanese candlesticks offer a quick picture into the psychology of short-term trading, studying
the effect, not the cause. Therefore, if candlestick analysis is combined with other technical
analysis tools, candlestick pattern analysis can be a very useful way to select entry and exit
points.

Candlestick analysis is based on single candle to combination of candles. Let's discuss

candlestick patterns in detail.

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2.2 ONE CANDLE PATTERN:

2.2.1 HAMMER:

Hammer is a one candle pattern that occurs in a downtrend. This

is the time when bulls try to step into the rally. It is so named
because it hammers out the bottom. Conditions need to be
watched out, while identifying hammer pattern.

Criteria:

(1) The lower shadow of hammer has to be minimum two to three times the length of body.

(2) Longer the lower shadow, higher is the potential of reversal happening.

(3) There should be no upper shadow or very small upper shadow.

(4) Colour of the real body in hammer has less significance but a green body has slightly more
bullish implications than the red body.

(5) A strong positive candle on the following day is required to confirm hammer as a reversal
pattern.

(6) Large volume on the hammer formation day sets up for strong reversal day.

(7) A gap down from the previous day's close sets up for a stronger reversal move, provided the
next day opens higher.

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Pattern Psychology:

The market has been in a downtrend, so there is an air of bearishness. The price opens and
starts to trade lower. However, the sell-off is abated and market returns to high for the day as
the bulls have stepped in. They start bringing the price back up towards the top of the trading
range. This creates a large lower shadow with a small body at the top of formation. This
represents that the bears could not maintain control. The long lower shadow now has the bears
questioning whether the decline is still intact. Confirmation would be a higher open (preferably a
small gap up opening) with even higher close (green candle) on the next trading day

2.2.2 HANGING MAN:

Hanging man is a one candle pattern that occurs in an uptrend. This

signifies a potential topping out of the present up move. This is the
time when bears try to step into the rally. Conditions need to be
watched out, while identifying hanging man pattern.

Criteria:

(1) The lower shadow of hammer has to be minimum two to three times the length of body.

(2) Longer the lower shadow, higher is the potential of reversal happening.

(3) There should be no upper shadow or very small upper shadow.

(4) Colour of the real body in hammer has less significance but a red body has slightly more
bearish implications than the green body.

(5) A strong bearish candle on the following day is required to confirm hanging man as a reversal
pattern.

(6) Large volume on the hanging man formation day sets up for strong reversal day.

7) A gap up from the previous day's close sets up for a stronge reversal move, provided the
next day opens lower.

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Pattern Psychology:

The market has been in an uptrend, so there is clear bullish sentiment in the market. The price
opens positive and starts trade higher. However, the buying fizzles away and mark returns to
low for the day as the bears have stepped in. They start bringing the price back down towards
the bottom of the trading range. Somehow bulls could pull prices little more upward and this
creates a large lower shadow with a small body at the top formation. Somewhere there is a
sense that bears have started stepping in. Confirmation would be a lower open (preferably small
gap down opening) with even lower close (red candle) on the next trading day.

2.2.3 SHOOTING STAR:

Shooting star is a one candle pattern that occurs in an uptrend This

is upside down of hanging man. This too signifies a potential topping
out of the present up move. This is the time when bears try to step
into the rally, which is clearly evident from the formation of candle
itself. Conditions need to be watched out, while identifying shooting
star pattern.

Criteria:

(1) The higher shadow of hammer has to be minimum two to three times the length of body.

(2) Longer the higher shadow, higher is the potential of reversal happening.

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(3) There should be no lower shadow or very small lower shadow.

(4) Color of the real body in hammer has less significance but a red body has slightly more
bearish implications than the green body.

(5) A strong bearish candle on the following day is required to confirm shooting star as a
reversal pattern.

(6) Large volume on the shooting star formation day sets up for strong reversal day.

7) A gap up from the previous day's close sets up for a strong reversal move, provided the next
day opens lower.

Pattern Psychology:

The market has been in an uptrend, so there is clear bullish sentiment in the market. The price
opens positive and starts to trade higher. However, the buying fizzles away and market returns
to low for the day as the bears have stepped in. They star bringing the price back down towards
the bottom of the trading range. This creates a large higher shadow with a small body at the
bottom of formation. Somewhere there is a clue that bears have started stepping in.
Confirmation would be a lower open (preferably a small gap down opening) with even lower close
(red candle) on the next trading day.

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2.2.4 INVERTED HAMMER:

Inverted hammer is a one candle pattern that occurs in a

downtrend. This is upside down of hammer. This too signifies a
potential bottoming out of the present down move. This is the time
when bulls probably try to step into the rally. Conditions need to
be watched out, while identifying inverted hammer pattern.

Criteria:

(1) The higher shadow of hammer has to be minimum two to three times the length of body.

(2) Longer the higher shadow, higher is the potential of reversal happening.

(3) There should be no lower shadow or very small lower shadow.

(4) Colour of the real body in hammer has less significance but a green body has slightly more
bullish implications than the red body. required to

(5) A strong bullish candle on the following day is confirm inverted hammer as a reversal
pattern.

(6) Large volume on the inverted hammer formation day sets up for strong reversal day.

(7) A gap down from the previous day's close sets up for a stronger reversal move, provided the
next day opens higher.

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Pattern Psychology:

After a downtrend has been in effect, the atmosphere is bearish. The price opens and starts to
trade higher. The Bulls have stepped in, but they cannot maintain the strength. The existing
sellers knock the price back down to the lower end of the trading range. The Bears are still in
control. But the next day, the Bulls step in and take the price back up without major resistance
from the Bears. If the price maintains strong after the Inverted Hammer day, the signal is
confirmed.

As mentioned by Thomas Bulkowski in his book 'Encyclopaedia of candlestick Charts', reliability

of single candlestick pattern is less and so solely trading on candlestick patterns may not be so
fruitful. But if these methods (patterns) are combined with other indicators or tools, one may
get fantastic successful results.

2.2.5 DOJI

Doji is a single candle where opening price and the closing price
are same (almost same). It basically represents confusion or
indecisiveness in the market between bulls and bears. It also
serves as a reversal pattern, if the following day candle is decisive
in action.

The diagram clearly shows the indecisiveness. Here, open and

close price are at the same level. Higher shadow shows high of the day and lower shadow shows
low of the day. Importance of doji is more if it is infrequent on chart of the security. If it
frequently appears on the chart, then the doji turns out to be less important.

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Doji at Tops and Bottoms:

Doji at tops and bottoms signify reversal of the existing trend. As it is the sign of
indecisiveness, when spotted at the top or bottom, signifies the possible trend reversal. The
indecisiveness doesn't necessarily mean reversal all the time. But it shows possible pause of the
present trend. If the following candle shows the trend reversal with decisiveness, then the
reversal gets confirmed with high probability. One needs to consider Doji as a warning sign and
be ready for surprise.

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2.3 TWO CANDLE PATTERNS:

2.3.1 BULLISH ENGULFING:

Bullish engulfing pattern turns up at the end of the downtrend,

where the bullish green candle engulfs the previous red candle
completely. This signifies that the buyers are overwhelming the
sellers.

This is one of the major reversal patterns which is generally

found at the point of reversal. It is formed when the small red
body is completely eclipsed by the next big green candle. It
basically opens below the low of the previous day and closes above the high of the previous day.

Criteria:

(1) Candlestick body of the previous day is completely covered by the next day's candlestick.

(2) Previous price rally has to be downtrend, even if for short term.

(3) If the first candle is small enough and the second candle is large in size, that gives a very
strong confirmation of the reverse rally.

(4) Large volume on the engulfing day increases the probability of reversal.

(5) After engulfing candle, a strong bullish candle serves as a confirmation of beginning of
uptrend.

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Pattern Psychology:

In a persistent downtrend, on the day of engulfing candle, prices opened gap down. That was an
indication of downtrend continuation. Suddenly buying starts and bulls takeover the charge.
Huge buying blow offs sellers and they are wiped out of market for the day. Closing turns to be
stronger as closing is near the high of the day. This shows that bulls have taken over serious
charge of the reversal. If the next day turns even more bullish, the reversal gets confirmed.

2.3.2 BEARISH ENGULFING PATTERN:

Bearish engulfing pattern comes at the end of uptrend, when the

bearish red candle engulfs the previous green candle completely.
This signifies that the sellers are overwhelming the buyers. This
is one of the major reversal patterns which is generally found at
the point of reversal. It is formed when the small green body is
completely eclipsed by the next big red candle. It gaps up above
the high of the previous day and closes below the low of the
previous day.

Criteria:

(1) Candlestick body of the previous day is completely covered by the next day's candlestick

(2) Previous price rally has to be uptrend, even if for short term.

3) If the first candle is small enough and the second candle is large in size, that gives a very
strong confirmation of the reverse rally.

(4) Large volume on the engulfing day increases the probability of reversal.

(5) After engulfing candle, a strong bearish candle serves as a confirmation of beginning of
uptrend.

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Pattern Psychology:

In a persistent uptrend, on the day of engulfing candle, prices opened gap up with the
expectations of continued north rally. Suddenly selling starts and bears takeover the charge.
Huge selling blow offs buyers and prices started south rally with huge volume. Closing turns to
be weak as closing is near to low of the day. This shows that bears have taken over serious
charge of the reversal. If the next day turns even more bearish and selling is imminent from
the beginning of the next trading day till the close of the day, the reversal gets confirmed.

2.3.3 BULLISH PIERCING

Bullish piercing pattern consists of 2 candles, one is red and the

another is green, which opens gap down and pullbacks beyond mid of
the red candle. It is a clear reversal pattern.

Following conditions need to be fulfilled:

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Criteria:

(1) The downtrend has to been evident for a good period.

(2) The body of the first candle is red; the body of the second candle is green.

3) A long red candle occurs at the end of the trend.

(4) The second day opens lower than the trading of the prior da

(5) If the gap between second day opening and first day closing is more, the reversal seems
more strong.

(6) The green candle closes more than halfway up the red candle.

(7) Higher the green candle closes compared to red candle stronger is the reversal.

(8) Large volume during pattern, specially second candle; increases the significance of reversal.

Pattern Psychology:

The atmosphere becomes bearish once a strong downtrend has been in effect. The price goes
down. Bears may move the price even further but before the day ends, the bulls enter and bring
a dramatic change in price in the opposite direction. They finish near the high of the day. The
move has almost negated the price decline of the previous day, as candle pierce the previous
bearish candle till its half way. This has now concerned the bears in a big way. More buying the
next day will confirm the move.

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2.3.4 BEARISH PIERCING:

Bearish piercing pattern consists of 2 candles, one is green and the

another is red, which opens gap up and pullbacks beyond mid of the
green candle. It is a clear reversal pattern.

Following conditions need to be fulfilled:

Criteria:

(1) The uptrend has to been evident for a good period.

(2) The body of the first candle is green; the body of the seco candle is red.

(3) A long green candle occurs at the end of the trend.

(4) The second day opens higher than the trading of the period day.

(5) If the gap between second day opening and first day closing is more, the reversal seems
more strong.

(6) The red candle closes more than halfway down the green candle.

(7) Lower the red candle closes compared to green candle, stronger is the reversal.

(8) Large volume during pattern, specially second candle increases the significance of reversal.

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Pattern Psychology:

The environment is clearly bullish as the trend is up. The prices open gap up, which even pushes
the positive sentiments. Bulls may move the price even further up but before the day ends, the
bears enter in a big way and bring a dramatic change in price in the opposite direction. They
finish near the low of the day. The move has almost negated the price rise of the previous day,
as candle pierce the previous bullish candle till more than its half way. This has now concerned
the bulls in a big way. More selling on the following day will confirm the move.

2.4.5 BULLISH HARAMI:

“Harami" in Japanese language means pregnant lady. As clearly

evident, a big red candlestick, which is followed by the small green
candlestick at the bottom of the trend is bullish harami pattern.
The small candle is covered within the large candle, creating
harami form. It is a reversal pattern. Its presence indicates that
the previous downtrend is over.

Criteria:

(1) The first candle is red in body; the body of the second candle is green.

(2) The downtrend has been evident for a good period.

(3) A long red candle occurs at the end of the trend.

(4) The second day opens higher than the close of the previous day and closes lower than the
open of the prior day. It completely gets covered within the previous candle.

(5) For a reversal signal, further confirmation is required to indicate that the trend is changed.

(6) Reversal is more forceful when the size of both candles is large.

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Pattern Psychology:

After a strong down-trend has been in effect and after a selling day, the bulls open at a price
higher than the previous close. The short's get concerned and start covering. The price for the
day finishes at a higher level. This gives enough notice to the short sellers that trend has been
violated. A strong day i.e. the next day would convince everybody that the trend was reversing.
Usually the volume is above the recent norm due to the unwinding of short positions.

2.3.6 BEARISH HARAMI:

As clearly evident, a big green candlestick, which is followed by

the small red candlestick at the top of the trend is bearish
harami pattern. The small candle is covered within the large
candle, creating harami form. It is a prominent reversal pattern.
Its presence indicates that the previous uptrend is about to
over.

Criteria:

(1) The first candle is green in body; the body of the second candle is red.

(2) The uptrend has been evident for a good period.

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(3) A long green candle occurs at the end of the uptrend.

(4) The second day opens lower than the close of the previous day and closes above the open of
the prior day. It completely gets covered within the previous candle.

(5) For a reversal signal, further confirmation is required to indicate that the trend is changed.

(6) Reversal is more forceful when the size of both candles is large.

Pattern Psychology:

The bears open the price lower than the previous close, after a strong uptrend has been in
effect and after a long white candle day. The longs get concerned and start profit taking. The
price for the day ends at a lower level. The bulls are now concerned as the price closes lower. It
is becoming evident that the trend has been violated. A weak day after that would convince
everybody that the trend was reversing. Volume increases due to the profit taking and the
addition of short sales.

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2.4 THREE CANDLE PATTERNS:

2.4.1 MORNING STAR PATTERN:

Morning star is a bullish 3 candle bottom reversal pattern. As the

features go, it is found at the bottom of the downtrend. It is
formed by a long red candle, followed by a gap down small green
candle (trading range is very narrow) and a clear gap up bullish
decisive green candle, which closes well into the first red candle.

Criteria:

(1) There should be persistent down trend.

(2) Body of the first candle is red, signifying continuous down trend.

(3) Second candle is indecision candle, with a preferably down opening and narrow range.

(4) Third day is a clear reversal day, strong green candle, with gap up opening.

(5) Third candle should close at least half way of the first red candle.

(6) More indecision the star candle indicates, more chances of reversal.

(7) Gap before and after the star day candle is highly desirable for reliable reversal.

(8) Huge volume on star candle day and following strong bullish day adds to confirmation.

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Pattern Psychology:

While a strong downtrend has been in effect, there is a large sell-off day. The selling continues.
The second day does not have large trading range. It's a kind of tug of war day, where buyers
and sellers are just trying to gain control, but decisiveness is pending. Huge volume is created
this day, which is kind of concern for the bears as the prices have halted in a narrow range. On
the third day, the bears start to lose conviction as the bull increase their buying. When the
price starts moving back into the trading range of the first day, the sellers diminish and the
buyers seize control.

2.4.2 EVENING STAR PATTERN:

The Evening Star is a top reversal pattern that occurs at the top of
an uptrend. It is formed by a tall green body candle, a second candle
with a small red/green body that gaps above the first real body to
form a "star" and a third red candle that closes well into the first
session's green real body. The Evening Star pattern is a bearish
reversal signal.

Criteria:

(1) There should be persistent up trend.

(2) Body of the first candle is green, signifying persistent up trend. (3) Second candle is
indecision candle, with a preferably gap up opening and narrow range.

(4) Third day is a clear reversal day, a strong red candle, with a gap down opening.

5) Third candle should close at least half way of the first candle. green

(6) More indecision the star candle indicates, more chances of reversal.

(7) Gap before and after the star day candle is highly desirable for reliable reversal.

(8) Huge volume on star candle day and following strong bearish day.

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Pattern Psychology:

The psychology behind this pattern is that a strong uptrend has been in effect. Buyers have
been piling up the stock. However, it is the level where smart buyers start taking profits or
think the price is fairly valued. The next day all the buying is being met with the selling, causing
for a small trading range. The bulls get concerned and the bears start taking over. The third
day is a large sell off day. Sellers may even start shorting stock, being overvalued. If there is
big volume during these days, it shows that the ownership has dramatically changed hands. The
change of direction is immediately seen in the colour of the bodies.

2.4.3 THREE WHITE SOLDIERS:

"Three white soldiers' is a downtrend reversal pattern, found at the

bottom of the trend. One of the highly reliable patterns, three
white soldiers shows decisive buying and potential change in trend
reversal.

Criteria:

(i) There has to be a persistent down trend before pattern formation.

(ii) Has to occur at the bottom of the downtrend for super positive rally.

(iii) First candle should open gap down compared to previous downtrend.
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(iv) Larger the size of candle, more reliable is the candle pattern.

(v) Every subsequent candle must open within the previous candle body, leaving no gap, giving
buying opportunity.

vi) Heavy volume (above average) can make pattern even more reliable.

Pattern Psychology:

In the persistent down trend, prices opened gapped down, giving confidence to bears to
continue selling. Suddenly selling is absorbed and prices start rising, leaving bears in confusion.
Trading day closes at the high of the day with huge volume at the bottom of the trend. Bears
are confused of the happening and bulls have entered market in a big way. Second day, bulls
continue buying and bears run to cover the shorts and take out profits on selling position, which
brings short covering in the market and prices continue north rally. Third day also follows the
same way and bulls gain complete control on the move and lead the rally.

2.4.4 THREE BLACK SOLDIERS:

Three black soldiers' is an uptrend reversal pattern, found at the

top of the trend. One of the highly reliable patterns, three black
soldiers shows decisive selling and potential change in trend reversal.

Criteria:

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(1) There has to be a persistent up trend before pattern formation.

(2) Has to occur at the top of the uptrend for trend reversal.

(3) First candle should open gap up compared to previous downtrend.

(4) Larger the size of candle, more reliable is the candle pattern.

(5) Every subsequent candle must open within the previous candle body, leaving no gap, giving
clear and decisive selling signals.

(6) Heavy volume (above average) can make pattern even more reliable.

Pattern Psychology:

In the persistent up trend, prices opened gapped up, showing decisive buying by bulls. Suddenly
demand is absorbed and prices start falling, absorbing entire supply. Trading day closes at the
low of the day with huge volume at the top of the trend. Bears enter the big way and leaving no
room for bulls to think for strong positive momentum. Second day, bears continue selling and
bulls run to cover the longs and take out profits on long positions!!! which brings long covering in
the market and prices continu south rally. Third day also follows the same way and bears gai
complete control on the down move and lead the southward rally

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2.5 SUPPORT AND RESISTANCE:

What are Support and Resistance Lines?

Support and resistance are the lines (can be trend lines, moving averages, curve lines, Fibonacci
levels etc.) where the current trend may halt, either temporary or permanent. It basically
represents key junctures where the market forces of supply and demand meet. These lines
appear as thresholds of the price patterns. They are the price levels or lines which stops the
prices from decreasing (support) or increasing (resistance).

A support line refers to that level below, which a stock's price will not fall. It denotes that
price level at which there is a sufficient amount of demand to stop and possibly, for time being,
turn a downtrend higher. This can be a pullback or even a trend reversal. Similarly, a resistance
line refers to that line beyond which a stock's price will not increase. It indicates that price
level at which a sufficient supply of stock is available to stop and possibly, for time being, blow
off an uptrend in prices,

2.5.1 SUPPORT:

Support is that price level where the prices halt from falling down and either take a pause or
make base formation for the next up rally. This is a level where buyers find great buying
opportunity, which in turn creates demand, which may overcome supply whereby security stops
declining and starts rising. Logically as the price declines towards support and gets cheaper,
buyers become more inclined to buy and sellers become less inclined to sell. By the time the
price reaches the support level, it is believed that demand will overcome supply and prevent the
price from falling further.

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2.5.2 RESISTANCE:

Resistance is the price level where prices halt from rising up and either take a pause or
distribution pattern for the next down rally. This is the level where buyers may think of taking
out profit from the long position may be because of the fact that security turns over priced.
Desperate sellers may push prices lower. Even bears may take a toll by shorting stock and
bringing down the prices. This is a possible level where supply is more than the demand and
excess supply will force the prices lower.

2.6 ROLE REVERSAL OF SUPPORT AND RESISTANCE:

This is very common phenomena. The prices continuously stop at certain resistance level for
longer time. That level is a strong resistance because of excess of supply over demand. Buyers
are not convinced to buy stock above resistance mark may be because fundamentals are not
supporting higher valuation of the security. But suddenly due to some fundamental shift, stock
is ready for positive re-rating. This leads to the fact that buyers will now be willing to buy
above that resistance mark also, as they may feel that the prices are still cheaper, keeping in
mind re-rating event. That pushes the prices above resistance. Now in future, whenever prices
will turn back to that level due to volatility, buyers will definitely add the stock as it is available
cheaper. So, same resistance mark now acts as support mark. This is known as role reversal.

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2.6.1 SUPPORT AND RESISTANCE ZONES:

Technical analysis is a subjective concept. It doesn't deal with fixed rules and regulations all
the time. It is based on past happenings, behaviour of people over time and the reactions of
market participants on different price levels. Participants many times look at support and
resistance as a price level. But in reality, it is never being the case. Support and resistance is
actually to deal with the range of levels near the actual found level. E.g. when a support is
considered at nifty level of 9150, that means nifty is expected to take support near 9150 mark.
Taken support may be little higher or lower than the mentioned level. Similarly, the resistance
has to be a range of price levels rather than actual exact level.

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The above chart is nifty weekly chart, highlighting support and resistance zone. One thing to
notice here is that the benefit of making or highlighting zone is that it also covers price spikes
which come near support and resistance. Second thing one needs to remember is that
performance can be improved if one give importance of support and resistance on closing basis
of the candle. When support and resistances are taken on closing basis, candle spikes are taken
off.

2.7 IMPORTANCE OF SUPPORT AND RESISTANCE LINE:

Technical analysts often say that the market has a memory. Support and resistance lines are a
key component of that memory.

Investors "tend" to remember previous area levels and thus make them important. Prices keep
fluctuating every day and lot of chaos is created over the period of time. But whenever those
important levels turn up on the screen, traders/investors try to build positions based on some
research base. This gives lot of importance to data, making them support or resistance.

Whenever the prices reach in that important zone, the volume increases and that level becomes
more important because investors remember it exceptionally well. That level is easy to visualize
on chart and technical analysts give name of either support or resistance. They also call those
levels as either stop loss levels or target levels, based on positions created.

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Chapter
Chart Patterns
3

Content:
3.1 Introduction to Chart Patterns
3.2 Head and Shoulders
3.3 Inverted Head and Shoulders
3.4 Double Tops
3.5 Double Bottoms
3.6 Triple Tops
3.7 Triple Bottoms
3.8 Channels
3.9 Rounded Top
3.10 Rounded Bottom
3.11 Cup and Handle
3.12 Triangles
3.13 Flag and Pennant
3.14 Wedges
3.15 Gap Theory
3.16 Island Cluster

3.1 Introduction to Chart Patterns:

In technical analysis, chart patterns have lot of importance Based on the fact that
history tends to repeat itself and market participants behave in the same way, chart patterns
created in the past and behaved in the past, will likely to perform almost same way in future.
One needs to follow the pattern in order to find entry points, exit points, supports, resistances
and expected, direction of future trend. Patterns also serve as warning signs for potential
reversal. One needs to keep in mind that there is no thumb rule or restriction on prices to
behave in a particular fashion after pattern breakout and so one needs to be flexible enough in
order to minimize losses and maximize profitable trades out of preferred system.

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3.2 HEAD AND SHOULDERS TOP:

As the name suggests, the pattern has 3 different picks, two smaller and one (the centre one)
larger. The pattern is found at the top of the trend. It is one of the highly reliable reversal
patterns. It basically has 3 peaks) the middle peak is the highest of all three (head) and the
remaining two peaks are low and approximately equal in height, on both sides of head (being left
shoulder and right shoulder).

Few importance points to remember while qualifying pattern as head and shoulders:

(1) Prior trend: It is important to establish the existence of a prior uptrend for this to be a
reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders
reversal pattern, or any reversal pattern for that matter.

(2) Left shoulder: While in an uptrend, the left shoulder forms a peak that marks the high
point of the current trend. It is formed usually at the end of an extensive advance during which
volume is quite heavy. At the end of the left shoulder there is usually a dip which typically
occurs on low volume.

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(3) Head: From the low of the left shoulder, an advance begins that exceeds the previous high
and marks the top of the head. At this point, prices must come down somewhere near the low of
the left shoulder.

(4) Right shoulder: The right shoulder is formed when the low d the head advances again. The
peak of the right shoulder almost equal in height to that of the left shoulder but lower than the
head. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline
from the peak of the right shoulder should break the neckline.

(5) Neckline: A neckline can be drawn across the bottoms of the left shoulder, the head and
the right shoulder. A breaking of this neckline on a decline from the right shoulder is the final
confirmation and completes the head and shoulder formation.

(6) Volume: As the head and shoulders pattern unfolds, volume plays an important role in
confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) simply by
analysing volume levels. Ideally, but not always, volume during the advance of the left shoulder
should be higher than during the advance of the head. These decreases in volume along with new
highs that form the head serve as a warning sign. The next warning sign comes when volume
increases on the decline from the peak of the head. Final confirmation comes when volume
further increases during the decline of the right shoulder.

(7) Neckline break: The head and shoulders pattern is said to be complete only when the
neckline support is broken. Ideally this should also occur in a convincing manner with an
expansion in volume.

(8) Support turned resistance: Once support is broken, it is common for this same support
level to turn into resistance Sometimes, but certainly not always, the price will return to the
support break (neckline) and offer a second chance to sell

(9) Price target: After breaking neckline support, the projected price decline is found by
measuring the distance from the neckline to the top of the head. Price target is calculated by
subtracting the above distance from the top to neckline, Any price target should serve as a
rough guide, and other factors needs to be considered.

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3.3 INVERTED HEAD AND SHOULDERS:

Inverted head and shoulders is exactly inverse of head and shoulders top. It is a clear reversal
pattern at the bottom of down trend. In a clear downtrend, prices fall below previous bottom
and bounce back till the high of previous bottom. Price falls again but fails to surpass previous
bottom and bounce back till high of previous low. Finally, price breakthrough neckline and
continue north rally, which validates inverse head and shoulders.

Few importance points to remember while qualifying pattern as head and shoulders:

(1) Prior trend: It is important to establish the existence of a prior down trend for this to be
a reversal pattern. Without a prior down trend to reverse, there cannot be a head and
shoulders reversal pattern, or any reversal pattern for that matter.

(2) Left shoulder: While in a down trend, the left shoulder form a bottom that marks the low
point of the current trend. It i formed usually at the end of an extensive decline during which
volume is quite heavy. At the end of the left shoulder there is usually a bounce which typically
occurs on low volume.

(3) Head: From the high of the left shoulder, a dip begins that exceeds the previous low of
shoulder and marks the new bottom of the head. At this point, prices must come up somewhere
near the high of the left shoulder.

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(4) Right shoulder: The right shoulder is formed when the prices dip again from the recent
high of head. Here, price decline but don't break the low made by even right shoulder. That is
an indication of inverse head and shoulder formation.

(5) Neckline: A neckline can be drawn across the tops of the left shoulder, the head and the
right shoulder. A breaking of this neckline on a pull back from the right shoulder is the final
confirmation and completes the inverse head and shoulder formation.

(6) Volume: Volume plays a vital role in formation. Here, participation is more on rising side and
less on falling side." Volume advances on rise in price and volume falls on falling price. That's an
evidence of a perfect inverse head and shoulder formation.

(7) Neckline break: The inverse head and shoulders pattern is said to be complete only when
the neckline resistance is broken. Ideally, this should also occur in a convincing manner with an
expansion in volume.

(8) Role Reversal: Once resistance is broken, it extends support to rising prices. Sometimes,
but certainly not always, the price will return to the neckline and offer a second chance to buy.

(9) Price target: price target is simply adding the different between the bottom of the head
and neckline to neckline on higher side.

3.4 DOUBLE TOPS:

As the name suggests, the formation is at the top of the uptrend and is making pair of peaks,
either of the same heights or near to same heights. This pattern highlights that price are not
able to sustain at the top level and there is persistent selling pressure the prices. Formation is
somewhat of M shape technical indication to sell is triggered once the prices fall below the
valley between two peaks.

Appearance: prices continuously move higher in uptrend an take a pause in the rally. A minor fall
comes in between the rally. But price then fails to surpass the immediate previous high ani halts
at almost the same price level. During the first peak, there is enough participation in market,
which creates volume. But in the first fall, participation is comparatively more than rise. During
the second peak, volume dries up and participation returns during the second fall. This volume
behaviour confirms the double top formation.

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Once the valley between the two adjacent peaks breaks down expect a strong selling with the
target, which is equal to difference between the top of peak and valley.

Few points to remember in case of double top formation:

(1) 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.

(2) First peak: The first peak marks the highest point of the current trend.

(3) Trough: Once the first peak is reached, a decline takes place that typically huge in size.
The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand.

(4) Second peak: The advance off the lows usually occurs with low volume and meets resistance
from the previous high Once the resistance is met, the possibility of a double top gets
confirmed. The pattern still needs to be confirmed. The time period between peaks can vary
from a few weeks to many months, ranging being 1-3 months. While exact peaks are preferable,
there is some leeway of around 3%.

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(5) Decline from second peak: Decline in the second peak is witnessed by an expanding volume
and an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the
forces of supply are stronger than the forces of demand and a support test is imminent.

(6) Support break: The double top and trend reversal are not complete even when the trading
till the support is done. The double top pattern is said to be complete when the support breaks
from the lowest point between the peaks. This too should occur with an increase in volume.

(7) Role reversal of Support: Broken support becomes potential resistance and there is
sometimes a test of this newfound resistance level with a reaction rally, giving the chance to
sell more.

(8) Price target: Price target is calculated by subtracting the distance from the support break
to peak from the support break. The larger the potential decline the bigger will be the
formation.

3.5 DOBBLE BOTOM

Inverse of double top formation is the double bottom formation. The formation is at the
bottom of the persistent down trend and is making pair of bottoms of almost same length. This
pattern highlights that prices are not able to sustain at the bottom level and there is some
buying interest seen. Formation somewhat of W shape. Technical indication to buy is triggered
once the prices cross above the valley between two peaks.

Appearance: prices continuously move lower in down trend and take a pause in the rally. A minor
pullback comes in between the fall. But price then fails to penetrate below previous low and
halts at almost the same price level. During the first bottom, there is enough participation in
market, which creates volume. But in s the first pullback, participation is comparatively more
than fall During the second bottom, volume dries up and participation returns during the second
rise. This volume behaviour confirms the double bottom formation.

Once the pullback between the two adjacent bottoms is the out, expect a strong buying with
the target, which is equal to difference between the bottom and peak.

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(1) Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the
case of the double bottom, a significant downtrend (of present timeframe) should be in place.

(2) First trough: It marks the lowest point of the current trend Though it is fairly normal in
appearance and the downtrend remains firmly in place.

(3) Peak: After the first trough is reached, an advancing rally 11. takes place. An increase in
the volume from the first trough signals an early accumulation. The peaks high is sometimes
rounded or drawn out a bit because of the hesitation in going back. This hesitation is an
indication of an increase in demand, but this increase is not strong enough for a breakout

(4) Second trough: The decline off the reaction high usually occurs with low volume and meets
support from the previous low. Bottom may not be the exact and some deviation is definitely
expected from previous bottom.

(5) Advance from trough: Volume gains more importance in the double bottom than in the
double top. The advance of the second trough should be clearly evidenced by the increasing
volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also
indicates a potential change in sentiment

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(6) Resistance break: The double top and trend reversal are considered incomplete, even after
they trade up to resistance Breaking resistance from the highest point between the troughs
completes the double bottom. This too should occur with an increase in volume and/ or an
accelerated ascent.

(7) Role reversal of Resistance: Broken resistance becomes potential support and there is
sometimes a re-testing 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.

(8) Price target: Target is estimated by adding the distance from the resistance breakout to
trough lows on top of the resistance break. This would imply that the bigger the formation is,
the larger the potential advance.

3.6 TRIPLE TOPS:

As the name suggests, price here makes 3 almost similar level tops. Pattern is found at the top
of uptrend. Prices fail to move further, fall down from the top and end the positive rally. This
pattern is easily misunderstood with either head and shoulders or channel, as in both the
patterns, prices make more than 2 tops and change the direction.

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The above drawn diagram shows the three, similar level tops. The horizontal line which is made
from valley of 3 tops is called neckline (support line). Breaking of that support line will trigger
selling call.

Points to remember in case of triple top formation:

(1) First top: security is in clear up trend and continues north rally, until it reaches first top.
Volume at the top is higher compared to recent past.

(2) First fall: Price falls from the first top. Trader and market participants consider the same
as a normal phenomenon as higher top higher bottom is part of uptrend.

(3) Second top: Price rises again but fails to surpass previous top. This is an indication of
double top formation. Here volume plays important role. Smart money participation is more
during first fall and less during price rise.

(4) Second Fall: Price falls again. Here few traders are cautious as they could have identified
undergoing double top formation, but majority of participants are still under bullish mind and
keep accumulating stocks. During this fall, volume is even more than first fall. Price fall, but fail
to break support made by first fall. Participants are convinced about strong up move and price
rise again.

(5) Third top: North rally, third time, is halted at the same tops, which are made earlier. Here
volume in the rally is almost dry and it's a clear indication of triple top formation. The
formation can even be a channel or rectangle, but certainly upside is capped.

(6) Third fall: highest participation in the fall forces price to surpass support level. Support is
that level where previous two falls halted. Prices fall with huge volume

(7) Pull back: after surpassing the support level, prices may reach support level once, as a part
of retesting the level. That is also confirmation of lower top and lower bottom formation.

(8) Target: Thrust between tops and bottoms can be expected to be the minimum target from
the support breakout level. Following is a classic triple top formation on very recent weekly
chart of Biocon. Post formation, stock is down almost 8%.

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3.7 TRIPLE BOTTOMS:

Price, in this formation, makes 3 almost similar level bottoms. Pattern is found at the bottom of
downtrend. Prices fail to fall further, rise from the bottom and end the southward rally. This
pattern is easily misunderstood with either inverse head and shoulders or channel
(consolidation), as in both the patterns, prices make more than 2 bottoms and change the
direction.

The above drawn diagram shows the three, similar level bottoms. The horizontal line which is
made from peaks of 3 bottoms is called neckline (resistance line). Breaking of that resistance
line will trigger buying call.

Points to remember in case of triple bottom formation:

(1) First bottom: security is in clear down trend and continues south rally, until it reaches first
bottom. Volume at the bottom is higher compared to recent past

(2) First top: Price rises from the first bottom. Trader and market participants consider the
same as a normal phenomenon as lower top lower bottom is part of down trend.

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(3) Second bottom: Price falls again but fails to surpass previous bottom. This is an indication
of double bottom formation. Here volume plays important role.

(4) Second top: Price rises again. Here few traders are cautious as they could have identified
undergoing double bottom formation, but majority of participants are still under bearish mind
and keep shorting. During this fall, volume is even more than first rise. Price rise, but fail to
break resistance, made by first fall. Participants are convinced about strong down move and
price falls again.

(5) Third bottom: down fall, third time, is halted at the same bottom, which is made earlier.
Volume in the rally is almost dry and it's a clear indication of triple bottom formation. The
formation can even be a channel or rectangle, but certainly downside is capped.

(6) Third top: highest participation in the price rise forces price to surpass resistance mark.
Resistance is that level, where previous two rallies halted. Prices rise with huge volume.

(7) Pull back: after surpassing the resistance level, prices may reach resistance level once, as a
part of retesting the level. That is also confirmation of higher top and higher bottom formation.

(8) Target: Thrust between tops and bottoms can be expected to be the minimum target from
the resistance breakout level.

3.8 CHANNELS:

It is kind of consolidation of the price in the narrow range. This I can be seen in any phase of
the market. Channels can be of different directions like up channel, down channel and sideways
channel. It is difficult to tag price formation as Channel unless few pattern failures come in.

Channel is confirmed only on failure of double tops, double bottoms, triple tops and triple
bottoms. When price continue to respect support and resistance over some period of time, it
forms basis for channel.

Upper line of the channel acts as ongoing resistance and lower line of the channel acts as
ongoing support. Role reversal of support and resistance comes into action once either side of
the channel is taken out decisively.

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Channels are of great help for traders to take active trading decisions on short term as well as
medium term. They are of great help to investors to take call on whether to accumulate
immediately or later.

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3.9 ROUNDED TOP:

Rounded top is one of the reliable topping out pattern, happening at the top of the uptrend.
This pattern shows distribution and potential fall in prices going forward. In this pattern, prices
gradually shift from bullish to bearish sentiment.

One needs to remember that it is very difficult to identify rounding formation at the initial
stage due to confusion, extreme bullishness in sentiments and slow distribution of position. The
only way to get hint is the volume behaviour. Prices stop rising and starts being sideways. During
that phase, volume initially dries up and then starts increasing at the level where prices start
falling. Volume decreases when price increases and volume increase when price decreases.

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3.10 ROUNDED BOTTOM:

As the name suggests, it forms curve formation at the bottom of the trend. Prices stop falling
in a persistent down trend and accumulation starts. Smart money silently captures stock. Price
gradually shifts from bearish sentiments to bullish sentiment. Capturing the early reversal is
possible by tracking volume activity.

Here, again volume plays the vital role in entering the formation. Smart money participation is
less when prices fall during rounding bottom and activity increases when prices start moving
higher. Volume decreases when price decreases and volume increase when price increases.

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3.11 CUP AND HANDLE FORMATION:

This is a classic curve continuation pattern. When price makes curve formation and halts at the
earlier high of the beginning of the curve, takes a small dip and re-begins the rally, that's cup &
handle formation. This can be continuation of uptrend as well as downtrend. It also gives enough
time to market players to accumulate stock in dips and ride the rally.

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3.12 TRIANGLES

Triangle is a consolidation of price) This pattern can be continuation of existing trend or

reversal. There are 3 types of triangle formation:

(1) Symmetrical triangle.

(2) Ascending triangle

(3) Descending triangle.

3.12.1 SYMMETRICAL TRIANGLE:

Under symmetrical triangle, prices continue to form higher bottoms and lower tops. In this
fashion, both lines of the triangle converge towards each other. Breakout of triangle can be
expected when convergence comes to a thrust level). Price spikes out of the consolidation phase
and takes directional move. (Generally, it is a continuation pattern, but trader should follow the
direction where the breakout comes).

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3.12.2 ASCENDING TRIANGLE:

In ascending triangle, price take a pause in an uptrend and continue uptrend on breakout. Prices
continuously make higher bottoms but fail to make higher top (like in uptrend), taking a pause
and making same tops, creating a resistance line at the top. This clearly shows good demand in
market on every fall. As demand overweigh supply, price continue up rally. Once prices move out
of triangle, a big positive rally can be expected. Target of the breakout can be found out by
adding the difference between the starting point of the triangle to the first top to the bottom
of final breakout. Ascending triangle is generally seen when fundamentals of the stock are
positive on long term and some kind of result or announcement is awaited.

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3.12.3 DESCENDING TRIANGLE:

In descending triangle, security is expected to continue its downfall after a temporary pause.
Prices continue to make lower top but somehow manage to take a pause on lower side and form
almost same bottom. Selling pressure is clearly visible in the pattern as lower top formation
shows extra supply on every rise. Once prices breach support line, which is formed by
connecting the same lows, down rally starts again. Target price can be found out by taking the
difference between the beginning of the triangle to the first bottom of triangle and
subtracting the same from the last spike of the triangle.

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3.13 FLAG AND PENNANT:

Flag and pennant formation are pause in the present rally, small consolidation and rally
continuation, on breakout. This is a good chance on either catching the rally, if missed out, or
increasing the contribution on present position, if trade is already taken.

Main difference between the flag and pennant is that in case of flag formation, prices
consolidate in a channel (rectangle) whereas in case of pennant, prices consolidate and form
triangle (mostly symmetrical one).

Present up rally is very sharp. Prices consolidate for some time before resuming its uptrend
again. Reverse situation exists in bearish formation. Prices fall, consolidate and breaks down
from the formation.

Word of Caution on Patterns:

One should remember one thing that these studies are always with some probability attached to
them. One should follow the price and direction after breakout. Being flexible is the only way to
make money in financial markets.

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3.14 WEDGES

Wedge is a kind of consolidation pattern which is unfolding over the period of time. There are 2
kinds of wedges: Rising wedge & Falling wedge.

Under wedge formation, every successive rise in price and every successive fall in price is lower
in terms of magnitude compared to previous rise and fall swing. Support line and resistance line,
thus, converge towards each-other.

Rising wedge has upward sloping formation and Falling wedge has downward sloping formation.

These patterns are potential reversal patterns and confirmation of the same comes on the
breakout. Breakout needs closing follow through along with trend continuation.

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3.15 GAP THEORY:

A gap is an area on a price chart in which there were no trades. Normally this occurs after the
close of the market on one day and the next day's open. Any kind of gap up or gap down opening
will create gaps on charts. There can be many reasons for the gaps, such as earnings declared
by company after market hours, any economic data released in evening, outcome of major event
in foreign markets etc. If the event outcomes are better than expected, then market opens gap
up compared to previous close. If the trading that day continues to trade above that point, a
gap will exist in the price chart. Gaps can offer evidence that something important has
happened to the fundamentals or the psychology of the crowd that accompanies this market
movement.

Gaps appear more frequently on daily charts, where every day is an opportunity to create an
opening gap. Gaps can be subdivided into four basic categories:

(1) Common Gap.

(2) Breakaway Gap.

(3) Runaway Gap.

(4) Exhaustion Gap.

3.15.1 COMMON GAP:

Common Gap is also referred to as a 'trading gap' or an 'area gap. It is actually uneventful. This
gap occurs characteristically in regular inactive markets and is generally closed within few days.
In fact, they can be caused by a stock going ex-dividend when the trading volume is low. Within
few trading sessions or few trading weeks, price retraces till the blank space created by gap,
known as filling the gap.

A common gap usually appears in a trading range or congestion area. It apparently shows lack of
interest in the stock at that time. Many times this is further exacerbated by low trading
volume. Being aware of these types of gaps is good. But these gaps don't provide any great
trading opportunities.

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3.15.2 BREAKAWAY GAPS:

Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their
trading range or congestion area. A congestion area is just a price range in which the market
has traded for some period of time, usually a few weeks or so. It is kind of channel formation,
where price remains between a range. Upper line of the formation is resistance and the bottom
line of the formation is support. Either to break support or to break resistance, market needs
enthusiasm, more power in terms of demand (while breaching resistance) or supply (while
breaching support).

Volume should also pick up significantly. New positions must be created in the breakout
direction itself and opposite positions must be covered. This generates huge volume. Volume
should happen after the gap and not before, in order to have a sustainable rally. The point of
breakout now becomes the new support (if an upside breakout) or resistance (if a downside
breakout). One should not wait for the gap to fill in order to create position, when gap comes
along with volume. That may lead to loss of rally. It might take a long time. One should go with
the fact that a new trend in the direction of the stock has taken place and one should trade
accordingly.

A good confirmation for trading gaps is if they are associated with classic chart patterns. For
example, if an ascending triangle all of a sudden has a breakout gap to the upside, or inverse
head and shoulder has a sudden breakout of neckline with gap etc. This can be a much better
trade than a breakaway gap without a good chart pattern associated with it.

Runaway gaps are also called measuring gaps, and are be described as gape that are caused by
increased interest in the stock Runaway gaps in uptrend shows the participants who couldn't get
into the rally in initial stage probably because they were waiting for the prices to retrace,
which didn't happen and now entering market either to unwind bearish position or to overcome
their left-out feeling. Increased buying interest happens all of a sudden, and the price gaps
above the previous day's close This type of runaway gap represents an almost panic state in
traders. Also, a good uptrend can have runaway gaps caused by significant news events that
cause new interest in the stock due to change in fundamentals and way of looking at projections

Runaway gaps can also happen in downtrends. This usually represents increased liquidation of
that stock by traders and buyers who are standing on the side lines. These can become very
serious as those who are holding onto the stock will eventually panic and sell. Even regular

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traders participate in market by shorting stock. The price has to continue to drop and gap down
to find buyers.

Runaway gaps are frequently caused in futures market too. The main reason behind this is the
situation of contango and backwardation. One needs to be careful in tagging between runaway
gap and common gap in initial stage, while dealing in futures Exhaustion gaps are those that
happen near the end of a good and up or down trend. As the name suggests, it will exhaust the
present rally. Exhaustion gap, many times, is the first signal of the end of that move. It is
identified by high volume and large price difference between the previous day's close and the
new opening price. The only way by which one can differentiate between runaway gap and
exhaustion gap is exceptionally high volume.

It is almost a state of panic if, during a long down move, pessimism has set in. Selling all
positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled
as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria
overcomes trades and they cannot get enough of that stock. The prices gap up with huge
volume, then there is great profit taking and the demand for the stock totally dries up. Prices
drop and a significant change in trend occurs.

3.16 ISLAND CLUSTER:

Island cluster is basically an exhaustion gap which is followed by a breakaway gap in opposite
direction of the present rally. Island is one of the strongest reversal patterns. Gap up opening
in uptrend forms an island. Further rally confirms exhaustion gap and immediately gap is filled.
Prices may remain in small consolidation and immediately breaks out of range, creating
breakaway gap.

Conclusion:

Gaps have lot of importance in technical analysis. It is one of the strongest indicators for
reversal/continuation of the present trend. Being a technical follower, one can't afford to
ignore the gap theories.

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