Module 2 — Technical Analysis

Chapter 17

The Dow Theory (Part 1)

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

The Dow Theory was introduced to the world by Charles H. Dow, who also founded
the Dow-Jones financial news service (Wall Street Journal). During his time, he wrote
a series of articles starting from 1900s which in the later years was referred to as
‘The Dow Theory’. Much credit goes to William P Hamilton, who compiled these
articles with relevant examples over a period of 27 years. Much has changed since
the time of Charles Dow, and hence there are supporters and critics of the Dow
Theory.

17.1 – The Dow Theory Principles

The Dow Theory is built on a few beliefs. These are called the Dow Theory tenets.
These tenets were developed by Charles H Dow over the years of his observation on
the markets. There are 9 tenets that are considered as the guiding force behind the
Dow Theory. They are as follows:

Sl
Tenet What does it mean?
No

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

Overall there are 3 broad

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

This is the major trend of the market that lasts from a year to
several years. It indicates the broader multiyear direction of the
03 The Primary Trend market. While the long term investor is interested in the primary
trend, an active trader is interested in all trends. The primary trend
could be a primary uptrend or a primary down trend

These are corrections to the primary trend. Think of this as a minor

counter reaction to the larger movement in the market. Example –
04 The Secondary Trend corrections in the bull market, rallies & recoveries in the bear
market. The counter trend can last anywhere between a few
weeks to several months

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

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

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

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

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

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

17.2 – The different phases of Market

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

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

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

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than not, this is how the support levels are created. Accumulation phase can last up
to several months.

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

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

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

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

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

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

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

1. The Double bottom & Double top formation

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

17.4 – The Double bottom and top formation

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

A double bottom formation is considered bullish, and hence one should look at
buying opportunities. Here is a chart that shows a double bottom formation in Cipla
Limited:

Notice the time interval between the two bottom formations. It is evident that the
price level was well spaced in time.

Likewise in a double top formation, the stock attempts to hit the same high price
twice but eventually sells off. Of course the time gap between the two attempts of
crossing the high should at least be 2 weeks. In the chart below (Cairn India Ltd), we
can notice the double top at 336 levels. On close observation you will notice the first

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top was around Rs.336, and the second top was around Rs.332. With some amount
of flexibility a small difference such as this should be considered alright.

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

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

17.5 – The triple top and bottom

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

As a rule of thumb the more number of times the price tests, and reacts to a certain
price level, the more sacred the price level is considered. Therefore by virtue of this,
the triple formation is considered more powerful than the double formation.

The following chart shows a triple top formation for DLF Limited. Notice the sharp
sell off after testing the price level for the 3rd time, thus completing the triple top.

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 Key takeaways from this chapter

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

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 Module 2 — Technical Analysis
Chapter 18

The Dow Theory (Part 2)

91

18.1 – Trading Range

The concept of range is a natural extension to the double and triple formation. In a
range, the stock attempts to hit the same upper and lower price level multiple times
for an extended period of time. This is also referred to as the sideways market. As
the price oscillates in a narrow range without forming a particular trend, it is called a
sideways market or sideways drift. So, when both the buyers and sellers are not
confident about the market direction, the price would typically move in a range, and
hence typical long term investors would find the markets a bit frustrating during this
period.

However the range provides multiple opportunities to trade both ways (long and
short) with reasonable accuracy for a short term trader. The upside is capped by
resistance and the downside by the support. Thus it is known as a range bound
market or a trading market as there are enough opportunities for both the buyers
and the sellers.

In the chart below you can see the stock’s behaviour in a typical range:

As you can see the stock hit the same upper (Rs.165) and the same lower (Rs.128)
level multiple times, and continued to trade within the range. The area between the
upper and lower level is called the width of the range. One of the easy trades to
initiate in such a scenario would be to buy near the lower level, and sell near the
higher level. In fact the trade can be both ways with the trader opting to short at the
higher level and buying it back at the lower level.

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 In fact the chart above is a classic example of blending Dow Theory with candlestick
patterns. Starting from left, notice the encircled candles:

1. The bullish engulfing pattern is suggesting a long

2. Morning doji star suggesting a long
3. Bearish engulfing pattern is suggesting a short
4. Bearish harami pattern is suggesting a short
The short term trader should not miss out such trades, as these are easy to identify
trading opportunities with high probability of being profitable. The duration of the
range can be anywhere between a few weeks to a couple of years. The longer the
duration of the range the longer is the width of the range.

18.2 – The range breakout

Stocks do breakout of the range after being in the range for a long time. Before we
explore this, it is interesting to understand why stocks trade in the range in the first
place.

Stocks can trade in the range for two reasons:

1. When there are no meaningful fundamental triggers that can move the stock –
These triggers are usually quarterly/ annual result announcement, new products
launches, new geographic expansions, change in management, joint ventures,
mergers, acquisitions etc. When there is nothing exciting or nothing bad about the
company the stock tends to trade in a trading range. The range under these
circumstances could be quite long lasting until a meaningful trigger occurs
2. In anticipation of a big announcement – When market anticipates a big corporate
announcement the stock can swing in either directions based on the outcome of the
announcement. Till the announcement is made both buyers and sellers would be
hesitant to take action and hence the stock gets into the range. The range under

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 such circumstances can be short-lived lasting until the announcement (event) is
made.
The stock after being in the range can break out of the range. The range breakout
more often than not indicates the start of a new trend. The direction in which the
stock will breakout depends on the nature of the trigger or the outcome of the
event. What is more important is the breakout itself, and the trading opportunity it
provides.

A trader will take a long position when the stock price breaks the resistance levels
and will go short after the stock price breaks the support level.

Think of the range as an enclosed compression chamber where the pressure builds
up on each passing day. With a small vent, the pressure eases out with a great force.
This is how the breakout happens. However, the trader needs to be aware of the
concept of a ‘false breakout’.

A false breakout happens when the trigger is not strong enough to pull the stock in
a particular direction. Loosely put, a false breakout happens when a ‘not so trigger
friendly event’ occurs and impatient retail market participants react to it. Usually the
volumes are low on false range breakouts indicating, there is no smart money
involved in the move. After a false breakout, the stock usually falls back within the
range.

A true breakout has two distinct characteristics:

1. Volumes are high and

2. After the breakout, the momentum (rate of change of price) is high
Have a look at the chart below:

The stock attempted to breakout of the range three times, however the first two
attempts were false breakouts. The first 1st breakout (starting from left) was

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characterized by low volumes, and low momentum. The 2nd breakout was
characterized by impressive volumes but lacked momentum.

However the 3rd breakout had the classic breakout attributes i.e high volumes and
high momentum.

18.3 – Trading the range breakout

Traders buy the stock as soon as the stock breaks out of the range on good
volumes. Good volumes confirm just one of the prerequisite of the range breakout.
However, there is no way for the trader to figure out if the momentum (second
prerequisite) will continue to build. Hence, the trader should always have a stoploss
for range breakout trades.

For example – Assume the stock is trading in a range between Rs.128 and Rs.165.
The stock breaks out of the range and surges above Rs.165 and now trades at
Rs.170. Then trader would be advised to go long 170 and place a stoploss at Rs.165.

Alternatively assume the stock breaks out at Rs.128 (also called the breakdown) and
trades at Rs.123. The trader can initiate a short trade at Rs.123 and treat the level of
Rs.128 as the stoploss level.

After initiating the trade, if the breakout is genuine then the trader can expect a
move in the stock which is at least equivalent to the width of the range. For example
with the breakout at Rs.168, the minimum target expectation would be 43 points
since the width is 168 – 125 = 43. This translates to a price target of Rs.168+43 = 211.

18.4 – The Flag formation

The flag formation usually takes place when the stock posts a sustained rally with
almost a vertical or a steep increase in stock prices. Flag patterns are marked by a
big move which is followed by a short correction. In the correction phase, the price
would generally move within two parallel lines. Flag pattern takes the shape of a
parallelogram or a rectangle and they have the appearance of a flag on the pole.
The price decline can last anywhere between 5 and 15 trading session.

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With these two events (i.e price rally, and price decline) occurring consecutively a
flag formation is formed. When a flag forms, the stock invariably spurts back all of a
sudden and continues to rally upwards.

For a trader who has missed the opportunity to buy the stock, the flag formation
offers a second chance to buy. However the trader has to be quick in taking the
position as the stock tends to move up all of a sudden. In the chart above the
sudden upward moved is quite evident.

The logic behind the flag formation is fairly simple. The steep rally in the stock offers
an opportunity for market participants to book profits. Invariably, the retail
participants who are happy with the recent gains in the stock start booking profits
by selling the stock. This leads to a decline in the stock price. As only the retail
participants are selling, the volumes are on the lower side. The smart money is still
invested in the stock, and hence the sentiment is positive for the stock. Many
traders see this as an opportunity to buy the stock and hence the price rallies all of
a sudden.

18.5 – The Reward to Risk Ratio (RRR)

The concept of reward to risk ratio (RRR) is generic and not really specific to Dow
Theory. It would have been apt to discuss this under ‘trading systems and Risk
management’. However RRR finds its application across every type of trading, be it
trades based on technical analysis or investments through fundamentals. For this
reason we will discuss the concept of RRR here.

The calculation of the reward to risk ratio is very simple. Look at the details of this
short term long trade:
Entry: 55.75
Stop loss: 53.55
Expected target: 57.20

On the face of it, considering it is a short term trade, the trade looks alright.
However, let us inspect this further:

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What is the risk the trader is taking? – [Entry – Stoploss] i.e 55.75 – 53.55 = 2.2

What is the reward the trader is expecting? – [Exit – Entry] i.e 57.2 – 55.75 = 1.45

This means for a reward of 1.45 points the trader is risking 2.2 points or in other
words the Reward to Risk ratio is 1.45/2.2 = 0.65. Clearly this is not a great trade.

A good trade should be characterised by a rich RRR. In other words, for every Rs.1/-
you risk on a trade your expected return should be at least Rs.1.3/- or higher,
otherwise it is simply not a worth the risk.

For example consider this long trade:

Entry: 107
Stop loss: 102
Expected target: 114

In this trade the trader is risking Rs.5/- (107 – 102) for an expected reward of Rs.7/-
(114 – 107). RRR in this case is 7/5 = 1.4. This means for every Rs.1/- of risk the
trader is assuming, he is expecting Rs.1.4 as reward. Not a bad deal.

The minimum RRR threshold should be set by each trader based on his/her risk
appetite. For instance, I personally don’t like to take up trades with a RRR of less
than 1.5. Some aggressive traders don’t mind a RRR of 1, meaning for every Rs.1
they risk they expect a reward of Rs.1. Some would prefer the RRR to be at least
1.25. Ultra cautious traders would prefer their RRR to be upwards of 2, meaning for
every Rs.1/- of risk they would expect at least Rs.2 as reward.

A trade must qualify the trader’s RRR requirement. Remember a low RRR is just not
worth the trade. Ultimately if RRR is not satisfied then even a trade that looks
attractive must be dropped as it is just not worth the risk.

To give you a perspective think about this hypothetical situation:

A bearish engulfing pattern has been formed, right at the top end of a trade. The
point at which the bearish engulfing pattern has formed also marks a double top
formation. The volumes are very attractive as they are at least 30% more than the
10 day average volumes. Near the bearish engulfing patterns high the chart is
showing a medium term support.

In the above situation, everything seems perfectly aligned to short trade. Assume
the trade details are as below:
Entry: 765.67
Stop loss: 772.85
Target: 758.5
Risk: 7.18 (772.85 – 765.67) i.e [Stoploss – Entry]
Reward: 7.17 (765.67 – 758.5) i.e [Entry – Exit]
RRR: 7.17/7.18 = ~ 1.0

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 As I mentioned earlier, I do have a stringent RRR requirement of at least 1.5. For this
reason even though the trade above looks great, I would be happy to drop it and
move on to scout the next opportunity.

As you may have guessed by now, RRR finds a spot in the checklist.

18.6 – The Grand Checklist

Having covered all the important aspects of Technical Analysis, we now need to
look at the checklist again and finalize it. As you may have guessed Dow Theory
obviously finds a place in the checklist as it provides another round of confirmation
to initiate the trade.

1. The stock should form a recognisable candlestick pattern

2. S&R should confirm to the trade. The stoploss price should be around S&R
1. For a long trade, the low of the pattern should be around the support
2. For a short trade, the high of the pattern should be around the resistance
3. Volumes should confirm
1. Ensure above average volumes on both buy and sell day
2. Low volumes are not encouraging, and hence do feel free to hesitate while taking
trade where the volumes are low
4. Look at the trade from the Dow Theory perspective.
1. Primary, secondary trends
2. Double, triple, range formations
3. Recognisable Dow formation
5. Indicators should confirm
1. Scale the trade size higher if indicators confirm to your plan of action
2. If the indicators do not confirm go ahead with the original plan
6. RRR should be satisfactory
1. Think about your risk appetite and identify your RRR threshold
2. For a complete beginner, I would suggest the RRR to be as high as possible as this
provides a margin of safety
3. For an active trader, I would suggest a RRR of at least 1.5
When you identify a trading opportunity, always look how the trade is positioned
from the Dow Theory perspective. For example if you are considering a long trade
based on candlesticks, then look at what the primary and secondary trend is
suggesting. If the primary trend is bullish, then it would be a good sign, however if
we are in the secondary trend (which is counter to the primary) then you may want
to think twice as the immediate trend is counter to the long trade.

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 If you follow the checklist mentioned above and completely understand its
importance, I can assure you that your trading will improve multiple folds. So the
next time you take a trade, ensure you comply with above checklist. If not for
anything, at least you will have no reason to initiate a trade based on loose and
unscientific logic.

18.7 – What next?

We have covered many aspects of technical analysis in this module. I can assure you
the topics covered here are good enough to put you on a strong platform. You may
believe there is a need to explore other patterns and indicators that we have not
discussed here. If we have not discussed a pattern or an indicator here on Varsity,
do remember it is for a specific purpose. So be assured that you have all that you
need to begin your journey with Technical analysis.

If you can devote time to understanding each one of these topics thoroughly, then
you can be certain about developing a strong TA based thinking framework. The
next logical progression from here would be to explore ideas behind back testing
trading strategies, risk management, and trading psychology. All of which we will
cover in the subsequent modules.

In the next concluding chapter, we will discuss few practical aspects that will help
you get started with Technical Analysis.

Key takeaways from this chapter

1. A range is formed when the stock oscillates between the two price points
2. A trader can buy at the lower price point, and sell at the higher price point
3. The stock gets into a range for a specific reason such as the lack of fundamental
triggers, or event expectation
4. The stock can break out of the range. A good breakout is characterized by above
average volumes and sharp surge in prices
5. If the trader has missed an opportunity to buy a stock, the flag formation offers
another window to buy
6. RRR is a critical parameter for trade evaluation. Develop a minimum RRR threshold
based on your risk appetite
7. Before initiating a trade the trader should look at the opportunity from the Dow
Theory perspective

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 Module 2 — Technical Analysis
Chapter 19

The Finale – Helping you get started

458

19.1 – The Charting Software

Over the last 18 chapters we have learnt many aspects of Technical Analysis. If you
have read through all the chapters and understood what is being discussed, you are
certainly at a stage where you can start trading based on Technical Analysis. The
objective of this chapter is to help you get started with identifying technical trading
opportunities.

Kindly note, the suggestions I have put forth in this chapter are based on my trading
experience.

To begin with, you need a chart visualization software, simply called the ‘Charting
Software’. The charting software helps you look at the various stock charts and
analyze the same. Needless to say, the charting software is a very important tool for
a technical analyst.

There are many charting software’s available. The two most popular ones are
‘Metastock’ and ‘Amibroker’. Majority of the technical analysts use one of the two
charting software’s. Needless to say, these are paid software’s and you need to
purchase the software license before using it.

There are a few online free charting tools that are available which you can use –
these are available on Yahoo Finance, Google Finance and pretty much all the
business media websites. However, my advice to you is – if you aspire to become a
technical analyst, get access to a good charting software.

Think of the charting software as a DVD player, once you have a DVD player
installed, you will still need to rent DVDs to watch movies. Similarly, once you have a

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 charting software installed, you will still need to feed it with data to actually view the
charts. The data feed required is provided by the data vendors.

There are many data vendors in India giving you access to data feeds. I would
suggest you look up on the internet for reliable vendors. You just need to inform
the data vendor which charting software you have, and he will provide you the data
feeds in a format that is compatible with your charting software. Of course, the data
feeds come at a cost. Once you sign up with a data vendor, he will first give you all
the historical data, after which you will have to update the data from his server on a
daily basis to stay current.

From my experience buying the latest version of a good charting software

(Metastock or Amibroker) can cost you a onetime fee of anywhere between
Rs.25,000/- and Rs.30,000/-. Add to this another Rs.15,000/- to Rs.25,000 towards
the data feeds. Of course, while the software cost is one time, the cost of data feeds
recurs annually. Do note, the older versions of the charting software may cost you
much lesser.

Now, if you are in no mood to spend so much for the charting software & data feed
combination there is another alternative. And that would be Zerodha’s Pi.

As you may know, Zerodha has a proprietary trading terminal called ‘Pi’. Pi helps you
in many ways; I would like to draw your attention to some of its features in the
context of Technical Analysis:

1. It is bundled – Pi is a charting software and a data feed package bundled into a

single software
2. Great Visualizations – Pi helps you visualize charts across multiple time frames
including intraday charts
3. Advanced Features – Pi has advanced charting features and includes 80 built-in
technical indicators and over 30 drawing tools
4. Scripting you strategy – Pi has a scripting language employing which you can code
technical strategies and back test the same on historical data. Do note, on Varsity
we will soon include a module on building trading strategies and scripting
5. Easy Opportunity Recognition – Pi has pattern recognition feature that lets you
draw a pattern on the screen. Once you draw, just command Pi to scout for that
pattern across the market and it will do just that for you
6. Trade from Pi – Pi also lets you execute trades directly from the chart (a huge plus
point for a technical trader)
7. Data Dump – Pi has a massive historical data dump (over 50,000 candles) which
means back testing your strategy will be more efficient
8. Your personal trading assistant – Pi’s ‘Expert Advisor’, keeps you informed about
the patterns being developed in the live markets

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9. Super Advanced features – Pi has Artificial Intelligence and Genetic Algorithms.
These are optimisation tools which helps you optimize your trading algorithms
10. It is free – Zerodha is giving it free of cost to all its active traders
The list is quite exhaustive ranging from the basic to advanced features. I would
strongly suggest you try out Pi before you decide to venture out for charting
package and data feed bundle.

19.2 – Which timeframe to choose?

We discussed ‘Timeframes in chapter 3. I would request you to read through it again
to refresh your memory.

Selecting the timeframe while scanning for trading opportunities is perhaps one of
the biggest confusion a newbie technical analyst has. There are many timeframes
you can choose from – 1 minute, 5 minutes, 10 minutes, 15 minutes, EOD, Weekly,
Monthly, and Yearly. It is quite easy to get confused with this.

As a thumb rule, the higher the timeframe, the more reliable the trading signal is.
For example a ‘Bullish Engulfing’ pattern on the 15 minute timeframe is far more
reliable than a ‘Bullish Engulfing’ pattern on a 5 minute timeframe. So keeping this
in perspective, one has to choose a timeframe based on the intended length of the
trade.

So how do you decide your intended length of your trade?

If you are starting out fresh or if you are not a seasoned trader I would suggest you
avoid day trading. Start with trades with an intention to hold the trade for a few
days. This is called ‘Positional Trading’ or ‘Swing Trading’. An active swing trader
usually keeps his trading position open for a few days. The best look back period for
a swing trader is 6 months to 1 year.

On the other hand, a scalper is a seasoned day trader; typically he uses 1minute or
5 minutes timeframe.

Once you are comfortable with holding trades over multiple days, graduate yourself
to ‘Day Trading’. My guess is, your transition from a positional trader to a day trader

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will take some time. Needless to say for a dedicated and disciplined trader, the
transition period is remarkably lesser.

19.3 – Look back period

Look back period is simply the number of candles you wish to view before taking a
trading decision. For instance, a look back period of 3 months means you are
looking at today’s candle in the backdrop of at least the recent 3 months data. By
doing this you will develop a perspective on today’s price action with reference to
last 3 months price action.

For swing trading opportunities, what is the ideal look back period? From my
experience, I would suggest that a swing trader should look for at least 6 months to
1 year data. Likewise a scalper is better off looking at last 5 days data.

However, while plotting the S&R levels you should increase the look back period to
at least 2 years.

19.4 – The opportunity universe

There are roughly about 6000 listed stocks in the Bombay Stock Exchange (BSE) and
close to about 2000 listed stocks in the National Stock Exchange (NSE). Does it make
sense for you to scan for opportunities across these thousands of stocks, on a daily
basis? Obviously not. Over a period of time you need to identify a set of stocks that
you are comfortable trading. These set of stocks would constitute your “Opportunity

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 Universe’. On a daily basis you scan your opportunity universe to identify trading
opportunities.

Here are some pointers to select stocks to build your opportunity universe:

1. Ensure the stock has adequate liquidity. One way to ensure adequate liquidity is to
look at the bid ask spread. The lesser the spread, the more liquid the stock
1. Alternatively you can have ‘minimum volume criteria’. For example you can consider
only those stocks where the volume per day is at least 500000
2. Make sure the stock is in the ‘EQ’ segment. This is basically because stocks in the ‘EQ’
segment can be day traded. I agree, I discouraged day trading for a newbie,
however in a situation where you initiated a positional trade and the target is
achieved the same day, there is no harm in closing the position intraday
3. This is a bit tricky, but make sure the stock is not operator driven. Unfortunately
there is no quantifiable method to identify operator driven stocks. This comes to
you by sheer experience
If you find it difficult to find stocks that comply with the above points, I would advise
you to simply stick to the Nifty 50 or the Sensex 30 stocks. These are called the
index stocks. Index stocks are carefully selected by the exchanges, this selection
process ensures they comply with many points including the ones mentioned
above.

Keeping Nifty 50 as your opportunity universe is probably a good idea for both
swing trader and scalper.

19.5 – The Scout

Let us now proceed to understand how one should go about selecting stocks for
trading. In other words, we will try and indentify a process, employing which we can
scan for trading opportunities. The process is mainly suited for a swing trader.

We have now set the 4 important aspects –

1. The charting software – Suggest you use Zerodha’s Pi

2. Timeframe – End of Day data

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3. Opportunity Universe – Nifty 50 stocks
4. Trade type – Positional trades with an option to square off intraday, provided the
target hits the same day
5. Look back period – Between 6 months to 1 year. Increase to 2 years while plotting
the S&R level
Having fixed these important practical aspects, I will now proceed to share my
methodology of scanning trading opportunities. I have divided the process into 2
parts:

Part 1 – The Short listing process

1. I look at the chart of all the stocks within my opportunity universe

2. While looking at the chart, my attention is only on the recent 3 or maximum 4
candles
3. While looking at the recent 3 candles, I check if there is any recognisable candlestick
pattern being developed
4. If I find an interesting pattern, I short list this stock for further investigation and I
continue the scouting process. I always ensure I check all the 50 charts
Part 2 – The Evaluation process

At this stage, I am usually left with 4-5 shortlisted stocks (out of the 50 stocks in my
opportunity universe) which exhibit a recognisable candlestick pattern. I then
proceed to evaluate these 4-5 charts in detail. Typically I spend at least 15 – 20
minutes on each chart. Here is what I do when looking at the shortlisted chart:

1. I generally look at how strong the pattern is – I am specifically interested in checking

if there is any need for me to be more flexible
1. For example, if a Bullish Marubuzo has a shadow, I evaluate the length of the
shadow with reference to the range
2. After this I look at the ‘prior trend’. For all bullish patterns, the prior trend should be
a downtrend, and for all bearish patterns the prior trend should be an uptrend. I do
pay a lot of attention to prior trends
3. At this stage if everything looks good (i.e. I have identified a recognizable pattern
with a well defined prior trend), I proceed to inspect the chart further
4. After this I look at the volumes. The volume should be at least equal to or more than
the 10 day average volume
5. Provided both the candlestick pattern and volumes confirm, I then proceed to check
the existence of the support (in case of a long trade) and resistance (in case of a
short trade) level
1. The S&R level should coincide (as much as possible) with the stoploss of the trade
(as defined by the candlestick pattern)

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2. If the S&R level is more than 4% away from the stoploss, I stop evaluating the chart
further and proceed to the next chart
6. I then look for Dow patterns – particularly for double and triple top & bottom
formations, flags formations and the possibility of a range breakout
1. Needless to say, I also establish the Primary and secondary market trend
7. If the steps 1 to 5 are satisfactory, I proceed to calculate the risk to reward ratio
(RRR)
1. To calculate RRR, I first establish the target by plotting either the support or
resistance level
2. The minimum RRR should be at least 1.5
8. At last I look at the MACD and RSI indicators to get a perspective, if they confirm and
if I have spare cash I increase my trade size
Usually out of the 4-5 shortlisted stocks, at the most 1 or 2 may qualify for a trade.
There are days when there are no trading opportunities. Deciding not to trade in
itself is a big trading decision. Do remember this is a fairly stringent checklist, if a
stock is confirming to the checklist, my conviction to trade is very high.

I have mentioned this many times in this module, I will mention this for one last
time – once you place a trade, do nothing till either your target is achieved or
stoploss is triggered. Of course you can trail your stoploss, which is a healthy
practice. But otherwise do nothing, if your trade complies with the checklist and do
remember the trade is highly curetted; hence the chance of being successful is high.
So it makes sense to stay put with conviction.

19.5 – The Scalper

For a seasoned swing trader, scalping is another option. Scalping is a technique
where the trader initiates a fairly large trade with an intention of holding the trade
for a few minutes. Here is a typical example of the trade done by a scalper –

1st Leg of the trade 2nd leg of the trade

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 Time – 10:15 AM Time – 10:25 AM

Stock – Infosys Stock – Infosys

Price – 3980 Price – 3976

Action – Sell Action – Buy

Quantity – 1000 shares Quantity – 1000 shares

Overall profit after applicable charges = Rs.2653/-

Do note, the overall profit is calculated considering that you are trading with
Zerodha, the overall profitability would shrink remarkably if you are scalping with an
expensive brokerage rates. Containing transaction charges is one of the keys to
successful scalping.

A scalper is a highly focused trader with a sharp sense for price. He utilizes highly
precise charts such with 1 minute and 5 minute timeframe to make his trading
decisions. A successful scalper executes many such trades within the day. His
objective is simple – large quantity trade with an intention to hold for a few minutes.
He intends to profit from the small moves in the stock.

If you aspire to be a scalper, here are few guidelines –

1. Do remember the checklist we have mentioned but do not expect all the checklist
items to comply as the trade duration is very low
2. If I were to handpick just 1 or 2 items in the checklist for scalping, it would be
candlestick pattern and volume
3. A risk reward ratio of even 0.5 to 0.75 is acceptable while scalping
4. Scalping should be done only on liquid stocks
5. Have an effective risk management system – be really quick to book a loss if need
be
6. Keep a tab on the bid ask spread to see how the volumes are building
7. Keep a tab on global markets – for example if there is a sudden drop in the Hang
Seng (Hong Kong stock exchange) it invariably leads to a sudden drop in local
markets
8. Choose a low cost broker to ensure your costs are controlled

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9. Use margins effectively, do not over leverage
10. Have a reliable intraday charting software
11. If you sense the day is going wrong, stop trading and move away from your terminal
Scalping as a day trading technique requires a great presence of mind and a
machine like approach. A successful scalper embraces volatility and is indifferent to
market swings.

Key takeaways from this chapter

1. If you aspire to become a technical trader ensure you equip yourself with good
charting software. Zerodha’s Pi is my preference
2. Choose EOD chart for both day trading and swing trading
3. Look at intraday charts if you like scalping the markets
4. The look back period should be at least 6 months to 1 year for swing trading
5. Nifty 50 is a great opportunity universe to begin with
6. The opportunity scanning can be done in 2 parts
7. Part 1 involves skimming through the charts of all the stocks in opportunity universe
and short listing those charts that display a recognizable candlestick pattern
8. Part 2 involves investigating the shortlisted charts to figure out if they comply with
the checklist
9. Scalping is advisable for seasoned swing traders

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