Setting up a trading system technical analysis-II (part III)

Chart Pattern

We have already discussed that Candle Stick chart is the most preferred one. Chart could be of different time frame, like if the price action of one hour forms a candle then the corresponding chart is called hourly chart. Similarly, if the price action of one day forms a candle, then it would be Daily Chart. Likewise, Weekly, Monthly, Quarterly or Yearly Charts also are the part of the subject.

Now, for intraday Trading, you need to consult intraday charts, consisting of 10 minutes or 15 minutes, whatever you deem suitable for your own purpose, along with live daily and hourly charts. For Delivery based swing trading, you might feel the necessity of daily charts, as well as weekly charts.

Charts also form various patterns, which gives some message to traders, sometimes very prominent, sometimes subtle. There are various chart patterns, readers may explore some of them in detail. Those are:

Head & Shoulder / Inverse Head & Shoulder, Channels, Rising / Falling Wedge, Flag & Pole, Island & Island reversal, Pennants, Rounding Top & Bottom, Symmetrical / Ascending / Descending Triangle etc.

Moving Average

It is evident that trend in prices for any freely traded security can be very volatile, almost haphazard at times. One technique for dealing with this volatility is Moving Average (MA). Moving average attempts to tone down the fluctuations so that distortions are reduced to a minimum. It is very important to remember that Moving Averages are dynamic levels of supports and resistances, i.e, they keep changing their values with time.

There are two principal categories of Moving Averages – Simple and Exponential.

A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. It places equal value on every price for the time span selected. While it is possible to create moving averages from the Open, High, and Low data points, most moving averages are created using the Closing Price. The corresponding Moving Average is displayed in the chart as a line.

For example: a 5-day simple moving average (5 DMA) is calculated by adding the closing prices for the last 5 days and dividing the total by 5. Similarly, there are 9 DMA, 13 DMA, 20 DMA, 50 DMA, 200 DMA etc. In each case, simple average of closing price is calculated. Apart from daily moving averages, there are weekly moving averages (WMA) for longer time frame and hourly moving average (HMA) for very short term or Intra Day purpose.

Exponential moving averages also called as exponentially weighted moving averages are calculated by applying more weight to recent prices relative to older prices. In order to reduce the lag in simple moving averages, technicians often use exponential moving averages. The weightage applied to the most recent price depends on the specified period of the moving average. The shorter the EMA’s period, more weight is applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price at 18.18% while a 20-period EMA weighs the most recent price at 9.52%. Calculating EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average.

Even though there are clear differences between simple moving averages and exponential moving averages, one is not necessarily better than the other. Exponential moving averages have less lag and are therefore more sensitive to recent prices – and recent price changes. Exponential moving averages will turn before simple moving averages. Simple moving averages, on the other hand, represent a true average of prices for the entire time period.

Selection of moving average entirely depends on the historical success rate. Why 20 SMA or why 200EMA or why 50 SMA etc. depends upon the history of individual securities. There is no hard and fast rule that you have to take 50 DMA and not 53 DMA but history shows 50 DMA works and therefore chartists prefer 50 DMA. Similarly, selection of SMA or EMA also depends on individual securities under different time frames.

Apart from the above, traders need to understand in detail the use of moving average, cross over and trend identification from the Moving Averages. Generally short term traders prefer 5, 9 and 13 DMA and positional players prefers 20, 50, 100 and 200 DMA.


Fibonacci Series is a matter of pure mathematics, was discovered long before the birth of Stock Market, but amazingly it works in the Stock Market. The common nature of any stock or Index is retracement, if it rises then corrects thereafter and if it falls then reverses thereafter. Fibonacci numbers help determine the level up to which a particular stock or index may retrace.

Leonardo Fibonacci created a series of numbers, which is called Fibonacci Series. The series has its first two numbers 0 and 1. The other numbers are arrived as follows:






5+8=13 and so on.

Thus we arrive at a series of numbers 0,1,2,3,5,8,13,21,34,55,89…………….. and so on.Now these numbers are related to each other by a ratio. A lot of phenomena in nature, science and astrology are explained by this property of Fibonacci Numbers. For example,

21 / 34 = 0.618, 34 / 55 = 0.618, 55/89 = 0.618 etc.

Similarly, 34/21=1.618, 55/34=1.618, 89/55=1.618 etc.

This 61.8% ratio is known as Golden Ratio in Technical Analysis and forms the basis of the Fibonacci Methods in Technical Analysis. The other two important ratios most commonly used are 38.2% and 50%.

1 – 0.618 = 0.382 and 0.5 is the mean of 0.382 and 0.618.

In order to utilize the Fibonacci Ratios, first identify the swing High and swing Low of any particular security. Generally, 23.6%, 38.2%, 50%, 61.8% and 78.6% ratios are used in this method. Prices generally face resistance and takes support at these levels, the strength of supports and resistances depend upon individual securities and their nature and selection of High – Low range under different time frames. Generally it is observed that confluence of two Fibonacci Levels measured from two different swing lows to the same swing high in an upswing is considered the most significant support level. On the other hand, reverse is applicable in a down move.

When the security gets close to Fibonacci levels or confluence levels, traders need to be on their toes and look for supporting evidence in order to act. Please keep in mind that Fibonacci Retracement Levels like other indicators cannot be acted upon in isolation.

Traders need to understand in detail the use of Fibonacci Levels, selection of highs and lows under different time frames. For advanced studies, they also need to know Fibonacci Arc and Fibonacci Fan.

Relative Strength Indicator (RSI)

The Relative Strength Indicator (RSI) was developed by Wells Wilder. This is a momentum indicator that measures the relative internal strength of a stock or market against itself, instead of comparing one asset with another. The formula for the RSI is as follows:

RSI = 100 – (100 / 1+RS) where RS = the average of x day’s up close divided by the average of x day’s down close. The formula aims to overcome two problems involved in construction of a momentum indicator – erratic movements and the need for a constant trading band for comparison purposes. The default time span (x days) recommended by Wilder is 14 days, which he justified on the basis that it encompasses half of the 28-days Lunar Cycle. However, in actual fact this is no logic in selecting 14 days average. Anyways, it works well and that’s what matters.

There is a very common concept that RSI reading 30 denotes oversold and 70 denotes overbought level of any stock or Index. However, please keep in mind that it is not necessary that whenever the stock will reach RSI 70, it will correct immediately or whenever it reaches 30, it will bounce immediately.

RSI is available in all charting softwares. For Practical purposes, if your charting software contains average line apart from the actual RSI Line, it will give you a much clear idea about RSI reading and determining positive or negative divergence in RSI.

A Trader needs to understand in detail the use of RSI, its divergence under different time frames.


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