Module 2   Technical AnalysisChapter 18

The Dow Theory (Part 2)

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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:

M2-Ch18-Chart1

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.

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.

M2-Ch18-title

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 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:

M2-Ch18-Chart2

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 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.

M2-Ch18-Chart3

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:

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

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.

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

 

286 comments

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  1. jagadeesh says:

    Hello Sir,
    Regarding the chart patterns in 15min intraday chart, how much should be the minimum time spacing to recognize it as a dow patterns??

    • Karthik Rangappa says:

      I my personal trading experience, Dow theory works best on EOD basis. However, on 15 mins intraday basis I would advice you to use it with at least 60 mins separation..that would be four 15 mins candle.

    • Rodolfo Jose Camarena says:

      At first you say the formula of risk (RRR) is {Entry – Stoploss} and at the last example you put it as {Stoploss – Entry}???

      • Karthik Rangappa says:

        Need to correct that. Here is what I mean –

        Long trades –
        Reward: Target – Entry
        Risk: Entry – Stoploss

        Short trades –
        Reward: Entry – target
        Risk: Stoploss – Entry

  2. Anishcharith says:

    sir how can we set support and resistances for intraday trades ? can we do it with the data of few previous trading sessions ?

    • Karthik Rangappa says:

      When it comes to intra day S&R can be plotted by taking a look back period of at least 3 – 5 trading days.

      • Aj says:

        But sir, you had told in the chapter on S&R that for intraday you need to check short term S&R, where you had defined short term as 3-6 months or so.. ? Would you clarify? Thanks!

        • Karthik Rangappa says:

          Aj, yes, having a 3-6 months perspective certainly helps. That plus the recent few trading sessions is what you need to look for.

  3. Kishore says:

    In the first chart, in the third encircled zone before the formation of the bearish engulfing, the chart shows a clear cut gap up opening breaking away the traditional resistance, suggesting going long. However, on day 2 the stock has formed a bearish engulfing hitting my stops. On day three after the bearish engulfing it is clear to short from the top. How do you handle such cases, do you take up the loses fast and align with the trend and go short?

    • Karthik Rangappa says:

      Few points that come to my mind with respect to the chart you have pointed out, this is probably how I would handle the situation…

      1) The gap up opening is good but it should not be the sole point based on which the trade should be initiated

      2) Considering the stock was in a range – I would apply my thoughts on range breakout (which I have explained in the chapter)

      3) On the formation of a bearish engulfing pattern, I would initiate the short position (considering other checklist items are in place)

      4) After initiating, I would stay put till the target is hit or SL is breached.

  4. Keerthan says:

    Can I ask you certain questions on certain chart patterns on certain stocks? I need a confirmation before I ask you the questions. Thanks in advance.

    • Karthik Rangappa says:

      Of course, as long as it is educational and helpful to other 🙂

      • Keerthan says:

        Have a look at the following chart. Could you tell me what kind of pattern is this?
        1) Is it a pendant or a flag pattern. Is it ready for a breakout?
        2) The downtrend pattern, is it the Elliot wave 2 nearing its end and EW3 is ready to take off?

        • Keerthan says:

          Correction, It should have been Pennant and not Pendant

          • Karthik Rangappa says:

            I have seen all the charts that you have posted –

            1) I’m not too familiar with EW, so cant comment
            2) I guess there are too many elements in your charts, from my experience charts should be very basic with just few basic elements. Having too many distracts you from the price action to all the noise in the chart.

  5. Keerthan says:

    Have a look at the attached image. Is it following a similar pattern like that formed in Waterbase (the earlier image)?
    Could you tell us what is the current Elliot wave as in (EW1 or EW2 or others)?

    • Niranjan Krishna says:

      EW, you need to use in combination with fibanocci retracement. Based on S/ R lines you can judge if current EW is a continuation of the previous one or new EW altogether. Also you can take help of trendlines.
      Above one, looks like continuation of existing EW

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