Candlestick Anatomy

While in a bar chart the open and the close prices are shown by a tick on the left and the right
sides of the bar respectively, however in a candlestick the open and close prices are displayed by
a rectangular body.

In a candlestick chart, candles can be classified as a bullish or bearish candle usually

represented by blue/green/white and red/black candles respectively. Needless to say, the colours
can be customized to any colour of your choice; the technical analysis software allows you to do
this. In this module, we have opted for the blue and red combination to represent bullish and
bearish candles respectively.

Let us look at the bullish candle. The candlestick, like a bar chart, is made of 3 components.

1. The Central real body – The real body, rectangular connects the opening and closing
price
2. Upper shadow – Connects the high point to the close
3. Lower Shadow – Connects the low point to the open

Have a look at the image below to understand how a bullish candlestick is formed:

Likewise, the bearish candle also has 3 components:

1. The Central real body – The real body, rectangular which connects the opening and
closing price. However, the opening is at the top end and the closing is at the bottom end
of the rectangle
2. Upper shadow – Connects the high point to the open
3. Lower Shadow – Connects the Low point to the close

This is how a bearish candle would look like:

Before we jump in and start learning about the patterns, there are few more assumptions that we
need to keep in mind. These assumptions are specific to candlesticks. Do pay a lot of attention to
these assumptions as we will keep referring back to these assumptions quite often later.

At this stage, these assumptions may not be very clear to you. I will explain them in greater
detail as and when we proceed. However, do keep these assumptions in the back of your mind:

Buy strength and sell weakness – Strength is represented by a bullish (blue) candle and
weakness by a bearish (red) candle. Hence whenever you are buying ensure it is a blue candle
day and whenever you are selling, ensure it’s a red candle day.

Be flexible with patterns (quantify and verify) – While the textbook definition of a pattern could
state certain criteria, there could be minor variations to the pattern owing to market conditions.
So one needs to be a bit flexible. However one needs to be flexible within limits, and hence it is
required to always quantify the flexibility.

Look for a prior trend – If you are looking at a bullish pattern, the prior trend should be bearish
and likewise if you are looking for a bearish pattern, the prior trend should be bullish

Single Candlestick patterns

As the name suggests, a single candlestick pattern is formed by just one candle. So as you can
imagine, the trading signal is generated based on 1 day’s trading action. The trades based on a
single candlestick pattern can be extremely profitable provided the pattern has been identified
and executed correctly.

One needs to pay some attention to the length of the candle while trading based on candlestick
patterns. The length signifies the range for the day. In general, the longer the candle, the more
intense is the buying or selling activity. If the candles are short, it can be concluded that the
trading action was subdued.

The following picture gives a perspective on the long/short – bullish, and bearish candle.
The trades have to be qualified based on the length of the candle as well. One should avoid
trading based on subdued short candles. We will understand this perspective as and when we
learn about specific patterns.

The Marubozu
The word Marubozu means “Bald” in Japanese. We will understand the context of the
terminology soon. There are two types of marubozu – the bullish marubozu and the bearish
marubozu.

Before we proceed, let us lay down the three important rules pertaining to candlesticks. We
looked at it in the previous chapter; I’ve reproduced the same for quick reference:

1. Buy strength and sell weakness

2. Be flexible with patterns (verify and quantify)
3. Look for prior trend

Marubozu is probably the only candlestick pattern which violates rule number 3 i.e look for
prior trend. A Marubozu can appear anywhere in the chart irrespective of the prior trend, the
trading implication remains the same.

The text book defines Marubozu as a candlestick with no upper and lower shadow (therefore
appearing bald). A Marubozu has just the real body as shown below. However there are
exceptions to this. We will look into these exceptions shortly. The red candle represents the
bearish marubozu and the blue represents the bullish marubozu.
Bullish Marubozu
The absence of the upper and lower shadow in a bullish marubozu implies that the low is equal
to the open and the high is equal to the close. Hence whenever the, Open = Low and High =
close, a bullish marubozu is formed.

A bullish marubozu indicates that there is so much buying interest in the stock that the market
participants were willing to buy the stock at every price point during the day, so much so that the
stock closed near its high point for the day. It does not matter what the prior trend has been, the
action on the marubozu day suggests that the sentiment has changed and the stock in now
bullish.

The expectation is that with this sudden change in sentiment there is a surge of bullishness and
this bullish sentiment will continue over the next few trading sessions. Hence a trader should
look at buying opportunities with the occurrence of a bullish marubozu. The buy price should be
around the closing price of the marubozu.

In the chart above (ACC Limited), the encircled candle is a bullish marubozu. Notice the bullish
marubozu candle does not have a visible upper and a lower shadow. The OHLC data for the
candle is: Open = 971.8, High = 1030.2, Low = 970.1, Close = 1028.4

Please notice, as per the text book definition of a marubozu Open = Low, and High = Close.
However in reality there is a minor variation to this definition. The variation in price is not much
when measured in percentage terms, for example the variation between high and close is 1.8
which as a percentage of high is just 0.17%. This is where the 2nd rule applies – Be flexible,
Quantify and Verify.

With this occurrence of a marubozu the expectation has turned bullish and hence one would be a
buyer of the stock. The trade setup for this would be as follows:

Buy Price = Around 1028.4 and Stoploss = 970.0

As it is evident, candlestick patterns do not give us a target. However, we will address the issue
of setting targets at a later stage in this module.

Having decided to buy the stock, when do we actually buy the stock? The answer to this depends
on your risk appetite. Let us assume there are two types of trader with different risk profiles – the
risk taker and the risk averse.

The risk taker would buy the stock on the same day as the marubozu is being formed. However
the trader needs to validate the occurrence of a marubozu. Validating is quite simple. Indian
markets close at 3:30 PM. So, around 3:20 PM one needs to check if the current market price
(CMP) is approximately equal to the high price for the day, and the opening price of the day is
approximately equal to the low price the day. If this condition is satisfied, then you know the day
is forming a marubozu and therefore you can buy the stock around the closing price. It is also
very important to note that the risk taker is buying on a bullish/blue candle day, thereby
following rule 1 i.e buy on strength and sell on weakness.

The risk averse trader would buy the stock on the next day i.e the day after the pattern has been
formed. However before buying the trader needs to ensure that the day is a bullish day to comply
with the rule number 1. This means the risk averse buyer can buy the stock only around the close
of the day. The disadvantage of buying the next day is that the buy price is way above the
suggested buy price, and therefore the stoploss is quite deep. However as a trade off the risk
averse trader is buying only after doubly confirming that the bullishness is indeed established.

The Stoploss on Bullish Marubozu

What if after buying, the market reverses its direction and the trade goes wrong? Like I had
mentioned earlier, candlestick patterns comes with a inbuilt risk management mechanism. In
case of a bullish marubozu, the low of the stock acts as a stoploss. So after you initiate a buy
trade , in case the markets moves in the opposite direction, you should exit the stock if price
breaches the low of the marubozu.

Here is an example where the bullish marubozu qualified as a buy for both the risk averse and
the risk taker. The OHLC is : O = 960.2, H = 988.6, L = 959.85, C = 988.5.
But the pattern eventually failed and one would have booked a loss. The stoploss for this trade
would be the low of marubozu, i.e 959.85.

Booking a loss is a part of the game. Even a seasoned trader goes through this. However the best
part of following the candlestick is that the losses are not allowed to run indefinitely. There is a
clear agenda as to what price one has to get out of a trade provided the trade starts to move in
the opposite direction. In this particular case booking a loss would have been the most prudent
thing to do as the stock continued to go down.

Of course there could be instances where the stoploss gets triggered and you pull out of the
trade. But the stock could reverse direction and start going up after you pulled out of the trade.
But unfortunately this is also a part of the game and one cannot really help it. No matter what
happens, the trader should stick to the rules and not find excuses to deviate from it.

Bearish Marubozu
Bearish Marubozu indicates extreme bearishness. Here the open is equal to the high and close
the is equal to low. Open = High, and Close = Low.

A bearish marubozu indicates that there is so much selling pressure in the stock that the market
participants actually sold at every price point during the day, so much so that the stock closed
near its low point of the day. It does not matter what the prior trend has been, the action on the
marubozu day suggests that the sentiment has changed and the stock is now bearish.

The expectation is that this sudden change in sentiment will be carried forward over the next few
trading sessions and hence one should look at shorting opportunities. The sell price should be
around the closing price of the marubozu.
The Spinning Top
The spinning top is a very interesting candlestick. Unlike the Marubuzo, it does not give the
trader a trading signal with specific entry or an exit point. However the spinning top gives out
useful information with regard to the current situation in the market. The trader can use this
information to position himself in the market.

A spinning top looks like the candle shown below. Take a good look at the candle. What
observations do you make with regard to the structure of the candle?

two things are quite prominent…

 The candles have a small real body

 The upper and lower shadow are almost equal

What do you think would have transpired during the day that leads to the creation of a spinning
top? On the face of it, the spinning top looks like a humble candle with a small real body, but in
reality there were a few dramatic events which took place during the day.

Let us follow these events:

1. Small real body – This indicates that the open price and close price are quite close to
each other. For instance the open could be 210 and the close could be 213. Or the open
could be 210 and close at 207. Both these situations lead to the creation of a small real
body because a 3 point move on a 200 Rupee stock is not much. Because the open and
close price points are nearby to one another, the color of the candle does not really
matter. It could be a blue or a red candle, what really matters is the fact that the open
prices and close prices are near to one another.
2. The upper shadow – The upper shadow connects the real body to the high point of the
day. If it is a red candle, the high and open are connected. If it is blue candle, the high
and close are connected. If you think about the real body in conjunction with the upper
shadow ignoring the lower shadow what do you think had happened? The presence of the
upper shadow tells us that the bulls did attempt to take the market higher. However they
were not really successful in their endeavor. If the bulls were truly successful, then the
real body would have been a long blue candle and not really a short candle. Hence this
 can be treated as an attempt by the bulls to take the markets higher but they were not
really successful at it.
3. The lower shadow – The lower shadow connects the real body to the low point of the
day. If it is a red candle, the low and close are connected. If it is a blue candle, the low
and open are connected. If you think about the real body in conjunction with the lower
shadow ignoring the upper shadow what do you think had happened? This is pretty much
the same thing that happened with the bulls. The presence of the lower shadow tells us
that the bears did attempt to take the market lower. However they were not really
successful in their endeavor. If the bears were truly successful, then the real body would
have been long red candle and not really a short candle. Hence this can be treated as an
attempt by the bears to take the markets lower but they were not really successful.
4. Now think about the spinning top as a whole along with all its components i.e real body,
upper shadow, and lower shadow. The bulls made a futile attempt to take the market
higher. The bears tried to take the markets lower and it did not work either. Neither the
bulls nor the bears were able to establish any influence on the market as this is evident
with the small real body. Thus Spinning tops are indicative of a market where indecision
and uncertainty prevails.

If you look at a spinning top in isolation it does not mean much. It just conveys indecision as
both bulls and bears were not able to influence the markets. However when you see the
spinning top with respect to the trend in the chart it gives out a really powerful message
based on which you can position your stance in the markets.

Spinning tops in a downtrend

What if the spinning tops were to occur when the stock is in a down trend?

In a down trend, the bears are in absolute control as they manage to grind the prices lower. With
the spinning top in the down trend the bears could be consolidating their position before
resuming another bout of selling. Also, the bulls have attempted to arrest the price fall and have
tried to hold on to their position, though not successfully. After all, if they were successful the
day would have resulted in a good blue candle and not really a spinning top.

So what stance would you take considering that there are spinning tops in a down trend. The
stance depends on what we expect going forward. Clearly there are two foreseeable situations
with an equal probability:

1. Either there will be another round of selling

2. Or the markets could reverse its directions and the prices could increase

Clearly, with no clarity on what is likely to happen, the trader needs to be prepared for both the
situations i.e reversal and continuation.

If the trader has been waiting for an opportunity to go long on the stock, probably this could be
his opportunity to do so. However to play safe he could test the waters with only half the
quantity. If the trader wants to buy 500 shares, he could probably enter the trade with 250
shares and could wait and watch the market. If the market reverses its direction, and the prices
indeed start going up then the trader can average up by buying again. If the prices reverse; most
likely the trader would have bought the stocks at the lowest prices.

If the stock starts to fall, the trader can exit the trade and book a loss. At least the loss is just on
half the quantity and not really on the entire quantity.

Here is a chart, which shows the downtrend followed by a set of spinning tops. The stock rallied
post the occurrence of the spinning top.

Here is another chart which shows the continuation of a down trend after the occurrence of
spinning tops.

So, think about the spinning top as “The calm before the storm”. The storm could be in the form
of a continuation or a reversal of the trend. In which way the price will eventually move is not
certain, however what is certain is the movement itself. One needs to be prepared for both the
situations.
Spinning tops in an uptrend
A spinning top in an uptrend has similar implications as the spinning top in a down trend, except
that we look at it slightly differently. Look at the chart below, what can you see and what would
be the inference?

An obvious observation is the fact that there is an uptrend in the market, which implies the bulls
have been in absolute control over the last few trading sessions. However with the occurrence of
the recent spinning tops the situation is a bit tricky:

1. The bulls are no longer in control, if they were, spinning tops would not be form on the
charts
2. With the formation of spinning tops, the bears have made an entry to the markets. Though
not successful, but the emphasis is on the fact that the bulls gave a leeway to bears

Having observed the above, what does it actually mean and how do you position yourself in the
market?

1. The spinning top basically conveys indecision in the market i.e neither the bulls nor the
bears are able to influence the markets.
2. Placing the above fact in the context of an uptrend we can conclude two things..

1. The bulls could be consolidating their position before initiating another leg of up move
2. Or the bulls are fatigued and may give way to bears. Hence a correction could be around
the corner.
 3. The chances of both these events taking place is equal i.e 50%
4. Having said that, what should you do? The chances of both events playing out are equal,
how are you going to take a stance? Well, in such a situation you should prepare for both
the outcomes!

Assume you had bought the stock before the rally started; this could be your chance to book
some profits. However, you do not book profits on the entire quantity. Assume you own 500
shares; you can use this opportunity to book profits on 50% of your holding i.e 250 shares. Two
things can happen after you do this:

1. The bears make an entry – When this happens the market starts to slide down, and as you
have booked 50% profits at a higher price, and can now choose to book profits on the
balance 50% as well. Your net selling price will anyway be higher than the current
market price.
2. The bulls make an entry – It turns out that the bulls were indeed taking a pause and the
rally continues, at least you are not completely out of the market as you still have the
balance 50% of your holdings invested in the markets

The stance you take helps you tackle both the outcomes.

Here is a chart which shows an uptrend and after the occurrence of spinning tops, the stock
rallied. By being invested 50%, you can continue to ride the rally.

To sum up, the spinning top candle shows confusion and indecision in the market with an equal
probability of reversal or continuation. Until the situation becomes clear the traders should be
cautious and they should minimize their position size.

The Dojis
The Doji’s are very similar to the spinning tops, except that it does not have a real body at all.
This means the open and close prices are equal. Doji’s provide crucial information about the
market sentiments and is an important candlestick pattern.

The classic definition of a doji suggests that the open price should be equal to the close price
with virtually a non existant real body. The upper and lower wicks can be of any length.

However keeping in mind the 2nd rule i.e ‘be flexible, verify and quantify’ even if there is a
wafer thin body, the candle can be considered as a doji.

Obviously the color of the candle does not matter in case of a wafer thin real body. What matters
is the fact that the open and close prices were very close to each other.

The Dojis have similar implications as the spinning top. Whatever we learnt for spinning tops
applies to Dojis as well. In fact more often than not, the dojis and spinning tops appear in a
cluster indicating indecision in the market.

Have a look at the chart below, where the dojis appear in a downtrend indicating indecision in
the market before the next big move.

Here is another chart where the doji appears after a healthy up trend after which the market
reverses its direction and corrects.
So the next time you see either a Spinning top or a Doji individually or in a cluster, remember
there is indecision is the market. The market could swing either ways and you need to build a
stance that adapts to the expected movement in the market.

Paper Umbrella
The paper umbrella is a single candlestick pattern which helps traders in setting up directional
trades. The interpretation of the paper umbrella changes based on where it appears on the chart.

A paper umbrella consists of two trend reversal patterns namely the hanging man and the
hammer. The hanging man pattern is bearish and the hammer pattern is relatively bullish. A
paper umbrella is characterized by a long lower shadow with a small upper body.

If the paper umbrella appears at the bottom end of a downward rally, it is called the ‘Hammer’.

If the paper umbrella appears at the top end of an uptrend rally, it is called the ‘Hanging man’.

To qualify a candle as a paper umbrella, the length of the lower shadow should be at least twice
the length of the real body. This is called the ‘shadow to real body ratio’.

Let us look at this example: Open = 100, High = 103, Low = 94, Close = 102 (bullish candle).
Here, the length of the real body is Close – Open i.e 102-100 = 2 and the length of the lower
shadow is Open – Low i.e 100 – 94 = 6. As the length of the lower shadow is more than twice of
the length of the real body; hence we can conclude that a paper umbrella has formed.

The Hammer formation

The bullish hammer is a significant candlestick pattern that occurs at the bottom of the trend. A
hammer consists of a small real body at the upper end of the trading range with a long lower
shadow. The longer the lower shadow the more bullish the pattern.

The chart below shows the presence of two hammers formed at the bottom of a down trend.

Notice the blue hammer has a very tiny upper shadow, which is acceptable considering the “Be
flexible – quantify and verify” rule.

A hammer can be of any color as it does not really matter as long as it qualifies ‘the shadow to
real body’ ratio. However, it is slightly more comforting to see a blue colored real body.

The prior trend for the hammer should be a down trend. The prior trend is highlighted with the
curved line. The thought process behind a hammer is as follows:

1. The market is in a down trend, where the bears are in absolute control of the markets
2. During a downtrend, every day the market would open lower compared to the previous
day’s close and again closes lower to form a new low
3. On the day the hammer pattern forms, the market as expected trades lower, and makes a
new low
4. However at the low point, there is some amount of buying interest that emerges, which
pushes the prices higher to the extent that the stock closes near the high point of the day
5. The price action on the hammer formation day indicates that the bulls attempted to break
the prices from falling further, and were reasonably successful
6. This action by the bulls has the potential to change the sentiment in the stock, hence one
should look at buying opportunities

The trade setup for the hammer is as follows:

1. A hammer formation suggests a long trade

 2. The trader’s entry time depends on the risk appetite of the trader. If the trader is a risk
taker, he can buy the stock the same day. Remember, the color of the real body in
hammer does not matter; hence there is no violation to the Rule 1. If the trader is risk
averse, he can buy the stock the day after the pattern has formed only after ensuring that
the day is a blue candle day

1. Risk takers can qualify the day as a hammer by checking the following condition at
3:20PM on the hammer day.

1. Open and close should be almost the same (within 1-2% range)
2. Lower shadow length should be at least twice the length of real body
3. If both these conditions are met, then the pattern is a hammer and the risk taker can
go long

2. The risk averse trader should evaluate the OHLC data on the 2nd If it’s a blue candle,
the trade is valid and hence he can go long
3. The low of the hammer acts as the stoploss for the trade

The chart below shows the formation of a hammer where both the risk taker and the risk averse
would have set up a profitable trade. This is a 15 minutes intraday chart of Cipla Ltd.

The trade set up would be as follows:

Buy Price for a risk taker – He takes the trade on the Hammer candle itself at – Rs.444/-

Buy price for a risk averse – He takes the trade on the next candle after evaluating that the
candle is blue at – Rs. 445.4/-

Stoploss for both the traders is at Rs.441.5/-, which is the low of the hammer formation.

Do notice how the trade has evolved, yielding a desirable intraday profit.

Here is another chart where the risk averse trader would have benefited by virtue of the ‘Buy
strength and Sell weakness’ rule.
Here is another interesting chart with two hammer formation.

Both the hammers qualified on the pre conditions of a hammer i.e :

4. Prior trend to be a down trend

5. Shadow to real body ratio

On the first hammer, the risk averse trader would have saved himself from a loss making trade,
thanks to Rule 1 of candlesticks. However, the second hammer would have enticed both the risk
averse and risk taker to enter a trade. After initiating the trade, the stock did not move up, it
stayed nearly flat and cracked down eventually.

Please note once you initiate the trade you stay in it until either the stop loss or the target is
reached. You should not tweak the trade until one of these events occurs. The loss in this
particular trade (first hammer) is inevitable. But remember this is a calculated risk and not a
mere speculative risk.

Here is another chart where a perfect hammer appears, however it does not satisfy the prior
trend condition and hence it is not defined pattern.
The Hanging man
If a paper umbrella appears at the top end of a trend, it is called a Hanging man. The bearish
hanging man is a single candlestick, and a top reversal pattern. A hanging man signals a market
high. The hanging man is classified as a hanging man only if is preceded by an uptrend. Since
the hanging man is seen after a high, the bearish hanging man pattern signals selling pressure.

A hanging man can be of any color and it does not really matter as long as it qualifies ‘the
shadow to real body’ ratio. The prior trend for the hanging man should be an uptrend, as
highlighted by the curved line in the chart above. The thought process behind a hanging man is
as follows:

1. The market is in an uptrend, hence the bulls are in absolute control

2. The market is characterized by new highs and higher lows
3. The day the hanging man pattern appears, the bears have managed to make an entry
4. This is emphasized by a long lower shadow of the hanging man
5. The entry of bears signifies that they are trying to break the strong hold of the bulls
Thus, the hanging man makes a case for shorting the stock. The trade set up would be as follows:

1. For the risk taker, a short trade can be initiated the same day around the closing
price
2. For the risk averse, a short trade can be initiated at the close of the next day after
ensuring that a red candle would appear
3. The method to validate the candle for the risk averse, and risk taker is exactly the
same as explained in the case of a hammer pattern

1. Once the short has been initiated, the high of the candle works as a stoploss for the
trade.

In the chart above, BPCL Limited has formed a hanging man at 593. The OHLC details are –

Open = 592, High = 593.75, Low = 587, Close = 593. Based on this, the trade set up would be
as follows:

 The risk taker, initiates the short trade on the day the pattern appears (at 593)
 The risk averse, initiates the short trade on the next day at closing prices after ensuring it
is a red candle day
 Both the risk taker and the risk averse would have initiated their respective trades
 The stoploss price for this trade would be the high price i.e above 593.75
 The trade would have been profitable for both the risk types.

The shooting star

The shooting star is the last single candlestick pattern that we will learn about before we move to
multiple candlestick patterns. The price action on the shooting star is quite powerful, thus
making the shooting star a very popular candlestick pattern to trade.

The shooting star looks just like an inverted paper umbrella.

Unlike a paper umbrella, the shooting star does not have a long lower shadow. Instead it has a
long upper shadow where the length of the shadow is at least twice the length of the real body.
The colour of the body does not matter, but the pattern is slightly more reliable if the real body is
red. The longer the upper wick, the more bearish is the pattern. The small real body is a common
feature between the shooting star and the paper umbrella. Going by the text book definition, the
shooting star should not have a lower shadow, however a small lower shadow, as seen in the
chart above is considered alright. The shooting star is a bearish pattern; hence the prior trend
should be bullish.

The thought process behind the shooting star is as follows:

 The stock is in an uptrend implying that the bulls are in absolute control. When bulls are
in control, the stock or the market tends to make a new high and higher low
 On the day the shooting star pattern forms, the market as expected trades higher, and in
the process makes a new high
 However at the high point of the day, there is a selling pressure to an extent where the
stock price recedes to close near the low point of the day, thus forming a shooting star
 The selling indicates that the bears have made an entry, and they were actually quite
successful in pushing the prices down. This is evident by the long upper shadow
 The expectation is that the bears will continue selling over the next few trading sessions,
hence the traders should look for shorting opportunities
 Take a look at this chart where a shooting star has been formed right at the top of an
uptrend.

The OHLC data on the shooting star is; open = 1426, high = 1453, low = 1410, close = 1417.
The short trade set up on this would be:

1. The risk taker will initiate the trade at 1417, basically on the same day the shooting star
forms
2. The risk taker initiates the trade the same day after ensuring that the day has formed a shooting
star. To confirm this the trader has to validate:

1. If the current market price is more or less equal to the low price
2. The length of the upper shadow is at least twice the length of the real body

3. The risk averse will initiate the trade on the next day, only after ensuring that the 2nd day a red
candle has formed
2. Once the trade has been initiated, the stoploss is to be placed at the high of the pattern.
In the case the stop loss is at 1453

As we have discussed this before, once a trade has been set up, we should wait for either the
stoploss or the target to be triggered. It is advisable not to do anything else, except for maybe
trailing your stoploss. Of course, we still haven’t discussed about trailing stoploss yet. We will
discuss it at later stage.

Here is a chart where both the risk taker and the risk averse would have made a remarkable
profit on a trade based on shooting star.

Here is an example, where both the risk averse and the risk taker would have initiated the trade
based on a shooting star. However the stoploss has been breached. Do remember, when the stop
loss triggers, the trader will have to exit the trade, as the trade no longer stands valid. More
often than not exiting the trade is the best thing to do when the stoploss triggers.
 The Engulfing Pattern
In a single candlestick pattern, the trader needed just one candlestick to identify a trading
opportunity. However when analyzing multiple candlestick patterns, the trader needs 2 or
sometimes 3 candlesticks to identify a trading opportunity. This means the trading opportunity
evolves over a minimum of 2 trading sessions.

The engulfing pattern is the first multiple candlestick pattern that we need to look into. The
engulfing pattern needs 2 trading sessions to evolve. In a typical engulfing pattern, you will find
a small candle on day 1 and a relatively long candle on day 2 which appears as if it engulfs the
candle on day 1. If the engulfing pattern appears at the bottom of the trend, it is called the
“Bullish Engulfing” pattern. If the engulfing pattern appears at the top end of the trend, it is
called the “Bearish Engulfing” pattern.

The Bullish Engulfing Pattern

The bullish engulfing pattern is a two candlestick pattern which appears at the bottom of the
down trend. As the name suggests, this is a bullish pattern which prompts the trader to go long.
The two day bullish engulfing pattern is encircled in the chart below. The prerequisites for the
pattern are as follows:

1. The prior trend should be a downtrend

2. The first day of the pattern (P1) should be a red candle reconfirming the bearishness in the
market
3. The candle on the 2nd day of pattern (P2) should be a blue candle, long enough to engulf the red
candle
 The thought process behind the bullish engulfing pattern is as follows:

1. The market is in down trend with prices steadily moving down

2. On the first day of the pattern (P1), the market opens low and makes a new low. This forms a red
candle in the process
3. On the second day of the pattern (P2), the stock opens near the closing prices of P1, and
attempts to make a new low. However, at this low point of the day there is a sudden buying
interest, which drives the prices to close higher than the previous day’s open. This price action
forms a blue candle
4. The price action on P2 also suggests that bulls made a very sudden and strong attempt to break
the bearish trend and they did so quite successfully. This is evident by the long blue candle on P2
5. The bears would not have expected the bull’s sudden action on P2 and hence the bull’s action
kind of rattles the bears causing them some amount of nervousness
6. The bullishness is expected to continue over the next few successive trading sessions, driving the
prices higher and hence the trader should look for buying opportunities
he trade set up for the bullish engulfing pattern is as follows:

1. The bullish engulfing pattern evolves over two days

2. The suggested buy price is around the close price of blue candle i.e on P2
o Risk taker initiates the trade on P2 itself after ensuring P2 is engulfing P1
o The risk averse initiates the trade on the next day i.e the day after P2 around the closing price, after
confirming the day is forming a blue candle
o If the day after P2 is a red candle day, the risk averse trader will ignore the trade, owing to rule 1 of
candlesticks (Buy strength and Sell weakness)
o On a personal note, in multiple candlestick patterns where the trade evolves over 2 or more days it is
worth to be a risk taker as opposed to a risk averse trader
3. The stop loss for the trade would be at the lowest low between P1, and P2
 Needless to say, once the trade has been initiated you will have to wait until the target has been
hit or the stoploss has been breached. Of course, one can always trail the stop loss to lock in
profits.

Have a look at DLF’s chart below; the bullish engulfing pattern is encircled.

The OHLC on P1 – Open = 163, High = 168, Low = 158.5, Close = 160. On P2 the OHLC
details are – Open = 159.5, High = 170.2, Low = 159, Close = 169.

The trade set up for the bullish engulfing pattern is as follows:

1. The risk taker would go long on P2 at 169. He can do this by validating P2 as an engulfing
pattern. To validate P2 as an engulfing patterns there are 2 conditions:
o One, the current market price at 3:20PM on P2 should be higher than P1’s open.
o Second, the open on P2 should be equal to or lower than P1’s close
The risk averse will initiate the trade, the day after P2 only after ensuring that the day is a blue
candle day. So if the P1 falls on a Monday, the risk averse would be initiating the trade on
Wednesday, around 3:20 PM. However, as I had mentioned earlier, while trading based on
multiple candlestick pattern, it may be worth initiating the trade on pattern completion day itself
i.e P2

The stop loss on this trade will be the lowest low between P1 and P2. In this example, lowest low
falls on P1 at 158.5

In this example, both the risk averse and the risk taker would have been profitable.

Here is an example of a perfect bullish engulfing pattern formed on Cipla Ltd, the risk averse
trader would have completely missed out a great trading opportunity.
There is often a lot of confusion on whether the candle should engulf just the real body or the
whole candle, including the lower and upper shadows. In my personal experience, as long as the
real bodies are engulfed, I would be happy to classify the candle as a bullish engulfing pattern.
Of course, candlestick sticklers would object to this but what really matters is how well you hone
your skills in trading with a particular candlestick pattern.

So going by that thought, I’d be happy to classify the following pattern as a bullish engulfing
pattern, even though the shadows are not engulfed.

The bearish engulfing pattern

The bearish engulfing pattern is a two candlestick pattern which appears at the top end of the
trend, thus making it a bearish pattern. The thought process remains very similar to the bullish
engulfing pattern, except one has to think about it from a shorting perspective.

Take a look at the chart below, the two candles that make up the bearish engulfing pattern is
encircled. You will notice:
1. To begin with the bulls are in absolute control pushing the prices higher
2. On P1, as expected the market moves up and makes a new high, reconfirming a bullish trend in
the market
3. On P2, as expected the market opens higher and attempts to make a new high. However at this
high point selling pressure starts. This selling comes unexpected and hence tends to displace the
bulls
4. The sellers push the prices lower, so much so that the stock closes below the previous day’s (P1)
open. This creates nervousness amongst the bulls
5. The strong sell on P2 indicates that the bears may have successfully broken down the bull’s
stronghold and the market may continue to witness selling pressure over the next few days
6. The idea is to short the index or the stock in order to capitalize on the expected downward slide
in prices
The trade set up would be as follows:

1. The bearish engulfing pattern suggests a short trade

2. The risk taker initiates the trade on the same day after validating two conditions
o The open on P2 is higher than P1’s close
o The current market price at 3:20 PM on P2 is lower than P1’s open price. If the two conditions are
satisfied, then it would be logical to conclude that it is a bearish engulfing pattern
3. The risk averse will initiate the trade on the day after P2 only after ensuring that the day is a red
candle day
4. Since the bearish engulfing pattern is a 2 day pattern, it makes sense to be a risk taker. However
this purely depends on the individual’s risk appetite

Take a look at the chart below of Ambuja Cements. There are two bearish engulfing patterns
formed. The first pattern on the chart (encircled, starting from left) did not work in favor of a
risk taker. However the risk averse would have completely avoided taking the trade. The second
bearish engulfing pattern would have been profitable for both the risk taker and the risk averse
 The OHLC data for the bearing engulfing pattern (encircled at the top end of the chart) is as
below:

P1: Open – 214, High – 220, Low – 213.3, Close – 218.75

P2: Open – 220, High – 221, Low – 207.3, Close – 209.4

The trade setup for the short trade, based on the bearish engulfing pattern is as follows:

1. On P2 by 3:20 PM the risk taker would initiate the short trade at 209 after ensuring P1, and P2
together form a bearish engulfing pattern
2. The risk averse will initiate the trade, the day after P2 only after ensuring that the day is a red
candle day
3. The stoploss in both the cases will the highest high of P1 and P2, which in this case is at 221.
Both the risk averse and the risk taker would have been profitable in this particular case

The Piercing Pattern

The piercing pattern is very similar to the bullish engulfing pattern with a very minor variation.
In a bullish engulfing pattern the P2’s blue candle engulfs P1’s red candle completely. However
in a piercing pattern P2’s blue candle partially engulfs P1’s red candle, however the engulfing
should be between 50% and less than 100%. You can validate this visually or calculate the same.
For example if P1’s range (Open – Close) is 12 , P2’s range should be at least 6 or higher but
below 12.
As long as this condition is satisfied, everything else is similar to the bullish engulfing including
the trade set up. Here a risk taker would initiate the trade on P2 around the close. The risk
averse would initiate the trade, the day after P2 only after ensuring a blue candle is formed. The
stoploss would be the low of the pattern.

Have a look at the following chart:

Here P2’s blue candle engulfs just under 50% of P1’s red candle. For this reason we do not
consider this as a piercing pattern.

The Dark Cloud Cover

The dark cloud cover is very similar to the bearish engulfing pattern with a minor variation. In a
bearish engulfing pattern the red candle on P2 engulfs P1’s blue candle completely. However in
a dark cloud cover, the red candle on P2 engulfs about 50 to 100% of P1’s blue candle. The
trade set up is exactly the same as the bearish engulfing pattern. Think about the dark cloud
cover as the inverse of a piercing pattern.

A perspective on selecting a trade

Typically stocks in the same sector have similar price movement. For example, think about TCS
and Infosys or ICICI Bank and HDFC bank. Their price movement is similar because these
companies are more or less of the same size, have similar business, and the same external
factors that affect their business. However this does not mean their stock price movement would
match point to point. For example if there is negative news in the banking sector, banking stocks
are bound to fall. In such a scenario if the stock price of ICICI Bank falls by 2%, it is not really
necessary that HDFC Bank’s stock price should also fall exactly 2%. Probably HDFC Bank
stock price may fall by 1.5% or 2.5%. Hence the two stocks may form 2 different (but somewhat
similar) candlestick patterns such as a bearish engulfing and dark cloud cover at the same time.

Both these are recognisable candlestick patterns but if I were to choose between the two patterns
to set up a trade. I would put my money on the bearish engulfing pattern as opposed to a dark
cloud cover. This is because the bearishness in a bearish engulfing pattern is more pronounced
(due to the fact that it engulfs the previous day’s entire candle). On the same lines I would
choose a bullish engulfing pattern over a piercing pattern.

However there is an exception to this selection criterion. Later in this module I will introduce a 6
point trading checklist. A trade should satisfy at least 3 to 4 points on this checklist for it to be
considered as a qualified trade. Keeping this point in perspective, assume there is a situation
where the ICICI Bank stock forms a piercing pattern and the HDFC Bank stock forms a bullish
 engulfing pattern. Naturally one would be tempted to trade the bullish engulfing pattern,
however if the HDFC Bank stock satisfies 3 checklist points, and ICICI Bank stock satisfies 4
checklist points, I would go ahead with the ICICI Bank stock even though it forms a less
convincing candlestick pattern.

On the other hand, if both the stocks satisfy 4 checklist points I will go ahead with the HDFC
Bank trade.

The Harami Pattern

Before you get thinking, the word ‘Harami’ does not stand for the word harami used in

Hindi . Apparently it is old Japanese word for ‘pregnant’. You’d appreciate the
intuitiveness of this word, when you see the candlestick formation.
Harami is a two candle pattern. The first candle is usually long and the second candle has a
small body. The second candle is generally opposite in colour to the first candle. On the
appearance of the harami pattern a trend reversal is possible. There are two types of harami
patterns – the bullish harami and the bearish harami.

The Bullish Harami

As the name suggests, the bullish harami is a bullish pattern appearing at the bottom end of the
chart. The bullish harami pattern evolves over a two day period, similar to the engulfing
[Link] the chart below, the bullish harami pattern is encircled.

The thought process behind a bullish harami pattern is as follows:

1. The market is in a downtrend pushing the prices lower, therefore giving the bears absolute
control over the markets
2. On day 1 of the pattern (P1) a red candle with a new low is formed, reinforcing the bear’s
position in the market
3. On day 2 of the pattern (P2) the market opens at a price higher than the previous day’s close. On
seeing a high opening price the bears panic ,as they would have otherwise expected a lower
opening price
4. The market gains strength on P2 and manages to close on a positive note, thus forming a blue
candle. However P2’s closing price is just below the previous days (P1) open price
5. The price action on P2 creates a small blue candle which appears contained (pregnant) within
P1’s long red candle
6. The small blue candle on a standalone basis looks harmless, but what really causes the panic is
the fact that the bullish candle appears all of a sudden, when it is least expected
7. The blue candle not only encourages the bulls to build long positions, but also unnerves the
bears
8. The expectation is that panic amongst the bears will spread in an accelerated manner, giving a
greater push to bulls. This tends to push the prices higher. Hence one should look at going long
on the stock.
The trade setup for the bullish harami is as follows:

1. The idea is to go long on the bullish harami formation

2. Risk takers can initiate a long trade around the close of the P2 candle
3. Risk takers can validate the following conditions to confirm if P1, and P2 together form a bullish
harami pattern:
1. The opening on P2 should be higher than the close of P1
2. The current market price at 3:20 PM on P2 should be less than P1’s opening price
3. If both these conditions are satisfied then one can conclude that both P1 and P2 together form a bullish
harami pattern
4. The risk averse can initiate a long trade at the close of the day after P2, only after confirming that the day
is forming a blue candle
5. The lowest low of the pattern will be the stoploss for the trade

Here is a chart of Axis Bank; the bullish harami is encircled below:

The OHLC details for the pattern are as follows:

P1 – Open = 868, High = 874, Low = 810, Close = 815

P2 – Open = 824, High = 847, Low = 818, Close = 835

The risk taker would initiate the long position at the close of P2 which is around 835. The stop
loss for the trade would be lowest low price between P1 and P2; which in this case it is 810.

The risk averse will initiate the trade the day near the close of the day after P2, provided it is a
blue candle day, which in this case is.

Once the trade has been initiated, the trader will have to wait for either the target to be hit or the
stop loss to be triggered.

Here is a chart below where the encircled candles depict a bullish harami pattern, but it is not.
The prior trend should be bearish, but in this case the prior trend is almost flat which prevents
us from classifying this candlestick pattern as a bullish harami.
 The bearish harami
The thought process behind shorting a bearish harami is as follows:

1. The market is in an uptrend, placing the bulls in absolute control

2. On P1, the market trades higher, and makes a new high and closes positively forming a blue
candle day. The trading action reconfirms the bulls dominance in the market
3. On P2 the market unexpectedly opens lower which displaces the bulls ,and sets in a bit of panic
to bulls
4. The market continues to trade lower to an extent where it manages to close negatively forming a
red candle day
5. The unexpected negative drift in the market causes panic making the bulls to unwind their
positions
6. The expectation is that this negative drift is likely to continue and therefore one should look at
setting up a short trade.
The trade setup for the short trade based on bearish harami is as follows:

1. The risk taker will short the market near the close of P2 after ensuring P1 and P2 together forms
a bearish harami. To validate this, two conditions must be satisfied:
1. The open price on P2 should be lower than the close price of P1
2. The close price on P2 should be greater than the open price of P1
2. The risk averse will short the market the day after P2 after ensuring it forms a red candle day
3. The highest high between P1 and P2 acts as the stoploss for the trade.
Here is a chart of IDFC Limited where the bearish harami is identified. The OHLC details are as
follows:

P1 – Open = 124, High = 129, Low = 122, Close = 127

P2 – Open = 126.9, High = 129.70, Low, = 125, Close = 124.80
The risk taker will initiate the trade on day 2, near the closing price of 125. The risk averse will
initiate the trade on the day after P2, only after ensuring it forms a red candle day. In the above
example, the risk averse would have avoided the trade completely.

The stop loss for the trade would be the highest high between P1 and P2. In this case it would be
129.70.

The Gaps
Gap up opening – A gap up opening indicates buyer’s enthusiasm. Buyers are willing to buy
stocks at a price higher than the previous day’s close. Hence, because of enthusiastic buyer’s
outlook, the stock (or the index) opens directly above the previous day’s close. For example
consider the closing price of ABC Ltd was Rs.100 on Monday. After the market closes on
Monday assume ABC Ltd announces their quarterly results. The numbers are so good that on
Tuesday morning the buyers are willing to buy the stock at any price. This enthusiasm would
lead to stock price jumping to Rs.104 directly. This means though there was no trading activity
between Rs.100 and Rs.104, yet the stock jumped to Rs.104. This is called a gap up opening.
Gap up opening portrays bullish sentiment.

In the following image the green arrows points to a gap up openings.

 Gap down opening – Similar to gap up opening, a gap down opening shows the enthusiasm of the bears.
The bears are so eager to sell, that they are willing to sell at a price lower than the previous day’s close.
In the example stated above, if the quarterly results were bad, the sellers would want to get rid of the
stock and hence the market on Tuesday could open directly at Rs.95 instead of Rs.100. In this case,
though there was no trading activity between Rs.100 and Rs.95 yet the stock plummeted to Rs.95. Gap
down opening portrays bearish sentiment. In the following image the green arrows points to a gap down
opening.

The Morning Star

The morning star is a bullish candlestick pattern which evolves over a three day period. It is a downtrend
reversal pattern. The pattern is formed by combining 3 consecutive candlesticks. The morning star
appears at the bottom end of a down trend. In the chart below the morning star is encircled.

The morning star pattern involves 3 candlesticks sequenced in a particular order. The pattern is
encircled in the chart above. The thought process behind the morning star is as follow:

1. Market is in a downtrend placing the bears in absolute control. Market makes successive new
lows during this period
2. On day 1 of the pattern (P1), as expected the market makes a new low and forms a long red
candle. The large red candle shows selling acceleration
3. On day 2 of the pattern (P2) the bears show dominance with a gap down opening. This reaffirms
the position of the bears
4. After the gap down opening, nothing much happens during the day (P2) resulting in either a doji
or a spinning top. Note the presence of doji/spinning top represents indecision in the market
5. The occurrence of a doji/spinning sets in a bit of restlessness within the bears, as they would
have otherwise expected another down day especially in the backdrop of a promising gap down
opening
6. On the third day of the pattern (P3) the market/stock opens with a gap up followed by a blue
candle which manages to close above P1’s red candle opening
7. In the absence of P2’s doji/spinning top it would have appeared as though P1 and P3 formed a
bullish engulfing pattern
8. P3 is where all the action unfolds. On the gap up opening itself the bears would have been a bit
jittery. Encouraged by the gap up opening buying persists through the day, so much so that it
manages to recover all the losses of P1
9. The expectation is that the bullishness on P3 is likely to continue over the next few trading
sessions and hence one should look at buying opportunities in the market
Unlike the single and two candlestick patterns, both the risk taker and the risk averse trader can
initiate the trade on P3 itself. Waiting for a confirmation on the 4th day may not be necessary
while trading based on a morning star pattern.

The long trade setup for a morning star would be as follows:

1. Initiate a long trade at the close of P3 (around 3:20PM) after ensuring that P1, P2, and P3
together form a morning star
2. To validate the formation of a morning star on P3 the following conditions should satisfy:
1. P1 should be a red candle
2. With a gap down opening, P2 should be either a doji or a spinning top
3. P3 opening should be a gap up, plus the current market price at 3:20 PM should be higher than
the opening of P1
3. The lowest low in the pattern would act as a stop loss for the trade

The evening star

The evening star is the last candlestick pattern that we would learn in this module.

The evening star is a bearish equivalent of the morning star. The evening star appears at the top
end of an uptrend. Like the morning star, the evening star is a three candle formation and
evolves over three trading sessions.
 The reasons to go short on an evening star are as follows:

1. The market is in an uptrend placing the bulls in absolute control

2. During an uptrend the market/stock makes new highs
3. On the first day of the pattern (P1), as expected the market opens high, makes a new high and
closes near the high point of the day. The long blue candle formed on day 1 (P1) shows buying
acceleration
4. On the 2nd day of the pattern (P2) the market opens with a gap reconfirming the bull’s stance in
the market. However after the encouraging open the market/stock does not move and closes by
forming a doji/spinning top. The closing on P2 sets in a bit of panic for bulls
5. On the 3rd day of the pattern (P3), the market opens gap down and progresses into a red candle.
The long red candle indicates that the sellers are taking control. The price action on P3 sets the
bulls in panic
6. The expectation is that the bulls will continue to panic and hence the bearishness will continue
over the next few trading session. Therefore one should look at shorting opportunities
The trade setup for an evening star is as follows:

1. Short the stock on P3, around the close of 3:20 PM after validating that P1 to P3 form an
evening star
2. To validate the evening star formation on day 3, one has to evaluate the following:
1. P1 should be a blue candle
2. P2 should be a doji or a spinning top with a gap up opening
3. P3 should be a red candle with a gap down opening. The current market price at 3:20PM on P3 should
be lower than the opening price of P1
3. Both risk taker and risk averse can initiate the trade on P3
4. The stop loss for the trade will be the highest high of P1, P2, and P3.
 The Resistance
As the name suggests, resistance is something which stops the price from rising further. The
resistance level is a price point on the chart where traders expect maximum supply (in terms of
selling) for the stock/index. The resistance level is always above the current market price.

The likely hood of the price rising up to the resistance level, consolidating, absorbing all the
supply, and then declining is high. The resistance is one of the critical technical analysis tool
which market participants look at in a rising market. The resistance often acts as a trigger to
sell.

The Support
Having learnt about resistance, understanding the support level should be quite simple and
intuitive. As the name suggests, the support is something that prevents the price from falling
further. The support level is a price point on the chart where the trader expects maximum
demand (in terms of buying) coming into the stock/index. Whenever the price falls to the support
line, it is likely to bounce back. The support level is always below the current market price.

There is a maximum likely hood that the price could fall till the support, consolidate, absorb all
the demand, and then start to move upwards. The support is one of the critical technical level
market participants look for in a falling market. The support often acts as a trigger to buy.

Construction/Drawing of the Support and Resistance level

Here is a 4 step guide to help you understand how to identify and construct the support and the
resistance line.

Step 1) Load data points – If the objective is to identify short term S&R load at least 3-6 months
of data points. If you want to identify long term S&R, load at least 12 – 18 months of data points.
When you load many data points, the chart looks compressed. This also explains why the above
two charts looks squeezed.

1. Long term S&R – is useful for swing trading

2. Short term S&R – is useful intraday and BTST trades
Here is a chart where I have loaded 12 months of data points
 Step 2) Identify at least 3 price action zones – A price action zone can be described as ‘sticky
points’ on chart where the price has displayed at least one of the behaviors:

1. Hesitated to move up further after a brief up move

2. Hesitated to move down further after a brief down move
3. Sharp reversals at particular price point
Here are a series of charts that identifies the above 3 points in the same order:

In the chart below, the encircled points indicate the price hesitating to move up further after a
brief up move:
n the chart below, the encircled points indicate sharp price reversals:

Step 3) Align the price action zones – When you look at a 12 month chart, it is common to spot many
price action zones. But the trick is to identify at least 3 price action zones that are at the same price level.

Look at the following chart, I have encircled 3 price action zones that are around the same price points:

A very important point to note while identifying these price action zones is to make sure these price zone
are well spaced in time. Meaning, if the 1st price action zone is identified on 2nd week on May, then it will
be meaningful to identify the 2nd price action zone at any point after 4th week of May (well spaced in time).
The more distance between two price action zones, the more powerful is the S&R identification.
Step 4) Fit a horizontal line – Connect the three price action zones with a horizontal line. Based
on where this line fits in with respect to the current market price, it either becomes a support or
resistance.

Have a look at this chart

 Starting from left:

1. The 1st circle highlights a price action zone where there is a sharp reversal of price
2. The 2nd circle highlights a price action zone where price is sticky
3. The 3rd circle highlights a price action zone where there is a sharp reversal of price
4. The 4th circle highlights a price action zone where price is sticky
5. The 5th circle highlights the current market price of Cipla – 442.5
In the above chart all the 4 price action zones are around the same price points i.e at 429.
Clearly, the horizontal line is below the current market price of 442.5, thus making 429 as an
immediate support price for Cipla.

Please note, whenever you run a visual exercise in Technical Analysis such as identifying S&R,
you run the risk of approximation. Hence always give room for error. The price level is usually
depicted in a range and not at a single price point. It is actually a zone or an area that acts as
support or resistance.

So going by the above logic, I would be happy to consider a price range around 426 to 432 as a
support region for Cipla. There is no specific rule for this range, I just subtracted and added 3
points to 429 to get my price range for support!

Reliability of S&R
The support and resistance lines are only indicative of a possible reversal of prices. They by no
means should be taken for as certain. Like anything else in technical analysis, one should weigh
the possibility of an event occurring (based on patterns) in terms of probability.

Optimization and checklist

Perhaps, we are now at the most important juncture in this module. We will start discovering few
optimization techniques which will help us identify high quality trades. Remember, when you
 seek quality, quantity is always compromised, but this is a compromise that is worth making. The
idea is to identify quality trading signals as opposed to identifying plenty, but worthless trades.

Optimization in general is a technique wherein you fine tune a process for best possible results.
The process in this context is about identifying trades.

Let us go back to candlesticks patterns, maybe to the very first we learnt – bullish marubuzo. A
bullish marubuzo suggests a long trade near the close of the marubuzo, with the low of the
marubuzo acting as the stoploss.

Assume the following credentials for the bullish marubuzo:

Open = 432, High = 449, Low = 430, Close = 448

Hence the entry for the long trade is approximately at 448, with 430 as the stoploss.

Now what if the low of the marubuzo also coincides with a good time tested support? Do you see
a remarkable confluence of two technical theories here?

We have a double confirmation to go long. Think about it on following terms:

1. A recognized candlestick pattern (bullish marubuzo) suggests the trader to initiate a long trade
2. A support near the stoploss price suggests the trader the presence of significant buying interest
around the low
While dealing with a fairly random environment such as the markets, what a trader really needs
is a well crafted trade setup. The occurrence of the above two conditions (marubuzo + support
near the low) suggests the same action i.e to initiate a long trade in this case.

Volumes
Volume plays a very integral role in technical analysis as it helps us to confirm trends and patterns.
Consider volumes as means to gain insights into how other participants perceive the market.

Volumes indicate how many shares are bought and sold over a given period of time. The more active the
share, higher would be its volume. For example, you decide to buy 100 shares of Amara Raja Batteries at
485, and I decide to sell 100 shares of Amara Raja Batteries at 485. There is a price and quantity match,
which results in a trade. You and I together have created a volume of 100 shares. Many people tend to
assume volume count as 200 (100 buy + 100 sell) which is not the right way to look at volumes.

The volume trend table

Volume information on its own is quite useless. For example, we know that the volumes on
Cummins India is 13,49,736 shares. So how useful is this information when read in isolation? If
you think about it, it has no merit and hence would actually mean nothing. However when you
associate today’s volume information with the preceding price and volume trend, then volume
information becomes lot more meaningful.
In the table below you will find a summary of how to use volume information:

The first line in the table above says, when the price increases along with an increase in volume,
the expectation is bullish.

Before we understand the table above in detail, think about this – we are talking about an
‘increase in volume’. What does this actually mean? What is the reference point? Should it be
an increase over the previous day’s volume number or the previous week’s aggregate volume?

As a practice, traders usually compare today’s volume over the average of the last 10 days
volume. Generally the rule of thumb is as follows:

High Volume = Today’s volume > last 10 days average volume

Low Volume = Today’s volume < last 10 days average volume
Average Volume = Today’s volume = last 10 days average volume

To get the last 10 day average, all you need to do is draw a moving average line on the volume
bars and the job is done. Of course, we will discuss moving averages in the next chapter

In the chart above, you can see that volumes are represented by blue bars (at the bottom of the
chart). The red line overlaid on the volume bars indicates the 10 day average. As you notice, all
 the volume bars that are over and above the 10 day average can be considered as increased
volume where some institutional activity (or large participation) has taken place.

Thought process behind the volume trend table

When institutional investors buy or sell they obviously do not transact in small chunks. For
example, think about LIC of India, they are one of the biggest domestic institutional investors in
India. If they would buy shares of Cummins India, would you think they would buy 500 shares?
Obviously not, they would probably buy 500,000 shares or even more. Now, if they were to buy
500,000 shares from the open market, it will start reflecting in volumes. Besides, because they
are buying a large chunk of shares, the share price also tends to go up. Usually institutional
money is referred to as the “smart money”. It is perceived that ‘smart money’ always makes
wiser moves in the market compared to retail traders. Hence following the smart money seems
like a wise idea.

If both the price and the volume are increasing this only means one thing – a big player is
showing interest in the stock. Going by the assumption that smart money always makes smart
choices the expectation turns bullish and hence one should look at buying opportunity in the
stock.

Or as a corollary, whenever you decide to buy, ensure that the volumes are substantial. This
means that you are buying along with the smart money.

This is exactly what the 1st row in the volume trend table indicates – expectation turns bullish
when both the price and volume increases.

What do you think happens when the price increases but the volume decreases as indicated in
the 2nd row?

Think about it on the following terms:

1. Why is the price increasing?

Because market participants are buying

2. Are there any institutional buyers associated with the price increase?

Not likely

3. How would you know that there are no meaningful purchase by institutional investors

Simple, if they were buying then the volumes would have increased and not decrease

4. So what does an increase in price, associated by decreasing volumes indicate?

 It means the price is increasing because of a small retail participation and not really influential buying.
Hence you need to be cautious as this could be a possible bull trap
Going forward, the 3rd row says, a decrease in price along with an increase in volume sets a
bearish expectation. Why do you think so?

A decrease in price indicates that market participants are selling the stock. Increase in volumes
indicates the presence of smart money. Both events occurring together (decrease in price +
increase in volumes) should imply that smart money is selling stocks. Going by the assumption
that the smart money always makes smart choices, the expectation is bearish and hence one
should look at selling opportunity in the stock.

Or as a corollary, whenever you decide to sell, ensure that the volumes are good. This means
that you too are selling, along with the smart money.

Moving forward, what do you think happens when both volume and price decrease as indicated
in the 4th row?

Think about it in on following terms:

1. Why is the price decreasing?

Because market participants are selling.

2. Are there any institutional sellers associated with the price decrease?

Not likely

3. How would you know that there are no meaningful sell orders by institutional investors

Simple, if they were selling then the volume would increase and not decrease

4. So how would you infer a decline in price and a decline in volume?

It means the price is decreasing because of small retail participation, and not really influential (read as
smart money) selling. Hence you need to be cautions as this could be a possible bear trap.

Revisiting the checklist

Let us revisit the checklist and revaluate from the volumes perspective. Imagine this hypothetical
technical situation in a stock:

1. Occurrence of a bullish engulfing pattern – this suggests a long trade for reasons discussed
previously
2. A support level around the low of bullish engulfing – support indicates demand. Therefore the
occurrence of a bullish engulfing pattern near the support area suggests there is indeed a strong
demand for the stock and hence the trader can look at buying the stock.
1. With a recognizable candlestick pattern and support near the stoploss, the trader gets a double
confirmation to go long
Now along with support near the low, imagine high volumes on the 2nd day of the bullish
engulfing pattern i.e on P2 (blue candle). What can you infer from this?

The inference is quite clear – high volumes plus increase in price confirms to us that large
influential market participants are positioning themselves to buy the stock.

With all three independent variables i.e candlesticks, S&R, and volumes suggest to take the same
action i.e to go long. If you realize this is a triple confirmation!

The point that I want to drive across is the fact that volumes are very powerful as it helps the
trader in confirming a trade. For this reason it is an important factor and therefore must be
included in the checklist.

Here is how the updated checklist now stands:

1. The stock should form a recognizable candlestick pattern

2. S&R should confirm 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 to the trade
1. Presence of above average volumes on both buy and sell day
2. Low volumes are not encouraging and hence do feel free to hesitate taking a trade where the volumes
are low

A simple application of moving average

The moving average can be used to identify buying and selling opportunities with its
own merit. When the stock price trades above its average price, it means the traders
are willing to buy the stock at a price higher than its average price. This means the
traders are optimistic about the stock price going higher. Therefore one should look at
buying opportunities.

Likewise, when the stock price trades below its average price, it means the traders are
willing to sell the stock at a price lesser than its average price. This means the traders
are pessimistic about the stock price movement. Therefore one should look at selling
opportunities.

We can develop a simple trading system based on these conclusions. A trading system
can be defined as a set of rules that help you identify entry and exit points.

We will now try and define one such trading system based on a 50 day exponential
moving average. Remember a good trading system gives you a signal to enter a trade
and a signal to close out the trade. We can define the moving average trading system
with the following rules:

Rule 1) Buy (go long) when the current market price turns greater than the 50 day EMA.
Once you go long, you should stay invested till the necessary sell condition is satisfied

Rule 2) Exit the long position (square off) when the current market price turns lesser
than the 50 day EMA

Here is a chart that shows the application of the trading system on Ambuja cements.
The black line on the price chart is the 50 day exponential moving average.

Starting from left, the first opportunity to buy originated at 165, highlighted on the charts
as B1@165. Notice, at point B1, the stock price moved to a point higher than its 50 day
EMA. Hence as per the trading system rule, we initiate a fresh long position.

Going by the trading system, we stay invested till we get an exit signal, which we
eventually got at 187, marked as S1@187. This trade generated a profit of Rs.22 per
share.

The next signal to go long came at B2@178, followed by a signal to square off
at S2@182. This trade was not impressive as it resulted in a profit of just Rs.4. However
the last trade, B3@165, and S3@215 was quite impressive resulting in a profit of Rs.50.

Here is a quick summary of these trades based on the trading system fared:
 From the above table, it is very clear that the first and last trades were profitable, but the
2nd trade was not so profitable. If you inspect why this happened, it is evident that during
the 1st and the 3rd trade, the stock was trending but during the 2nd trade the stock moved
sideways.

This leads us to a very important conclusion about the moving averages. Moving
averages works brilliantly when there is a trend and fails to perform when the stock
moves sideways. This basically means the ‘Moving average’ in its simplest form is a
trend following system.

From my own personal experience of trading based on moving averages, I have noticed
a few important characteristics:

1. Moving averages gives you many trading signals (buy and sell) during a sideways
market. Most of these signals result in marginal profits, if not for losses
2. However usually one of those many trades results in a massive rally (like
the B3@165 trade) leading to impressive gains
3. It would be very difficult to segregate the big winner from the many small trades
4. Hence the trader should not be selective in terms of selecting signals that moving
average system suggest. In fact the trader should trade all the trades that the system
suggests
5. Remember the losses are minimum in a moving average system, but that 1 big trade is
good enough to compensate all the losses and can give you sufficient profits
6. The profit making trade ensures you are in the trend as long as the trend lasts.
Sometime even upto several months. For this reason, MA can be used as a proxy for
identifying long term investment ideas
7. The key to MA trading system is to take all the trades and not be judgmental about the
signals being generated by the system.

Moving average crossover system

As its evident now the problem with the plain vanilla moving average system is that it
generates far too many trading signals in a sideway market. A moving average
crossover system is an improvisation over the plain vanilla moving average system. It
helps the trader to take fewer trades in a sideways market.

In a MA crossover system, instead of the usual single moving average, the trader
combines two moving averages. This is usually referred to as ‘smoothing’.

A typical example of this would be to combine a 50 day EMA, with a 100 day EMA. The
shorter moving average (50 days in this case) is also referred to as the faster moving
average. The longer moving average (100 days moving average) is referred to as the
slower moving average.
The shorter moving average takes lesser number of data points to calculate the average
and hence it tends to stick closer to the current market price, and therefore reacts more
quickly. A longer moving average takes more number of data points to calculate the
average and hence it tends to stay away from the current market price. Hence the
reactions are slower.

Here is the chart of Bank of Baroda, showing you how the two moving averages stack
up when loaded on a chart.

As you can see, the black 50 day EMA line is closer to the current market price (as it
reacts faster) when compared to the pink 100 day EMA (as its reacts slower).

Traders have modified the plain vanilla MA system with the crossover system to
smoothen out the entry and exit points. In the process, the trader gets far fewer signals,
but the chances of the trade being profitable are quite high.

The entry and exit rules for the crossover system is as stated below:

Rule 1) – Buy (fresh long) when the short term moving averages turns greater than the
long term moving average. Stay in the trade as long as this condition is satisfied

Rule 2) – Exit the long position (square off) when the short term moving average turns
lesser than the longer term moving average

Let us apply the MA crossover system to the same BPCL example that we looked at. For ease
of comparison, I have reproduced the BPCL’s chart with a single 50 day MA.
 Notice, when the markets were moving sideways, MA suggested at least 3 trading
signals. However the 4th trade was the winner which resulted in 67% profit.

The chart shown below shows the application of a MA crossover system with 50 and
100 day EMA.

The black line plots the 50 day moving average and the pink line plots the 100 day
moving average. As per the cross over rule, the signal to go long originates when the 50
day moving average (short term MA) crosses over the 100 day moving average (long
term MA). The crossover point has been highlighted with an arrow. Please do notice
how the crossover system keeps the trader away from the 3 unprofitable trades. This is
the biggest advantage of a cross over system.

A trader can use any combination to create a MA cross over system. Some of the
popular combinations for a swing trader would be:

1. 9 day EMA with 21 day EMA – use this for short term trades ( upto few trading session)
2. 25 day EMA with 50 day EMA – use this to identify medium term trade (upto few weeks)
3. 50 day EMA with 100 Day EMA – use this to identify trades that lasts upto few months
4. 100 day EMA with 200 day EMA – use this to identify long term trades (investment
opportunities), some of them can even last for over a year or more.
Remember, longer the time frame the lesser the number of trading signals.

Here is an example of a 25 x 50 EMA crossover. There are three trading signals that
qualify under the crossover rule.

The outlook is bullish when the current market price is greater than the EMA. The
outlook turns bearish when the current market price turns lesser than the EMA

The outlook turns bullish when the faster EMA crosses and is above the slower
EMA. Hence one should look at buying the stock. The trade lasts upto a point
where the faster EMA starts going below the slower EMA