Rogan Documentation -

Technical Analysis Guide

Start your stock market journey by understanding the most foundational concept in trading – technical analysis.

Chapter 1: Introduction to Technical Analysis

If you’re here, you must have made peace with the fact that you cannot pick stocks randomly and expect to get rich one day. The stock markets don’t work that way.

You must follow a method or structure backed by reason to build wealth in the stock markets. There are many logical methods, one of the most popular ones being technical analysis.

Understanding Technical Analysis

It must be pretty clear by now that you must buy and sell the right ones at the right time to profit from stocks. But how do you know when to buy or sell a stock? And what things should you look at before choosing a stock? This is where technical analysis comes into play.

Technical analysis helps predict the directionality of financial assets such as stocks. But what is technical analysis all about? And what exactly does this mean for you as someone who wants to trade and make money through stocks?

Let us understand with a simple example.

Imagine you are a farmer. You have bought new land in another town for agricultural purposes, and you must decide which crop to plant to maximize your land’s productivity.

Option 1: Research by yourself

Imagine you try to conduct some research of your own. You might want to answer questions like:

Based on the water conditions, which crop will suit this soil?
What is the most appropriate crop for this climate?
Which crop has the highest demand and will fetch a good price in the market?

After reviewing a vast checklist, you will try what seems ideal and hope for the best.

The advantage of this technique is that you will know more about the crop you are planting. However, this method will only give you an idea of what may happen, and you have to check for different crops in your limited time. Hence, there is a large uncertainty about the crop’s performance because it is based on a lot of guesswork and restricted information.

There are some advantages to this technique, too. You will have a deeper understanding of the crop you are planting. However, this method can be time-consuming, and there will be a long gestation period to determine if the chosen crop will yield the best results. The decision also risks being based on a limited set of data and personal assumptions, which may not provide the most reliable outcome.

Option 2: Learn from other who've done it

Another option to decide your crop too.

You can ask your neighbour farmers which crop they have been harvesting in the past. You will know that a particular crop has a high benefit in that area, and by following them, you can plant a crop that has worked for farmers in that area. There is a high chance that you would benefit by planting that specific crop because you’re relying on proven information from the market participants in that area.

The paramount comfort of this technique is its scalability. You need to know which crop is the best fit and has the most demand in that area. However, beware that your neighboring farmers might only sometimes be correct.

From Fields to Finance: Picking Winners

Option 1 is similar to fundamental analysis in financial markets, where you independently research the stock you buy.

Fundamental Analysis

Fundamental analysis is a way to determine a company’s actual value by examining its finances, business model, management, and the overall economy.

Option 2 is similar to technical analysis, where the idea is to select and trade stocks based on their historical data and market participants’ behavior.

Technical analysis studies market action, just like our farming analogy. You have farming tools and equipment to help you sow seeds and fertilize land. As a result, you get proper management to get the maximum yield of crops. Similarly, tools like historical price data and indicators help us estimate the market’s direction in technical analysis. Both technical and fundamental analysis solve the same problem: determining the direction in which prices will likely move. They just approach the situation differently.

Technical analysts focus on the effect, believing that the outcome is all they need to know, and do not unnecessarily consider the reasons or causes of that effect. On the other hand, fundamental analysts always seek to understand why something is happening and try to predict the factor instead of its impact.

Technical Analyst

A technical analyst studies past market data, primarily price and volume, to predict future price movements. They use charts and indicators to identify patterns and trends in the market.

Fundamental Analyst

A fundamental analyst examines a company’s financial health, such as its profits and growth, to determine whether its stock is a good investment. They study company earnings, revenue, and the overall economy to understand the stock’s value.

Like any other research technique, technical analysis has its own set of assumptions. As you trade based on technical analysis, you should know these to unleash the full potential of technical analysis.

Generally, people argue that one approach is more suitable for decoding the market. Each method has merits and demerits, and wise traders will educate themselves to look for investing and trading opportunities in the market.

Assumptions of Technical Analysis

Now that you understand the concept of technical analysis, it is crucial to know its assumptions. This approach is based on three premises:

Markets discount everything: This assumption means that all factors—fundamental, psychological, and political—are already reflected in the market price. For example, if someone with inside information buys a lot of a company’s stock because they expect good earnings, the stock price might rise even before the announcement. This price movement hints to technical analysts that something significant will happen. Here, we are assuming that no such publicly available information is yet to be reflected in the market price.
Price moves in a trend: Market prices always follow a trend. All significant market moves are the outcome of a trend. Most techniques used in technical analysis are trend-following, meaning they intend to identify and follow existing trends. For example, the recent rise in the NIFTY 50 index is a good illustration. The index has been reaching new highs and has surged significantly this year. Once a trend is established, prices tend to move in that direction.

All Time High

An all-time high in the context of stocks is the highest price a stock has ever reached in its trading history.

Technical Analysis Fits Everywhere

One of the beauties of technical analysis is that it can be applied to any asset class with historical time series data. Time series data in technical analysis includes price information such as open price, high price, low price, close price, and volume.

Types of Prices

Open Price: The first price at which a stock is traded when the market opens for the day.
High Price: The highest price at which a stock has been traded during a specific period, like a day.
Low Price: The lowest price at which a stock has been traded during a specific period, like a day.
Close Price: The last price at which a stock is traded when the market closes for the day.
Volume: The total number of shares of a stock that are bought and sold during a specific period, like a day.

Trading is just like learning to play guitar. Once you master the basic chords and techniques, you can play any song, regardless of the genre. Similarly, once you learn technical analysis, you can apply the concept to trade across Indian markets, such as equity, crypto, forex, and fixed income.

Fundamental Analysis vs. Technical Analysis

Technical analysis provides flexibility across asset classes, which is impossible with any other research technique. However, fundamental analysis requires studying many aspects of an asset class. And these fundamentals change with each asset class. For example, while you will have to research company financials and management commentary when analyzing companies, you will have to check factors such as rainfall, harvest, demand, supply, inventory, etc., while studying commodities. On the other hand, technical analysis will remain the same. It is independent of the asset you are studying. We can apply the same technical indicator to various asset classes because it’s primarily about historical data.

Annual Report

An annual report is a detailed document that a company publishes yearly to show its financial performance and activities. It includes information about how much money the company made and spent, what it owns and owes, and its plans for the future. It helps investors understand the company’s performance, history, and future plans.

Can Technical Analysis be Used Across Time Frames?

Another strength of technical analysis is its ability to handle different time frames. The same principles apply when trading minute-by-minute changes for intraday or focusing on longer-term trends. Some believe this technique is only valid for short-term analysis, but that’s not true. It can also be very effective for long-term forecasting. Using weekly and monthly charts that span several years, you can successfully apply technical analysis for long-term predictions, just as you do for short-term trades.

Intraday

Intraday means within the same trading day, i.e., buying and selling a stock between market opening and closing.

When to Use Technical Analysis and When Not TO

Market players often see technical analysis as an easy way to earn money in the stock market because it involves identifying patterns and making trading opportunities for them. However, one must try to learn the technique to reach that stage.

Before diving deeper into this technical analysis guide, it’s essential to understand when and when not to use technical analysis.

When to use technical analysis

Short-term trading: Technical analysis is ideal for intraday or swing trading because it mainly helps capture quick gains based on short to medium-term trends.
Identifying entry and exit points: Technical analysis reads price and volume to determine the directionality. It helps traders decide when to enter and exit trades by identifying patterns and signals that indicate potential price changes.
Volatile and liquid markets: Technical analysis helps traders get more accurate signals in volatile markets where fundamental analysis might be less meaningful to deploy. For instance, forex markets have very high liquidity and volatility, and there is historical proof that technical analysis generates decent returns there.

Volatile

A market or stock is considered volatile when its prices change quickly and unpredictably, often with large swings up or down.

Liquid Markets

A liquid market is one where assets can be quickly bought or sold without causing a significant change in their price, typically because there are many buyers and sellers.

When to not use technical analysis

Just like you learned when to use technical analysis, you should also know when not to…

Not Suitable for Long-Term: Fundamental analysis is more suitable for long-term investments because, over long periods, factors like a company’s fundamentals, industry trends, and overall economic conditions have a more significant impact than price trends. These long-term trends are guided by underlying factors, which fundamental analysis aims to determine. Let’s understand this with TCS, short for Tata Consultancy Services, an IT company whose stock trades on Indian exchanges.

Technical analysis doesn’t always work…

Take Tata Consultancy Services (TCS), a leading IT company in India. You’d choose to invest in TCS for its long-term growth, strong earnings, and solid business model. However, in the short term, regulatory concerns might arise. Technical analysis might signal a short-term decline, helping you avoid buying TCS at a lower value and suffering a loss. So, from a long-term perspective, fundamentals typically play a vital role in the price of assets.

2. Unpredictable Events: Technical analysis offers little help in predicting and capturing profits from significant news events, such as election results, geopolitical issues, or economic events, like changes in GDP and interest rates, because market sentiment shifts suddenly. Thus, technical analysis of stocks is of little use in these situations.

3. Illiquid Markets: Technical analysis often fails in low-liquid assets because low trading activity makes assets easy to manipulate, rendering the logic of technical analysis meaningless. Here, general patterns or indicators of technical analysis don’t work.

In the next chapter, we’ll explore how stock prices fluctuate and learn how to read and interpret them for effective trading.

Summary

1. Technical analysis helps determine the future direction of financial assets using historical data, such as price and volume.

2. This method can be applied to various assets as long as historical data is available, making it adaptable to different time frames.

3. Technical analysis is based on a few core assumptions:

Markets discount everything: All factors are reflected in the market price.
Price moves in trends: Significant market moves follow established trends.
History tends to repeat itself: Price trends repeat due to consistent human psychology.

4. In liquid markets, technical analysis identifies short-term trading opportunities but is less suitable for predicting uncertain events and determining asset values in the long term.

Chapter 2: Types of Stock Price Charts

As we learned, technical analysis is like predicting the future by looking at the past. It assumes that prices follow trends, history repeats itself, and the market tells all. In this chapter, we’ll explore the exciting world of different types of stock price charts, such as line charts, bar charts, and candlestick charts. We’ll also understand the different types of prices: open (O), high (H), low (L), and close (C).

You may wonder why we need charts in the first place. Charts help us clearly see price movements over time, making it easier to spot trends, patterns, and trading opportunities. Since technical analysis requires four data points to be displayed simultaneously for a complete view of price movements, charts also provide a clear picture of the market’s behavior, helping traders make informed decisions.

This chapter will focus on the different types of charts, especially Japanese candlestick patterns, which are one of the most loved chart types. But before that, we’ll look at the pros and cons of other charts to understand why candlesticks are so popular.

Trade Summary

Before we discuss the formation of different types of charts, let’s consider the different types of prices a stock trades at during a regular market day.

The Indian stock market is open from 9:15 AM to 3:30 PM. During these market hours, numerous trades occur throughout the day. Tracking all of these price movements is impossible for a trader. One needs a summary of the trading action that points to the important stuff, not the details on every price point.

Let’s understand what the open, high, low, and close prices are using a real-life example of Reliance Industries’ stock price:

Open Price: The price at which Reliance Industries’ stock trades first when the market opens at 9:15 AM. For example, on June 7th 2024, the opening price was ₹2,857.
High Price: The highest price at which Reliance Industries’ stock is traded during the day, between 9:15 AM and 3:30 PM. On June 7th 2024, the high price was ₹2,944.
Low Price: The lowest price at which Reliance Industries’ stock is traded during the day, between 9:15 AM and 3:30 PM. On June 10th 2024, the low price was ₹2,853.
Close Price: The price at which Reliance Industries’ stock is traded when the market closes at 3:30 PM. On June 10th 2024, the closing price was ₹2,940.

The trading session is considered ‘positive’ if the closing price is higher than the opening price, like in this case (₹2,940 close vs. ₹2,857 open). It is considered ‘negative’ if the closing price is lower than the opening price.

We use these prices to plot charts, which help us analyze future price movements. But let’s first understand why are charts so useful in the first place.

Why Traders Love Charts?

The chart is a price sequence plotted over a specific time frame, typically with a price scale on the y-axis and a time scale on the x-axis. Charts mainly help see past price movements, which in turn help us predict future price movements. Technical analysts use charts to analyze various securities and forecast future price movements. Charts also help fundamental analysts because they show how a company’s stock price reacts to its financial health.

Security

In finance, security is a claim that you can buy, sell, or trade, like a stock or bond. Stocks represent owning a part of a company, while a bond is a certificate of lending to the company with a promise of repayment with interest. Securities represent financial interest and let you earn from either ownership or lending.

Let’s explore the different types of charts and learn how they can be used.

Line Chart

The most basic chart type is a line chart because it uses only the closing price of the stock price or index over a defined period to form the chart. On the chart, a dot is plotted on a specified period, that is, the closing price, and then these dots are connected, forming a line that is plotted across a specific period of time.

The advantage of a line chart is that it is simple and easy to understand, and a trader can identify general security trends over long periods of time like weeks, months, or years. The disadvantage is that they do not provide additional details besides closing prices, ignoring the open, high, and low prices. Though closing prices are useful,traders prefer seeing more information, taking us to the next type of chart.

Bar Chart

A bar chart is more flexible than a line chart because it considers all price types: open, high, low, and close. A bar chart looks like this and has three components:

Here is a table summarizing what the different lines mean in a bar chart:

Line	Meaning
Central vertical line	The price range of the security during a specific period. The top of this line is the high price, and the bottom is the low price.
The left horizontal line	Shows the price at which the security started trading in that period, i.e., opening price.
The right horizontal line	Shows the price at which the security traded at the end of that period, i.e., closing price.

Let’s understand with an example. Assume OHLC (open, high, low, close) price data for a stock as follows:

Open – 130
High – 140
Low – 120
Close – 136

For the above data, the bar chart would look like this:

Here, you can see that we can plot all price types over a specific period in a single bar. Hence, if we create one bar for one day, we will have five vertical bars to view a five-day chart. Here is how a bar chart looks:

If the left horizontal line, which represents the opening price, is lower than the right horizontal line, i.e., the closing price, then it is a positive day for the markets, called a bullish day. A bullish day is typically represented by a green or blue bar.

If the left horizontal line, which represents the opening price, is higher than the right horizontal line, i.e., the closing price, then it is a negative day for the markets, called a bearish day. A bullish day is typically represented by a red or black bar.

Here is a snapshot of both types of bars:

The bar chart displays all four data points, but its disadvantage is that it lacks visual appeal. It is difficult and tedious to spot potential patterns when looking at a bar chart, especially the opening and closing prices. Analyzing bar charts in multiple time frames becomes more challenging.

Some traders prefer bar charts, so they are worth mentioning. However, most traders prefer Japanese candlesticks, the default option for most charting tools.

So, let’s dive deeper into them.

Lighting Up Your Trading Game with Candlesticks

In the 18th century, Homma discovered that by observing rice’s opening, closing, high, and low prices, he could identify patterns that predicted future price movements. This method allowed him to gain insights into market psychology and price action.

Although candlesticks have been used in Japan for centuries, western traders were unaware of them until the 1980s when Steve Nison introduced them in his book, “Japanese Candlestick Charting Techniques.” Following the book, many candlestick patterns retain their original Japanese names, adding an oriental touch to technical analysis.

Understanding a Candlestick

You have seen the bar chart, which shows opening and closing prices by a tick on the left and right of the bar, respectively. However, in a candlestick chart, the opening and closing prices are displayed by a rectangular body, and the high and low prices are displayed using wicks.

The candlestick, like a bar chart, is made of 3 components. Let’s look at how a bullish candlestick looks:

The central body – The thicker, rectangular body connects the opening and closing price.
Upper shadow – Connects the high price to the opening or closing price, whichever is greater.
Lower Shadow – Connects the low price to the opening or closing price, whichever is lesser.

Here’s how a bullish candlestick looks:

Conversely, here’s how a bearish candlestick looks:

The candlestick chart takes shape by plotting them in a time series: green candles indicate bullishness, and red candles indicate bearishness.

In summary, candlesticks are easier to interpret than bar charts. They help you visualize the relationship between the opening and closing prices and the high and the low prices more clearly than any other chart type.

Interpreting Candlesticks

Candlesticks are super important because they help us predict market trends. They can show if prices will form trends that go up (bullish), down (bearish), or stay the same (sideways). Let’s check out each one!

Bullish Trends (Uptrends): An uptrend is when prices rise. A bullish trend can be spotted when several candlesticks form consecutively higher, often with most candlesticks being green.

Bearish Trends (Downtrends): A downtrend is when prices decline. A bearish trend can be spotted when you visit several candlesticks being formed consecutively lower, often with most candlesticks being red.

Sideways Trends (Consolidation): A sideways trend is when prices remain within a small range over time in a narrow range, indicating little to no movement. This happens when multiple candles on a chart form at about the same level, neither going up nor down.

Now that you have understood candlesticks and their versatility, let’s examine other types of non-candlestick charts as well.

Some Other Useful Chart Types

While Japanese candlestick charts are widely used for their versatility, other charts like point and figure, Renko, and Heikin-Ashi charts are also crucial for analyzing trends. These charts offer unique perspectives that can enhance a trader’s understanding of market movements, helping to create a more comprehensive view of price action and trends.

Let’s learn a little about each one of them.

Point and figure charts focus solely on price movements, using Xs and Os to indicate rising and falling prices while ignoring time. This method filters out minor price fluctuations, making identifying major trends easier. However, the downside is that these charts can miss detailed price action since they do not consider the time factor.

As you have seen, you can use different charting types to your advantage, depending on your objective. However, Japanese candlesticks are widely used because of their versatility and simplicity. Here’s a table summarizing the pros and cons of each chart type:

Chart Type	Pros	Cons
Bar Chart	Shows all price types (open, high, low, close), good for detailed analysis	Not very visually appealing, hard to spot patterns quickly
Candlestick	Easy to read and understand, shows market sentiment with color	Can look cluttered, might give insufficient context
Point and Figure	Filters out small price changes, highlights big trends	Ignores time, can miss detailed price movements
Renko	Simplifies trends, reduces market noise	Updates slowly, can miss short-term price changes
Heikin-Ashi	Makes trends clearer, reduces small price fluctuations	Lags behind real-time changes, can hide immediate price signals

The leading reason traders prefer candlestick charts is that they are easily read and visually apparent. It shows crucial information in a simple format, making it easy to spot trends and patterns. Candlesticks reflect market sentiment with color, helping traders understand the market’s mood. Their versatility allows other tools to be used on top of them for a more comprehensive view and valuable analysis.

Trading Time Frames: Your Secret Weapon

When studying how stock prices move, a time frame is the duration of the candlestick you choose to examine. A candlestick can represent the trading activity of a day, week, month, year, or even minute. Choosing the right time frame is crucial in your trading game because it helps you understand different market trends.

The most common time frames used by technical analysts are:

Monthly candlesticks
Weekly candlesticks
Daily or end-of-day candlesticks
Intraday candlesticks like 30 minutes, 15 minutes, and 5 minutes

Look at the stock price of HDFC Bank and see how its chart differs in different time frames.

The monthly chart (2007-2024) shows HDFC Bank’s long-term trends over 17 years, as you see the four different time frames. The weekly chart (May 2020-June 2024) captures medium-term trends over four years. The number of candles increases when the time frame reduces.

Now, let’s uncover which time frame is suitable for you.

How to Pick Your Ideal Time Frame for Trading

Choose a time frame that fits your investment goals, market volatility, personal schedule, and trading time availability.

An individual must align the time frame with their trading style and goals. Intraday charts suit short-term traders aiming for quick gains, while long-term investors seeking sustained growth often rely on monthly or weekly charts.

Market volatility also plays a role. For instance, shorter time frames capture rapid price changes in high-volatility markets, while more extended time frames are better for stable markets. One should also consider the time they can give for trading because shorter time frames require more frequent monitoring, which may not be feasible for those with limited availability.

So, choose a trading time frame that matches your goals, market volatility, and availability. Here’s a table summarizing various time frames and when they should be used

Time Frame	Useful When	Suitable For
Monthly	Identifying long-term trends and major market cycles	Long-term investors
Weekly	Spotting medium to long-term trends	Swing traders
Daily	Analyzing price movements over a period of a few days/weeks	Swing traders and long-term investors
Intraday	Detailed views of price movements within a single trading day need to be seen	Intraday traders

Swing trader

Swing traders buy and sell stocks to profit from short-term price changes, usually holding them for a few days or weeks. We’ll learn more about swing trading in further chapters.

Traders also combine other time-frames to get a comprehensive of the market. Let’s look at that.

Blending Time Frames for Trading Success

You do not necessarily have to stick to one time frame. You can look at different time frames for trade objectives or even at multiple time frames to get a wider perspective of a stock price’s movement.

To identify the overall trend, you can look at longer time frames, such as daily or weekly. Then, you can switch to shorter time frames, such as hourly or 15-minute charts, to identify entry and exit points in the market. Generally, this method is helpful to avoid false signals and confirm trends. Here’s how it can work.

Let’s get an idea of how this works.

A trader notices HDFC Bank’s stock rising on the daily chart, moving from ₹1,400 to ₹1,450 over the past week. This shows a strong upward trend. The trader switches to a 15-minute chart to find a good buying point.

The 15-minute chart shows that HDFC Bank opened at ₹1,455 but then dipped to ₹1,450. This dip can be seen as the stock price briefly returning to its average level before continuing to rise, a concept known as mean reversion.

Seeing this brief dip within the overall uptrend, the trader buys shares at ₹1,450. They increase their chances of success by aligning their short-term trade with the long-term trend and considering the mean reversion.

Using multiple timeframes and the idea of mean reversion, the trader makes a well-rounded decision, reducing the risk of false signals and improving the likelihood of a successful trade.

Summary

The different types of prices in a defined period – Open, High, Low, Close

Open Price: The first price at which a stock is traded when the market opens for the day.
High Price: The highest price at which a stock is traded during a specific period, like a day.
Low Price: The lowest price at which a stock is traded during a particular period, like a day.
Close Price: The final price at which a stock is traded, serving as a reference point for the next day.

Different chart types used in technical analysis include:

Line Charts: Simple and easy to understand, using only closing prices.
Bar Charts: Show all price types (open, high, low, close) without visual appeal.
Candlestick Charts: Preferred by traders for their visual clarity and ability to show market sentiment.

Japanese candlestick charts are highly favored for their versatility, ease of interpretation, and ability to highlight trends and market sentiment effectively.

Other Chart Types and Their Characteristics:

Point and Figure Charts: Focus on price movements and ignore time, making them suitable for spotting major trends but lacking detailed price action.
Renko Charts: Renko charts use bricks to simplify trends. They effectively highlight trends but can be slow to update as they only form a new brick when the price moves by a specific amount.
Heikin-Ashi Charts: Heikin-Ashi charts smooth out price data, making trends more apparent. The average price data reduces market noise, but this smoothing causes a lag in real-time changes.

Select a timeframe that aligns with your investment goals, matches the market’s volatility, and fits into your personal schedule for effective trading.

Combining longer timeframes (daily or weekly) with shorter ones (hourly or 15-minute) helps identify overall trends and find precise entry/exit points, reducing the risk of false signals.

Chapter 3: Single Candlestick Patterns - Part 1

We have learned that candlestick charts are a better way to interpret market movements than any other chart type. So, in this chapter, we will discuss the most prominent single candlestick patterns that can help us understand these movements better to take a trade.

As the name suggests, single candlestick patterns are formed by just one candle. The trading signal is generated based on a single-period trading action. Trades based on single candlestick patterns can be highly profitable, provided the patterns are identified, rules are followed, and the trade is correctly executed.

Another crucial factor to consider while trading based on candlestick patterns is the length of the candle. One candlestick shows the day's trading activity. Generally speaking, the longer the body, the more intense the buying or selling pressure. Conversely, short candlesticks indicate little price movement and represent consolidation. Here is an image depicting candles with long and short bodies, respectively:

Candlestick Trading Rules

Before we delve into single candlestick patterns, we must remember a few rules that must be followed.

Buy strength, sell weakness

The universal stock market rule says, “Buy low, sell high”. A bullish (green) candle represents a price strength, and a bearish (red) candle represents weakness. Hence, we must ensure it is a green day when we are buying, and whenever we are selling, ensure it’s a red candle day.

Be flexible with patterns

While the textbook definition of a pattern could state specific criteria, minor changes due to market conditions could occur. So we have to be flexible. However, one must be flexible within limits, so quantifying the flexibility is always required.

From now on, we will discuss the different single candlestick patterns. Let’s start with a simple but powerful pattern: the Marubozu.

Marubozu

How does a bullish marubozu form?

A bullish marubozu is a candle whose:

The closing price is greater than its opening price
The opening price is equal to the low price, and
The closing price is equal to the high price.

Whenever a candlestick with the above characteristics occurs, a bullish marubozu is said to be formed. Irrespective of prior trends, a bullish marubozu indicates strong bullishness in the market. It may look like this:

A bullish marubozu signifies enormous buying pressure in the market. Considering a daily chart, market participants are willing to buy from the start of the day until the market closes for trading. This shows buyers have gained control of the market, and the overall market sentiment is bullish.

How to trade a bullish marubozu?

As traders, we should seek buying opportunities since the market outlook has turned bullish with the appearance of the marubozu candlestick. This bullish sentiment is anticipated to persist for the subsequent few trading sessions.

Ideally, a trade can be entered on the same day the marubozu is formed, just before the market closes at 3:20 PM. Still, the bullish marubozu must be validated by checking that the candle’s high equals the stock’s current market price (CMP). If these conditions are met, we will confirm that a bullish marubozu is formed, and we can go long on the stock.

Long

Going “long” on an asset means buying and holding it because you expect its price to increase. This involves purchasing stocks, bonds, or other securities to sell them later at a higher price for a profit. It reflects a positive outlook on the asset’s future performance.

Entry point: Enter the trade at or just below the close of the bullish marubozu candle.
Confirmation: An uptrend is confirmed if the next candle is bullish and breaks the high of the marubozu. If you prefer a more risk-averse approach, you can also enter here.
Stop loss: A stop loss can be placed below the low of the bullish marubozu candle to limit potential losses.

Let’s understand with an example trade in Infosys.

Here, first, we will validate the physical characteristics of a candle as highlighted in the image.

Open = 1414
High = 1427
Low = 1413
Close = 1426

As we know, a bullish marubozu’s opening price should equal its low price, and a high price should equal its closing price. Although the opening price does not match its low price, there is hardly any difference between them. Remember that there can be minor variations in candlestick patterns, and we must be flexible as long as the logic of the concept holds.

Based on our method, the trade setup for the above Infosys stock would be as follows:
Entry price = Between 1427 and 1430
Stop Loss = 1413

But if we want to confirm the formation of a bullish marubozu or have a risk-averse approach, we must wait until the next day. The downside is that buying the next day results in a much higher purchase price and a deeper stop loss.

In our example, buying Infosys on the same or the next day would have been profitable.

Here is another example of a bullish marubozu pattern and a resulting uptrend:

The above example of HDFC Bank shows that it would have been profitable here if we had bought this stock on the same day or the next day. However, there will be some cases where marubozu candlesticks fail, like the one below:

After a bullish marubozu formed on Reliance’s stock, a downtrend resulted. Hence, remember that not every marubozu is foolproof, and having a stop loss can help you deal with such situations.

Now, let’s move on to the bearish marubozu.

Bearish Marubozu

How does a bearish marubozu form?

As a bullish marubozu indicates a strong sentiment of bullishness, the bearish marubozu reflects bearish sentiment in the market, and it is formed when a candle’s

The closing price is less than its opening price
The opening price is equal to its high price
The closing price is equal to its low price

This candlestick indicates selling is done for each price point throughout 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.

In the above chart of Asian Paints, a bearish marubozu pattern is formed after a significant drop in the stock. If we look at the OHLC data,

Open = 3563
High = 3563
Low = 3378
Close = 3378

As mentioned before, a slight variation in OHLC is acceptable up to a specific limit.

Typically, for a marubozu candle, the open and high (for bearish marubozu) or open and low (for bullish marubozu) can have a slight difference, generally not more than 1% of the stock's price. We use this 1% limit because it ensures the candle still clearly indicates strong selling (or buying) pressure without significant price fluctuations, which might otherwise weaken the reliability of the marubozu pattern.

For example, if the stock price is 3563, a 1% variation would be about 36 points. So, if the high were slightly higher at 3599, it would still be considered a valid marubozu pattern. This 1% limit maintains the integrity of the marubozu pattern by ensuring it accurately reflects market sentiment.

How to trade a bearish marubozu?

A trader should look out for shorting opportunities in the market because sudden changes in sentiment will be carried forward over the subsequent few trading sessions.

Entry Point: Enter the trade at the close of the bearish Marubozu candle or the opening of the next candle.
Confirmation: Confirm the downtrend by checking if the next candle breaks the marubozu low. If you prefer a more risk-averse approach, you can also enter here.
Setting Stop Loss: Place the stop loss at the high of the Marubozu candle to limit potential losses if the trade goes against you.

Let’s look at an example in HDFC Bank’s stock:

When the Pattern Falls Short

Earlier in this chapter, we discussed why a candle’s length is essential. We should avoid trading when the candles are small because they show low trading activity. Small candles make it hard to predict market movement because they indicate that prices are the same, making it unclear how the market is going. With fewer people trading, price signals are less reliable, increasing overall volatility.

Here is an example from the Tata Motors Ltd. chart:

For this reason, one should avoid trading in too short candles.

Let’s move on to the second candlestick pattern – the Doji.

Doji

How does a doji form?

A Doji is formed when

The opening price of a candle is equal to the closing price.

The upper and lower wicks can be of any length, resulting in the cross, inverted cross, or plus sign. It is a vital candlestick pattern that tells us about market sentiment. The word “doji” refers to both the singular and plural forms.

Though bullish and bearish dojis signify roughly the same sentiment, here’s a pictorial representation of the candlestick:

A doji conveys a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session but close at or near the opening level. The result is a standoff. Neither bulls nor bears could gain control, and a turning point could develop.

A doji can signal different things based on its place in the trend, making it a vital pattern to watch. Let’s discuss each one.

Doji in an uptrend

The relevance of doji depends upon the preceding trend or preceding candlesticks. The formation of doji after an uptrend or a long green candlestick shows that buying pressure is weakening. After a downtrend or a prolonged red candlestick, a doji signifies that selling pressure is easing.

Dojis indicate that supply and demand are balancing, and a trend change may be near. Dojis alone don’t confirm a reversal; further proof is needed.

Let’s look at the daily chart of the Infosys Ltd. chart.

Here, the doji appears after a healthy uptrend, after which the stock reverses its direction and corrects.

Doji in a downtrend

After a decline or long red candlestick, a doji shows that selling pressure might be easing, and the downtrend could end. Though the bears are losing control, more strength is needed to confirm a reversal.

The chart shows an initial downtrend, indicating a period of selling pressure for HDFC Bank. Following this, several doji candlesticks suggest indecisiveness in the market, as buyers and sellers have a definitive upper hand. After this period of indecision, the buyers are marking a significant upward movement.

So, the next time you see a doji individually or in a cluster, remember that the market is indecisive. The market could swing either way, and you need to build a stance that adapts to the expected movement.

Other types of doji candles also exist, depending on their shape and size. Let’s decode each one.

Long-Legged Doji: These candles have long upper and lower shadows almost equal in length. These reflect a significant amount of indecision in the market. Long-legged doji indicate that prices traded well above and below the session’s opening level but closed virtually even with the open. After much noise and commotion, the outcome was almost the same as the beginning of that day.
Dragonfly Doji: A Dragonfly Doji forms when the open, high, and close prices are the same, creating a long lower shadow. The candlestick resembles a “T” because there is no upper shadow. This pattern indicates that sellers controlled the session, pushing prices down, but by the end, buyers returned and brought prices back up to the opening level. A Dragonfly Doji suggests a potential reversal or shift in market sentiment.

Dragonfly Doji in a Downtrend: In a falling market or near a low point, this pattern can suggest a possible turnaround to higher prices.
Dragonfly Doji in an Uptrend: In a rising market, a Dragonfly Doji means buyers tried to push prices up, but sellers were still strong. After a good rally, this pattern suggests a price drop. We need more proof to confirm this change.

3. Gravestone Doji: This candle’s structure is inverted to dragonfly doji, resulting in an upside-down “T” due to the lack of a lower shadow. It is formed when the open, low, and close are equal. The psychology behind this candle is that sellers had resurfaced by the end of the day and pushed prices back to the opening level and the session low.

Gravestone Doji in a Downtrend: After a long downtrend, a long black candlestick, or near a low point, the focus shifts to the buying pressure, suggesting a potential bullish reversal.
Gravestone Doji in an Uptrend: Gravestone Doji shows a failed rally despite some buying pressure in a rising market. Near a high point, this pattern suggests a potential bearish reversal.

Here’s an image representing all types of Doji

In the next chapter, we will study the hammer candlestick pattern and its different variations. We will also understand how to set targets while trading with single candlestick patterns.

Summary

1. A single candle represents day trading activity. The length of the candle is very crucial. Longer bodies indicate stronger buying or selling pressure, while shorter ones indicate consolidation.

2. A marubozu candlestick does not have an upper or lower wick, which indicates strong momentum on either side.

Bullish marubozu candle’s open = low, close = high, shows bullishness
Bearish marubozu candle’s high=open, low=close,showing bearishness

3. A doji candlestick represents indecisiveness in the market. One should also consider the preceding candle to anticipate future market sentiment.

Chapter 4: Single Candlestick Patterns - Part 2

This chapter will focus on the four candlestick patterns: hammer, inverted hammer, hanging man, and shooting star.

Hammer

How does a hammer form?

A hammer is a significant candlestick pattern that is formed after a downtrend. It is formed when

The closing price is near the high,
The opening price is near the high, and
There is enough gap between the closing price (in case of bearish) or opening price (in case of bullish) and the candle’s low.

The longer, the lower the shadow, the more bullish the pattern. Here is how a hammer may look, whether bullish or bearish.

A hammer candlestick pattern forms when sellers push the price down, but buyers step in and drive it back up, showing strong buying interest and a potential reversal. The color of a hammer doesn’t matter much because its shape indicates a possible reversal. The key is the shadow-to-body ratio. The natural body of a hammer candlestick should be small compared to its long lower shadow, which should ideally be at least twice the length of the natural body.

Let’s understand the above chart. Tata Motors faced a significant decline with sellers in control. Each day, the stock opens and closes lower than the previous day’s close, making a new low. When the hammer candlestick is formed, some buyers step in and start buying the stock, pushing it to near the day’s high.

The hammer’s occurrence shows that buyers are trying to stop the stock from falling further and becoming somewhat successful. This has resulted in a bullish market sentiment, making it an excellent time to look for buying opportunities.

How to trade a hammer?

The trade setup for the hammer candle is that we should go long if it occurs after a downtrend, entering at the closing price of the hammer and keeping the stop loss as low as the hammer.

Entry: Enter a long position at the opening of the candle that forms after the hammer.
Confirmation: A hammer is more reliable in a downtrend if the next candlestick shows a higher close, indicating a potential bullish reversal.
Stop Loss: Place a stop loss below the low of the Hammer candle to limit potential losses if the trade goes against you.

For instance in the chart of Tata Motors Ltd. below, the buying price is the closing of stock, at 391, and the stop loss is placed at 376. As the above candle has a slight upper wick, we can consider it as a hammer according to the second candlestick rule (be flexible). In the below trade, we would have been profitable.

Hanging Man

How does a hanging man form?

A hanging man is nothing but a hammer pattern appearing an uptrend. It is formed when

The opening price is almost similar to the higher price,
The closing price is nearly identical to the higher price,
There is enough gap between the closing price (in case of bearish) or opening price (in case of bullish) and the candle’s low.

A hanging man signals a market high. The market is in an uptrend, signaling a bullish trend. The bears entered after the hanging man’s formation, depicted by a longer lower shadow. The entry of bears signifies that they are trying to break the stronghold of bulls. Forming after an uptrend, this candlestick pattern signals selling pressure.

A hanging man helps traders to set up directional trades. The color of the candlestick does not matter much, but the crucial thing we must consider is a shadow-to-accurate body ratio, where the length of the shadow should be at least double the size of the body.

Let’s look at the example of the hanging man below:

In the above chart of Asian Paints Ltd., a significant downfall can be seen after the occurrence of a hanging man.

How to trade a hanging man?

As a hanging man is a bearish reversal candlestick pattern, one should look for shorting opportunities in a particular stock or index. Wait for the formation of the closing of the hanging man candle.

Entry point: You can create a short position at the opening of the candle after the hanging man
Confirmation: Look for a bearish signal, like a gap down or lower close, after a significant uptrend and hammer pattern is formed, to ensure reliability
Stop loss: Place a stop loss above the high of the hanging man to limit potential losses if the trade goes against you.

In the above chart of Asian Paints, the entry would be at 3396, and the stop loss would be the high of the candle at 3398.

Shooting Star

How does a shooting star form?

The shooting star is a candlestick pattern, indicating potential trend reversal. It has a long upper shadow where the shadow length is at least twice the length of the natural body.

The opening price is almost equal to the closing price,
The low of the candle is nearly equal to the closing price, and
There is a significant gap between the closing price and the high of the candle

Though the color of the candlestick does not change its interpretation, it is comforting to know when a shooting star is bearish. Here is how it looks:

Let’s look at the pattern forming in a chart:

Here’s the logic for the shooting star candlestick pattern formation. The stock is in an uptrend, with bulls in control, making new highs and higher lows. On the day the shooting star pattern forms, the stock trades higher and creates a new high.

However, selling pressure at the high point causes the price to drop, closing near the day’s low and forming a shooting star. This indicates the bears have entered, successfully pushing prices down, as evidenced by the long upper shadow. The bears are expected to continue selling in the coming sessions, potentially reversing the uptrend.

The longer the upper wick, the more bearish the pattern. According to the textbook definition, the shooting star should not have a lower shadow. However, as the chart above shows, a small lower shadow is acceptable. The shooting star is a bearish pattern; hence, the prior trend should be bullish.

Here is another example of a shooting star forming on the chart of Cipla Ltd.:

The highlighted candle has the following prices:

Open = 1167

High= 1185

Low=1167

Close=1173

The above candle qualifies as a shooting star since

The prior trend is bullish
The shadow-to-body ratio is 1.8 (~ 2)

How to trade a shooting star?

You should look for shorting opportunities when coming across shooting star candlestick patterns.

Entry: Create a short position at the opening of the candle after the shooting star is formed
Confirmation: A shooting star is confirmed if the next candlestick shows a lower close, indicating a potential bearish reversal.
Stop loss: Place a stop loss at the high price of the shooting star candle to limit potential losses if the trade goes against you.

Inverted Hammer

How does an inverted hammer form?

The candlestick pattern is a shooting star formed at the bottom of a downtrend, signaling a bullish reversal.

An inverted hammer is formed when

The opening price is almost equal to the closing price
The low of the candle is nearly equal to the closing price, and
There is a significant gap between the height of the candle and the close of the candle

Just like a hammer, the interpretation of this candlestick does not depend upon the candle’s color. But we have to look for a shadow-to-body ratio is double. This candlestick has a long upper shadow and no lower shadow.

The psychology of the inverted hammer shows a possible end to a downtrend, indicating that buyers are starting to take interest in the stock at lower prices. This means that after selling for a while, buyers step in and push the price up, forming a long upper shadow. Then, some selling happened again, bringing the price back near the opening level, creating a small body.

The below chart shows that Infosys’s inverted hammer took place at the end of the downtrend; after which the stock rallied significantly.

How to trade an inverted hammer?

An inverted hammer signifies an upcoming bullish trend. Here’s how a trade can be taken:

Entry: Create a long position at the opening of the candle that forms after the inverted hammer.
Confirmation: An inverted hammer is confirmed if the next candlestick shows a higher close, indicating a potential bullish reversal.
Stop loss: Set a stop loss just below the low of the inverted hammer.

Let’s look at an example.

According to the rules, the trade setup for the above chart would be an entry at the closing of the inverted hammer at 398, and stop loss would be placed at the low of the candle at 392.

Target Setting for Single Candlestick Patterns

So far, we’ve explored the psychology behind single candlestick patterns and how to use them for entering trades. But have you ever thought about what our targets should be for these trades? Let’s dive into how we can set these targets strategically now.

To set a target, we need to know the risk-reward ratio concept.

The risk and reward ratio is a crucial concept in stock trading. It helps you understand how much you stand to gain compared to how much you might lose on each trade. This ratio can guide decisions to maximize profits and minimize losses.

Risk to Reward Ratio = Potential Gain / Potential Loss

If you buy a stock at a price of 100, and set a stop loss at 80, your potential loss (in case you hit the stop loss) is 20 (100 - 80). Similarly, if you set a target of 140, your potential gain (if you hit your target) is 40 (140 - 100).

Hence, the risk to reward ratio is 20:40, which can be written as 1:2.

We aim for a minimum risk-to-reward ratio of 1:1:5; let’s learn why.

Why Use the 1:1.5 Risk-to-Reward Ratio

The 1:1.5 risk-reward ratio means you aim to make 1.5 units of profit for every unit of risk. For example, if you risk ₹100 on a trade, your target profit is ₹150. This ensures your potential gains are more significant than your possible losses.

A key benefit is that it increases your chances of making a profit, even if not all trades are successful. With higher rewards for your risks, fewer winning trades can cover your losses and improve overall results. Setting a higher reward target keeps losses small compared to potential gains, which is crucial for long-term trading success. It helps you avoid significant losses that can impact your trading account.

Finally, the 1:1.5 risk-reward ratio offers a statistical advantage. Even if you win only 40% of your trades, this ratio can still lead to overall profits, making it an intelligent approach for trading in the volatile stock market.

Although it’s essential to choose a risk-reward ratio that matches your risk appetite, everyone’s comfort level with risk varies, so select a ratio that aligns with your individual trading goals and risk tolerance.

While knowing the 1:1.5 risk-reward ratio as a target is applicable, setting precise targets using a single candlestick pattern can be difficult. In the following chapters, we will discuss multiple candlestick patterns and indicators. These tools will help you set more effective targets and make better-informed trading decisions.

Let’s understand better with an example.

For instance, take Suzlon on a daily timeframe. It is forming a bearish marubozu angle candlestick. As we know, one should look for shorting opportunities because it signals bearishness. So we enter a short position at the closing of the candle, that is at 47.5, and we keep the stop loss at a high of the candle, which is at 52.40.

We now set a target of 40 so that Suzlon should go down by 7.5 points as our stop loss is approximately 4.5 points. In this way, we will have a risk of 5 in case it hits our stop loss and a reward of 6.8 points, maintaining the risk-to-reward of 1:1.5.

In the below image, you can see a short position on Suzlon’s stock, having a risk-to-reward ratio of 1:1.5:

Summary

A hammer candlestick indicates a potential reversal from bearish to bullish sentiment. It is formed after a downtrend, with a small body at the upper end and a long lower shadow.
The shooting star is a bearish candlestick that appears at the peak of an uptrend. It signals a potential bearish trend.
The 1:1.5 risk-reward ratio helps ensure that your potential gains are greater than your losses, improving your trading results and protecting your capital.
It’s difficult to set exact targets with single candlestick patterns alone, so we’ll examine more patterns and indicators for better accuracy.

Chapter 5: Two Candlestick Patterns

Two is better than one, even when it comes to candlestick patterns. In a double candlestick pattern, we analyze two candlesticks to make a trading decision. This means the trading opportunity unfolds over a minimum of two trading sessions.

This chapter will focus on some important two candlestick patterns: engulfing, harami, and tweezer candlestick patterns.

Engulfing Pattern

The first double candlestick pattern we are going to talk about is the engulfing pattern. As we have discussed earlier, double candlesticks require two candlesticks; the first candle with a relatively tiny body, and the second candle’s body completely engulfs the previous one and closes in the opposite direction of the trend. The engulfing pattern is a reversal pattern: it’s bullish at the end of a downtrend and bearish at the end of an uptrend.

Let’s look at their pictorial representation.

Bullish Engulfing Pattern

How does a bullish engulfing pattern form?

A bullish engulfing candlestick pattern occurs when it is found at the bottom of a downtrend. It is a potentially bullish reversal candle, which means that people tend to buy it after its formation.

The pre-requisites for a bullish engulfing candle are:

The prior trend should be a downtrend.
The first candle should be bearish, re-confirming the bearishness in the market.
The second candle should be bullish, with a body long enough to engulf the whole previous candle, including its wicks.

Here is an image of a bullish engulfing candle forming at the bottom of a downtrend:

This is how it works:

The market is in a downtrend, dominated by sellers, as shown by bearish (red) candles.
A large bullish (green) candle forms, completely engulfing the previous bearish candle, signaling a solid shift in control to buyers.
The bullish engulfing candle indicates strong buying interest and a change in market sentiment from bearish to bullish.
This pattern suggests a potential reversal of the downtrend, with buyers gaining strength and the market moving upwards.

How to trade a bullish engulfing pattern?

Bullish engulfing is a potential bullish reversal trend that signals bullish sentiment in the market. The trading plan would be:

Entry: Enter the trade at the opening price of the next candle, i.e., at the candle that forms just after the formation of the engulfing candle.
Confirmation: An entry is confirmed if it is found after a downtrend, the second candlestick is bullish and engulfs the previous bearish candle, and the candlestick formed after the pattern closes higher than the bullish candle’s high, indicating a potential bullish reversal.
Stop loss: Place the stop loss just below the low of the bullish engulfing pattern. This helps to minimize risk in case the pattern fails.

You must remember how to set a target, as explained at the end of the single candlestick chapter. If you need a refresher, give it a quick read here. The same applies to 2 candlestick patterns, too.

Assuming we are going long on Tata Motors, where a bullish engulfing pattern is formed.

Entry for the above bullish engulfing candle is the opening of the following candle, which is at 122.80.
Stop loss would be low of the previous candle, which would be at 113.00.
The target is to aim for a risk-to-reward ratio of 1:1.5.

There often needs to be more clarity about whether a bullish engulfing pattern needs to engulf the entire previous candle, including the wicks, or just the natural body. If the natural body is engulfed, it can be considered a bullish engulfing pattern. Some may disagree, but what truly matters is how effectively you develop your trading skills with this pattern.

Bearish Engulfing Pattern

How does a bearish engulfing pattern form?

A bearish engulfing pattern signals bearishness in the market and indicates a potential reversal from an uptrend to a downtrend. It forms during an uptrend and suggests that the market sentiment has shifted, opening the door for a downward move.

The pre-requisites for a bearish engulfing candle are:

The prior trend should be an uptrend.
The first candle should be bullish, reconfirming the bullishness in the market.
The second candle should be bearish, and long enough to engulf the green candle.

Here is a chart that has a bearish engulfing pattern forming at the end of an uptrend:

The above chart shows a bearish candle formed after an uptrend, totally covering the previous bullish (green) candle. There is a significant drop in the market after the occurrence of a bearish engulfing pattern.

The market is in an uptrend, dominated by buyers, as shown by bullish (green) candles.
A significant bearish (red) candle forms, completely engulfing the previous bullish candle, signaling a solid shift in control to sellers.
The bearish engulfing pattern indicates intense selling pressure and a change in market sentiment from bullish to bearish.
This pattern suggests a potential reversal of the uptrend, with sellers gaining strength and the market moving downwards.

Now, let’s see how we should trade the bearish engulfing pattern.

How to trade a bearish engulfing pattern?

Entry: Enter the trade at the opening price of the next candle, i.e., at the candle that forms just after the formation of the engulfing candle.
Confirmation: A bearish engulfing pattern is confirmed if it occurs after an uptrend, the bearish candle completely engulfs the previous bullish candle, and the next candle closes lower than the low of the bearish engulfing candle, signaling a potential bearish reversal.
Stop Loss: Set the stop loss at the high of the bearish engulfing candle to minimize risk if the pattern fails.

Let’s look at how a trade in Ashok Leyland enflolds using the bearish engulfing candlestick pattern.

Entry: Enter the trade at the opening of the next candle, which is 176.40.
Stop Loss: Set the stop loss at the high of the bearish engulfing candle, which is 177.00.
Target: Aim for a target with a risk-to-reward ratio of 1:1.5 based on the entry price.

Harami Pattern

Harami’ in Japanese means ‘pregnant’. Being a two-candlestick pattern, the first candle is significant and reflects strong market sentiment, either bullish or bearish, depending on the current trend. The second candle is smaller and has its body completely engulfed within the first candle’s body, indicating a potential reversal in the trend.

The below image shows a harami candlestick pattern.

Here, you can see that the previous candle completely covers the second candle. Now, let’s talk about both harami candlestick patterns – bullish harami and bearish harami.

Bullish Harami Pattern

How does a bullish harami pattern form?

The harami pattern is a potential reversal signal that signifies a change in market sentiment.

The pre-requisites for a bullish harami pattern are:

The prior trend should be a downtrend.
The first candle should be bearish, confirming the bearishness in the market.
The second candle should be bullish and small, fitting within the body of the first red candle.

Here is the formation of a bullish harami candlestick pattern, forming at the bottom of a downtrend.

The psychology behind a bullish harami candlestick pattern is:

Initially, the market was in a downtrend, dominated by sellers, which was reflected by the large bearish (red) candle.
The sizeable bearish candle confirms the ongoing bearish sentiment in the market.
The following day, a smaller bullish (green) candle forms within the body of the previous red candle.
This smaller candle represents a period of indecision (doji candles can be formed here) where the selling pressure has weakened, and buyers are starting to enter the market.
The green candle’s appearance suggests buyers are becoming more active, although their presence is not strong enough to reverse the trend completely.
The pattern indicates that the downtrend might be losing its momentum. If buyers continue to gain strength, a reversal from bearish to bullish could be on the horizon.

How to trade a bullish harami pattern?

With an understanding of the bullish harami candlestick pattern, let’s talk about trading it. This pattern suggests a bullish reversal, so look for buying opportunities in the stock.

Entry: Buy when the price moves above the high of the second (green) candle.
Confirmation: For added assurance, wait for the next candle (third candle) to close higher than the high of the first (bearish) candle.
Stop loss: Place the stop loss just at the low of the second (green) candle to protect yourself if the pattern doesn’t work out.

Let’s look at an example in Tata Motors.

The OHLC data of the above candlesticks are:

First candle:
Open = 414.50
High = 414.50
Low = 400.40
Close = 409.20

Second candle:
Open = 401.60
High = 410.60
Low = 401.40
Close = 409.60

You can see that the first candlestick does not entirely cover the low of the second candle. But remember that we need to be flexible!

Hence, here’s how we would trade:
Entry Point: 410.60
Stop Loss: 401.40

To gain more confidence in the bullish harami pattern, watch for the third candle. For a more decisive confirmation, the third candle should be bullish. You can initiate a trade setup if the third candle closes above the high of the first candle, i.e., above 414.50. Set your stop loss at the low of the first candle.

Now, let’s look at the bearish harami pattern, which works just the opposite of the bullish harami pattern.

Bearish Harami Pattern

How does a bearish harami pattern form?

It is a potential bearish reversal candle, and the pre-requisites for a bearish harami candlestick pattern are:

The prior trend should be an uptrend.
The first candle should be bullish, indicating bullishness in the market.
The second candle should be bearish and small enough to be contained within the body of the first candle.

The psychology behind the formation of bearish harami candlesticks is as follows:

The market is in an uptrend, dominated by buyers.
A large bullish (green) candle confirms the ongoing bullish sentiment.
The following day, a smaller bearish (red) candle forms within the body of the previous green candle.
This smaller red candle represents a period of indecision (Doji candles can form here), indicating that the buying pressure has weakened and sellers are starting to enter the market.
The new small bearish candle suggests that sellers are becoming more active, though their presence still needs to be more robust to reverse the trend completely.
The pattern indicates that the uptrend might be losing momentum.
If sellers continue to gain strength, a reversal from bullish to bearish could be on the horizon.

The image of a bearish harami, seen forming at the top of an uptrend in the price chart of Infosys:

How to trade a bearish harami pattern?

Entry: Sell when the price moves below the low of the second (red) harami candle.
Confirmation: For added assurance, wait for the next candle (third candle) to close lower than the low of the first (bullish) candle.
Stop Loss: Place the stop loss at the high of the second (red) harami candle to protect yourself if the pattern doesn’t work out.
Now, let’s look at another exciting double candlestick pattern!

Tweezer Tops and Tweezer Bottoms

These consist of two consecutive candles with matching highs (tweezer top) or matching lows (tweezer bottom). Here’s how they look:

Let’s take a closer look at each one of them.

Tweezer Bottoms Pattern

How is a tweezer bottom formed?

It is a potential bullish reversal pattern, called a tweezer bottom, because it is found after a downtrend. The pre-requisites for a tweezer bottom candlestick pattern are:

The prior trend should be a downtrend.
The first candle should be bearish (red), confirming the bearishness in the market.
The second candle should be bullish, and have a low that matches or is very close to the low of the first red candle.

Let’s examine the tweezer bottom pattern, which forms at the bottom of a downtrend of Infosys stock, for a better understanding.

As you can see in the above chart, Infosys stock rallied significantly after the formation of the tweezer bottom. This pattern, formed after a downtrend with both candles having similar lows, indicates a potential bullish reversal.

What does the tweezer bottom tell us?

Initially, the market was in a downtrend, dominated by sellers, as shown by the large bearish (red) candle. This sizeable bearish candle confirms the ongoing negative sentiment in the market.
The next day, a bullish (green) candle forms with a low that matches or is very close to the low of the previous red candle. This matching low suggests that the selling pressure is weakening, and buyers are starting to step in.
The green candle’s appearance indicates buyers are becoming more active, although their presence still needs to be stronger to reverse the trend completely.
This pattern signals that the downtrend might be losing its momentum if buyers continue to gain strength.

Let’s look at how to trade tweezer bottom.

How to trade a tweezer bottom?

Now that you understand the tweezer bottom candlestick pattern, let’s discuss how to trade it. This pattern shows a potential bullish reversal, so it’s a good time to look for buying opportunities in the stock.

Entry: Buy when the price moves above the high of the second (green) candle.
Confirmation: Make sure the next (third) candle closes higher than the high of the second (green) candle to confirm the reversal.
Stop Loss: Place the stop loss just below the low of the second (green) candle to protect yourself if the pattern doesn’t work out.

Now, let’s discover the tweezer top double candlestick pattern.

Tweezer Tops Pattern

How does a tweezer top get formed?

Converse to a tweezer bottom, a tweezer top is formed after an uptrend. The pre-requisites for the formation of a tweezer top are:

The prior trend should be an uptrend.
The first candle should be bullish, confirming the bullishness in the market.
The second candle should be bearish, and have a high that matches or is very close to the high of the first candle.

Let’s understand with an example.

In the above chart, you can see they are formed in an uptrend; the OHLC of the above candlesticks are:

First candle:
Open = 1553
High = 1575
Low =1547
Close =1573

Second candle:
Open = 1572
High = 1572
Low =1545
Close =1553

We can see the high prices of both candles match, confirming the tweezer top candlestick pattern.

The psychology behind the formation of the tweezer top is as follows:

Initially, the market was in a downtrend, dominated by sellers, shown by a large bearish (red) candle.
The next day, a bullish (green) candle forms with a low matching or very close to the previous red candle’s low, indicating weakening selling pressure.
This matching low suggests that buyers are starting to step in, though not yet strong enough to reverse the trend completely.
The pattern signals that the downtrend might be losing momentum.

If buyers continue to gain strength, a reversal from bullish to bearish could be on the horizon.

How to trade a tweezer top?

Entry: Sell when the price moves below the low of the second (red) candle.
Confirmation: Make sure the next candle closes lower than the low of the second (red) candle to confirm the reversal.
Stop Loss: To protect yourself if the pattern doesn’t work out, place the stop loss at the high of the second (red) candle.

Now that you’ve got the hang of interpreting and trading single and two-candlestick patterns, let’s move on to multi-candlestick patterns.

Chapter 6: Multiple Candlestick Patterns

Continuing from the previous chapter on double candlesticks, where we discussed engulfing, harami, and other patterns that help us enter the market, we now move on to multiple candlestick patterns. These patterns involve analyzing three or more candlesticks, but we will focus on just three candlesticks to understand the market direction better.

You might wonder why it is necessary to analyze three candlesticks. The reason is simple: the more candlesticks, the more solid and reliable the trend.

In this chapter, we will explore patterns like morning and evening stars, three black crows and soldiers, three inside up and down, and three rising and falling methods. These patterns give us a clearer picture of the market and help us make better trading decisions.

Let’s look at the first multiple candlestick pattern, the morning star.

Morning Star

How is a morning star pattern formed?

A bullish candlestick pattern generally formed at the bottom of a downtrend, the morning star consists of three candlesticks.

To improve our understanding, we will denote the first candle as C1, the second candle as C2, the third candle as C3, and so on.

The first candle (C1) is bearish, with the closing price near the previous candle’s low.
The second candle (C2) is a doji, having a negligible body. It should form below the low of the first candle
The third candle (C3) should be bullish and close higher than the high of the first candle (C1), like a bullish engulfing candle.

Here’s a pictorial representation of the same:

Let’s break down the same.

The market is in a downtrend, with the bears in control, forming successive new lows.
On day 1 (C1), the market forms a long red candle, showing selling acceleration.
On day 2 (C2), the market forms a doji or spinning top, indicating indecision and causing restlessness among the bears who expected another down day.
On day 3 (C3), a green candle forms, closing above C1’s red candle opening.
Buying persists throughout C3, recovering all losses of C1.
The bullishness on C3 will likely continue, suggesting buying opportunities in the market.

How to trade a morning star pattern?

The three characteristics of a morning star are found in the HDFC Bank chart below.

Here’s how to trade it.

Entry: Enter a long position at the candle’s opening that forms after the morning star pattern.
Confirmation: A morning star is more reliable in a downtrend if C3 (the green candle) closes above the midpoint of C1 (the red candle), indicating a potential bullish reversal.
Stop Loss: Place a stop loss at the low of C2 (the doji) to limit potential losses if the trade goes against you.

Let’s now move on to the evening star.

Evening Star

How is an evening star pattern formed?

This candlestick pattern signifies a potential bearish reversal, often forming at the end of an uptrend. It indicates that buyers have lost control and bears have made their entry. It also consists of 3 candlesticks.

Here’s how it is constructed:

The first candle (C1) is bullish, with the closing price near the previous candle’s high.
The second candle (C2) is a doji with a negligible body, indicating indecision. This forms above C1.
The third candle (C3) is bearish and closes lower than the first candle (C1), similar to a bearish engulfing candle.

Here is a pictorial representation of the same:

Let’s look at the psychology behind the formation of an evening star pattern.

The market is in an uptrend, with the bulls in control and successive new highs.
On day 1 (C1), the market forms a long green candle, showing buying acceleration.
On day 2 (C2), the market forms a doji, signaling indecision and causing restlessness among the bulls who expected another up day.
On day 3 (C3), a red candle forms, closing below C1’s green candle opening.
Selling persists throughout C3, erasing all gains of C1.
The bearishness on C3 will likely continue, suggesting selling opportunities in the market.

How to trade an evening star pattern?

Here is a picture of the evening star pattern forming on the daily chart of Ashok Leyland, making it clearer:

As you can see, after the formation of the evening star, Ashok Leyland stock has faced a significant downtrend. Here’s how one can trade it:

Entry: Enter a short position at the candle’s opening that forms after the evening star pattern.
Confirmation: An evening star is more reliable in an uptrend if C3 (the red candle) closes below the midpoint of C1 (the green candle), indicating a potential bearish reversal.
Stop Loss: Place a stop loss above the high of C2 (the doji) to limit potential losses if the trade moves against you.

Three Black Crows

How is the three black crows pattern formed?

The three black crows pattern is a bearish reversal pattern formed when bearish forces come into action and cause prices to fall for three consecutive days.

Pre-requisites for the formation of three black crows are:

The first candle (C1) is bearish, with the closing price near the previous candle’s low.
The second candle (C2) is also bearish, opening within the body of C1 and closing lower, indicating continued selling pressure.
The third candle (C3) is also bearish, opening within the body of C2 and closing lower, confirming the bearish reversal and strong presence of sellers.

Hence, it is named three black crows because the three bearish candles resemble three ominous crows in a row, indicating increasing selling pressure. Here is a pictorial representation of the same:

Sentiment behind the formation of three black crows:

The market is in an uptrend, with the bulls in control and successive new highs.
On day 1 (C1), the market forms a long red candle, signaling a strong shift in sentiment.
On day 2 (C2), another bearish candle forms, opening within C1’s body and closing lower, indicating continued selling pressure.
On day 3 (C3), a third bearish candle forms, opening within C2’s body and closing near its low, confirming the bearish reversal.
Selling persists throughout C3, erasing gains from the uptrend.
The bearishness suggested by the three black crows pattern will likely continue, indicating selling opportunities in the market.

Let’s uncover how to trade the three black crows.

How to trade the three black crows pattern?

Here’s how this pattern can be traded:

Entry: Enter a short position at the candle’s opening (C4) that forms after the three black crows pattern.
Confirmation: The three black crows pattern is more reliable if the third red candle (C3) closes near its low, indicating strong bearish momentum.
Stop Loss: Place a stop loss above the high of C1 (the first red candle) to limit potential losses if the trade moves against you.

You can notice the pattern forming on the daily chart of HDFC Bank:

OHLC of the candle are:

Data	Open	High	Low	Close
First candle	1666	1666	1602	1608
Second candle	1557	1589	1547	1550
Third candle	1541	1541	1513	1516

Based on the above data

Entry: Enter a short position just after the third candle (C3).
Confirmation: We have confirmation from the three black crows pattern formed in an uptrend.
Stop Loss: Place a stop loss above the high of the first candle (C1), at 1666.

Three White Soldiers

How is the three white soldiers pattern formed?

This multiple candlestick pattern, also known as three advancing white soldiers, helps predict a reversal from a downtrend to an uptrend. It is often found after a long downtrend, changing market sentiment to bullish.

The pre-requisites for the formation of this pattern are:

The first candle (C1) is bullish, with the closing price near the previous candle’s high.
The second candle (C2) is also bullish, opening within the body of C1 and closing higher, indicating continued buying pressure.
The third candle (C3) is bullish as well, opening within the body of C2 and closing higher, confirming the bullish reversal and strong presence of buyers.

Here is a pictorial representation of the same:

Market sentiment driving the formation of three white soldiers:

The market is in a downtrend, with the bears in control and successive new lows.
On day 1 (C1), the market forms a long green candle, signaling a strong shift in sentiment.
On day 2 (C2), another bullish candle forms, opening within C1’s body and closing higher, indicating continued buying pressure.
On day 3 (C3), a third bullish candle forms, opening within C2’s body and closing near its high, confirming the bullish reversal.
Buying persists throughout C3, reversing losses from the downtrend.
The bullishness suggested by the three white soldiers pattern will likely continue, indicating buying opportunities in the market.

Let’s learn how to trade this multiple-candlestick pattern.

How to trade the three white soldiers pattern?

Here’s how a trade can be taken:

Entry: Enter a long position at the candle’s opening (C4) that forms after the three white soldiers pattern.
Confirmation: The three white soldiers pattern is more reliable if the third green candle (C3) closes near its high, indicating strong bullish momentum.
Stop Loss: Place a stop loss below the low of C1 (the first green candle) to limit potential losses if the trade moves against you.

Three Inside Up

How is the three inside up pattern formed?

The three inside up is a type of reversal pattern. This pattern requires a specific sequence of individual candles, indicating that the current trend has lost momentum and is likely to change direction.
How is the three inside up pattern formed?
The pre-requisites for the formation of three inside up pattern are:

The pattern is typically found at the bottom of a downtrend.
The first candle (C1) is bearish, with the closing price near the previous candle’s low.
The second candle (C2) is bullish, opening within the body of C1 and closing above 50% of C1’s body length, indicating a potential shift in momentum.
The third candle (C3) is bullish as well, opening within the body of C2 and closing higher, confirming the bullish reversal and strong presence of buyers.

Here is an image of the three inside up candlestick pattern:

The psychology behind the formation of three inside up:

The market is in a downtrend, with the bears in control and successive new lows.
On day 1 (C1), the market forms a long red candle, maintaining a bearish sentiment.
On day 2 (C2), a bullish candle forms, opening within C1’s body and closing above its midpoint, signaling a potential shift in momentum.
On day 3 (C3), another bullish candle forms, opening within C2’s body and closing higher, confirming the bullish reversal.
Buying persists throughout C3, reversing losses from the downtrend.
The bullishness suggested by the three inside up is likely to continue.

How to trade the three inside up pattern?

Since it’s a bullish reversal candlestick, we should look for buying opportunities in the market. The trade setup will look like this:

Entry: Enter a long position at the candle’s opening (C4) that forms after the three inside up pattern.
Confirmation: The three inside up pattern is more reliable if the third green candle (C3) closes near its high, indicating strong bullish momentum.
Stop Loss: Place a stop loss below the low of C1 (the first red candle) to limit potential losses if the trade moves against you.

Here is a formation of the three inside up candlestick pattern on the daily chart of Wipro:

First, the stock was in a downtrend. After that, the three inside up pattern are formed: the middle candle, C2, managed to cover half of C1, and the third candle closed above the first candle, C1.

OHLC data of the above is as follows:

Data	Open	High	Low	Close
First candle	363	364	355	356
Second candle	358	360	355	359
Third candle	363	365	361	365

Here’s how it can be traded:

Entry: Enter a long position just after the third candle (C3), i.e., on the candle forming after C3.
Confirmation: For a stronger confirmation of the trend change, you can wait for the candle after C3 to open higher than C3.
Stop Loss: Place a stop loss below the low of the first candle (C1), which is 355.

Three Inside Down

How is the three inside down pattern formed?

The opposite of the three-inside-up candlestick pattern is the three-inside-down pattern, which forms after an uptrend and is a potential bearish reversal pattern.

The pre-requisites for the formation of three inside down are:

The pattern is typically found at the top of an uptrend.
The first candle (C1) is bullish, with the closing price near the previous candle’s high.
The second candle (C2) is bearish, opening within the body of C1 and closing below 50% of C1’s body length, with a body twice the size of C1.
The third candle (C3) is bearish as well, opening within the body of C2 and closing lower.

Here is a pictorial representation:

Market sentiment driving the formation of the three inside down pattern:

The market is in an uptrend, with the bulls in control and successive new highs.
On day 1 (C1), the market forms a long green candle, signaling a strong bullish sentiment.
On day 2 (C2), a bearish candle forms, opening within C1’s body and closing lower, indicating a shift in sentiment.
On day 3 (C3), a second bearish candle forms, opening within C2’s body and closing near its low, confirming the bearish reversal.
Selling persists throughout C3, reversing gains from the uptrend.
The bearishness suggested by the three inside down is likely to continue.

How to trade the three inside down pattern?

Given the bearish reversal indicated by the three inside down pattern, traders should consider potential short-selling opportunities. The trading setup will look like this:

Entry: Enter a short position at the candle’s opening (C4) that forms after the three inside down pattern.
Confirmation: The three inside down pattern is more reliable if the third red candle (C3) closes near its low, indicating strong bearish momentum.
Stop Loss: Place a stop loss above the high of C1 (the first green candle) to limit potential losses if the trade moves against you.

As you can see from the above chart, the second candle, C2, is closing more than 50% of the first candle, C1, indicating strong selling momentum. Hence, we should look out for shorting opportunities.

Now, let’s look at the rising three methods & falling three methods candlestick patterns.

Rising Three Methods

How is the rising three methods pattern formed?

We have seen many reversal candlestick patterns up until now. However, the rising three methods pattern is a bullish continuation pattern. This means the current uptrend is likely to continue in the near future. Consisting of five candlesticks, this pattern supports the ongoing trend instead of signaling a reversal.

The pre-requisites for formation are:

The pattern is typically found in the middle of an uptrend.
The first candle (C1) is bullish, with a strong upward move.
The second, third, and fourth candles (C2, C3, and C4) are small bearish candles, staying within the range of C1.
The fifth candle (C5) is bullish again, closing above the high of C1, confirming the continuation of the uptrend.

Here is a pictorial representation of the rising three methods pattern. This pattern contains five candlesticks, as you can see below:

The mindset that creates the rising three methods:

The market is in an uptrend, with the bulls in control and successive new highs.
On day 1 (C1), the market forms a long green candle, signaling strong bullish sentiment.
On day 2 (C2), a small bearish candle forms, opening within C1’s body and closing lower, indicating a temporary pause in the uptrend.
On day 3 (C3), another small bearish candle forms, opening within C2’s body and closing lower, maintaining the pause in bullish momentum.
On day 4 (C4), a third small bearish candle forms, opening within C3’s body and closing lower, continuing the pause.

The bullishness suggested by the rising three methods pattern is likely to continue. The small candlesticks between the two long bullish candlesticks are typically indecision candles, indicating a temporary pause in the uptrend before it resumes. All the small candles don’t need to be bearish; what matters is that they have small bodies and close below the previous candle’s close.

Let’s look at how we can trade the rising three methods pattern.

How to trade the rising three methods pattern?

We should focus on buying opportunities with the rising three methods being a bullish continuation pattern. The trade setup will look like this:

Entry: Enter a long position at the candle’s opening (C6) that forms after the rising three methods pattern.
Confirmation: The rising three methods pattern is more reliable if the fifth green candle (C5) closes near its high, indicating strong bullish momentum.
Stop Loss: Place a stop loss below the low of C2 (the second small bearish candle) to limit potential losses if the trade moves against you.

Look at how the uptrend has continued after the formation of the rising three methods pattern on the chart of Tata Power:

Falling Three Methods

How is the falling three methods pattern formed?

The falling three methods pattern shows a bearish trend. Bulls briefly interrupt with three short bullish candles, causing a pause. However, the bears quickly regain control, and a long bearish candle at the end closes below the first candle, completing the pattern.

The pre-requisites for formation are:

The pattern occurs within a bearish trend.
The first candle (C1) is a long red candle, showing strong selling pressure.
The next three candles (C2, C3, C4) are small green candles confined within the range of C1, indicating a brief pause.
The fifth candle (C5) is a long red candle that closes below the low of the first candle (C1), confirming the continuation of the bearish trend.

Here’s a pictorial representation:

The psychology behind the formation of the falling three-methods pattern works like this: The pattern starts with a strong red candle showing bearish control. Three small green candles follow, representing a brief attempt by bulls to push prices up. However, a final strong red candle indicates the bears have regained control, continuing the downtrend.

How to trade the falling three methods pattern?

A trade using the falling three methods can be taken as follows:

Entry: Enter a short position at the candle’s opening (C6) that forms after the falling three methods pattern.
Confirmation: The falling three methods pattern is more reliable if the fifth red candle (C5) closes near its low, indicating strong bearish momentum.
Stop Loss: Place a stop loss above the high of C2 (the second small green candle) to limit potential losses if the trade moves against you.

Summary

The morning star is a bullish reversal pattern at the bottom of a downtrend. It consists of a bearish candle, a doji, and a bullish candle.
The evening star is a bearish reversal pattern at the peak of an uptrend. It has a bullish candle, a doji, and a bearish candle.
The three black crows pattern has three consecutive bearish candles, indicating a strong bearish reversal after an uptrend.
The three white soldiers pattern has three consecutive bullish candles, indicating a strong bullish reversal after a downtrend.
The three inside-up patterns at the bottom of a downtrend involve a bearish candle, followed by a bullish candle closing above its midpoint, and another bullish candle.
The three inside down patterns at the top of an uptrend involve a bullish candle, followed by a bearish candle closing below its midpoint, and another bearish candle.
The rising three methods pattern, a bullish continuation pattern, has a long bullish candle, three small bearish candles within its range, and a final bullish candle closing above the first candle’s high.
The falling three methods pattern, a bearish continuation pattern, has a long bearish candle, three small bullish candles within its range, and a final bearish candle closing below the first candle’s low.

Chapter 7: Support, Resistance, and Dow Theory

Demand and supply are the most essential things in the stock market that drive prices. The fundamentals are that stock prices increase as demand increases and decrease as stock supply increases. How do you identify these levels for any particular stock price?

Concepts of support and resistance are useful here. This chapter will teach us about support and resistance, which will also help set targets and control losses.

We’ll also explore the Dow theory, an old but valuable method of technical analysis used before candlestick charts became popular. Even today, many traders combine ideas from both Dow theory and candlesticks to boost their trading success.

The support zone

As the name suggests, a support zone is a level at which the price stops falling further. Market participants believe that the support zone is the price level at which demand is strong enough to prevent the price from declining further.

The logic behind using a support zone is that as the price declines towards this level and becomes cheaper, participants believe that the stock does not command a lower price. Buyers are more likely to buy, while sellers are less likely to sell. By the time the price reaches the support level, demand is believed to be strong enough to overcome supply, preventing the price from falling further.

Here is an image of a horizontal line acting as a support level for Tata Power, from where the price has bounced back multiple times.

Types Of Support Levels

There are different types of support levels in technical analysis, but the most important are the horizontal support and the trendline support.

A horizontal support is formed by drawing a straight line horizontally that connects several low points on the chart, which hover along the same price. The more times the price touches and rebounds from this level without breaking it, the stronger the support is considered.

Here is an example of horizontal support in the HDFC Bank price chart:

A trendline support is a level where the price stops falling and bounces back up along a diagonal line. It is marked by drawing a straight line that connects several higher lows or lower lows on the chart. This line helps identify the general trend and provides support as long as the price stays above it.

The resistance zone

The resistance zone works conversely to the support zone. It is a level that stops the price from rising further. Market participants believe that the resistance zone is the price level where the supply is strong enough to prevent the price from rising further.

The logic of a resistance zone is that as the price rises and gets more expensive, more sellers are willing to sell, and fewer buyers want to buy. Here is the daily chart of Wipro Ltd. for better understanding:

Types Of Resistance Levels

Just like the support levels, there exist two variants: horizontal resistance and trendline resistance.

Horizontal resistance is a level at which the price tends to stop rising and drop back down. It is marked by drawing a straight line horizontally connecting several high points on the chart. The more times the price touches and falls from this level without breaking it, the stronger the resistance is considered.

The above chart of Wipro is an example of horizontal resistance.

A trendline resistance is where the price tends to stop rising and pull back down along a diagonal line. It is marked by drawing a straight line connecting several declining high points (or lower highs) on the chart. This line helps identify the general downward trend and acts as resistance as long as the price stays below it. Here’s an example:

This indicates intense selling pressure, with sellers consistently preventing the price from rising above the resistance level.

Now that you understand support and resistance levels, let’s learn to draw them.

How do you draw support and resistance levels in a chart?

Step 1: Selecting your timeframe

Selecting a timeframe depends on your trading style. For example, day traders often use 15-minute charts, swing traders use hourly, daily, or weekly charts, and positional traders use monthly charts. Choosing a suitable timeframe is crucial for aligning your analysis with your trading strategy.

Zoom out the chart after selecting a particular time frame until a trend can be deciphered, something like this:

Step 2: Connecting the highs and lows

After loading the price charts according to your timeframe, as mentioned in Step 1, mark the high and low price points. Once you can spot them, draw a trendline connecting the highs and another connecting the lows.

How To Use Support and Resistance Levels

Support and resistance are areas with potential for reversals. We can mainly use them to set entry and exit points in our trading strategy. Let’s demonstrate with a simple example.

First, we aim to mark the highs and lows in the daily chart of Asian Paints Ltd.

Now, we draw a trendline connecting those highs and lows, respectively.

The chart shows that the current price of Asian Paints is testing its resistance level. If the resistance breaks with a candlestick confirmation, such as a bullish engulfing pattern, we can confirm the uptrend and build a long position. However, if the price gets rejected by the resistance, our potential entry point for a long position would be at the support level.

The Dow theory

The Dow theory is a fundamental principle in trading that helps identify the overall market trend. Even today, traders use the Dow theory along with candlestick patterns to make better trading decisions.

Charles H. Dow created the Dow theory in the late 19th century. Dow, who co-founded Dow Jones & Company and the Wall Street Journal, developed this theory from his writings between 1884 and 1902. Dow theory helps traders understand market trends by analyzing price movements, and it is a vital part of modern technical analysis.

Principles of Dow Theory

The Dow theory is built on a few core beliefs called tenets. Over the years, through market observation, nine tenets have been identified. Here are the nine tenets, backed by examples:

1. The market discounts everything.
The stock market reflects all available information in stock prices, including earnings reports, economic conditions, and political developments. Market movements are the cumulative result of all known factors. For example, when Reliance Industries announces its earnings, the stock price quickly reflects this news. Good earnings make the price rise; bad earnings make it go down. Essentially, Reliance’s stock price includes all available information.

2. Three trends form the market
Dow identified three types of trends: primary, secondary, and minor.

3. The primary trend
These are significant market movements that last several months to years. They are characterized by a sustained movement in one direction, either upward or downward. The trend reflects the overall market sentiment, indicating either an upward (bull market) or downward (bear market) direction.

4. The secondary trend
These are short-term fluctuations within the primary trends, lasting from several weeks to several months. They move opposite the primary trend and represent a counter-trend movement, like a pullback or correction. While long-term investors focus on primary trends, swing and day traders pay attention to all trends.

5. The minor trend
These are daily market fluctuations, often called market noise. Minor trends last from a few days to a few weeks and move in the same direction as the primary trend. Short-term changes in supply and demand cause them.

6. Indices must confirm
Other significant indices should also confirm a trend to be valid. For example, in the Indian market, the Nifty 50 and the Nifty Bank index must show the same trend direction. If one index is rising while the other is falling, it may signal a trend reversal or weakening.

7. Volume confirms trends
The volume should also support the ongoing primary trend. In a bull market, volume should rise as prices increase and fall during corrections. In a bear market, volume should increase during declines and decrease during rallies. Low volume during a trend may indicate that the trend is weak and may not be sustained. You can learn about volume here.

Volume

In the stock market, volume refers to the number of shares bought and sold during a specific period, usually within a day.

8. Sideways markets can substitute secondary markets
Markets can sometimes move sideways, trading within a specific range for an extended period. For example, Tata Motors traded between ₹300 and ₹350 for several months. These sideways markets, where prices fluctuate within a range without significant upward or downward movement, can often substitute for a secondary trend.

9. Closing price and signal confirmation
In Dow theory, signals are based on closing prices rather than intraday movements. For example, if the Bank Nifty index shows a strong upward movement during the day but closes lower, it doesn’t confirm an uptrend. We wait for the closing price to avoid false signals from intraday volatility. If Bank Nifty consistently closes higher over several days, it confirms an uptrend. Similarly, for a downtrend, we look for consistent lower closing prices.

Bank Nifty

Bank Nifty is a stock market index in India that represents the performance of the banking sector.

The Three Phases of Major Trends

According to the Dow theory, markets go through three repeating phases: the accumulation phase, the markup phase, and the distribution phase. Let’s discuss each one:

The accumulation phase is the first phase of a primary trend. During this phase, informed investors, known as “smart money,” start buying stocks. These investors have a deeper understanding of the market. Smart money generally refers to institutional investors who think in long-term perspectives. After a steep sell-off, they buy many shares over an extended period. This defines the accumulation phase. During this time, sellers can easily find buyers, preventing prices from falling further. Therefore, the accumulation phase usually marks the bottom of the market and creates significant support levels for any stock.

Once these institutional investors have bought a significant amount of stocks, short-term traders start to support the market. This begins the markup phase, also known as the public participation phase. This phase is marked by increased investor activity, significant price movements, and rising trading volumes. The markup phase is relatively quick and coincides with improved business sentiment. As people see the impressive returns, everyone wants to join in and participate in the rally.

When stocks finally hit all-time highs, everyone becomes very optimistic about the stock market. News reports turn positive, the business environment seems vibrant, and the public is eager to invest. A large number of people want to put their money into the market. This is when the distribution phase occurs.

At this time, smart money, or institutional investors, will start selling off their investments. Since prices have already peaked, no further appreciation has been seen. This selloff leaves the public frustrated as prices begin to fall. Institutional players then wait for a market reversal to start the cycle again.

When the circle is completed, the selloff phase follows a fresh round of the accumulation phase, and the whole cycle repeats. The entire cycle from the accumulation phase to the selloff is believed to span over a few years.

Now that we’ve grasped the principles of Dow theory, let’s examine how we can effectively trade using them.

Dow theory trading strategy

This trading strategy is rooted in the principles of Dow theory, emphasizing the importance of analyzing stock trends to make informed investment decisions. Here are the critical steps involved in using Dow theory in your trading approach:

Step 1: Identify the primary trend
The first step of this strategy is to identify the primary trend from a long-term perspective. This is done by analyzing the market’s price movements over several months to years. If the stock is forming continuous higher highs and higher lows, it is said to be in an uptrend. Conversely, it is in a downtrend if it consistently forms lower lows and lower highs.

Step 2: Confirm the trend
After identifying the primary trend, the next step is to confirm it, as confirmation is crucial before entering a trade. To verify the trend, examine the trading volumes. It is a good sign if the trading volume increases as the market moves toward the trend.

We have yet to discuss volume but think of volume as the number of shares being traded.

Step 3: Identify secondary trends
As we discussed, secondary trends within the primary trend can provide opportunities for traders to enter or exit the market. These are short-term movements lasting several weeks to a few months. Swing traders make the best use of these secondary trends.

Step 4: Look for trend reversals
One fundamental principle of the Dow theory is that trends will continue until there are clear signs of a reversal. Traders using this strategy look for indications of the trend weakening or changing direction, such as a shift in trading volume or a break in crucial support or resistance levels.

Step 5: Use technical analysis
Technical analysis plays a vital role in the Dow theory trading strategy. Traders use charts to identify critical support and resistance levels, trend lines, and other patterns to decide a trade’s entry and exit points.

We will now finally look at the pros and cons of Dow theory.

Pros and cons of the Dow theory

Some advantages of Charles Dow’s theory are as follows:

Long-term perspective: Dow theory is based on long-term market trends, providing investors and traders with a big-picture view of market movements. It helps investors avoid knee-jerk reactions to short-term market fluctuations and focus on long-term growth potential.
Easy to understand: Dow theory is based on simple principles and provides clear guidelines for identifying market trends. It can be a valuable tool for investors who want to better understand market behavior.
Follows market trends: The Dow process is based on the idea that the market is always right. And it helps investors follow the current trend. By identifying the trend, investors can make better decisions about when to buy and sell securities.

Some disadvantages of Dow’s theory are as follows:

Not consistently accurate: While the Dow theory helps analyze market trends, it is only sometimes correct when predicting future movements. Various external factors, such as political and economic events, can influence market behavior and make it difficult to rely solely on the Dow theory.
Ignores other important factors: The Dow theory focuses mainly on market trends and does not consider other important factors, such as company fundamentals, macroeconomic indicators, and industry trends.

Summary

Understanding demand and supply is essential for identifying stock price movements through support and resistance levels.
Support is a price level where demand prevents further declines in stop prices. It is useful in deciding entry prices and stop loss levels for long positions.
Resistance is a price level at which supply prevents a stock price from rising further. It is useful in deciding target prices and stop-loss levels for short positions.
Select your timeframe to draw support and resistance levels, mark highs and lows, and connect them with trendlines.
Use support and resistance levels to set entry and exit points in your trading strategy.
Dow theory helps identify market trends through principles like primary, secondary, and minor trends.
Primary trends are long-term market movements lasting months to years, indicating overall market sentiment.
Secondary trends are short-term movements within primary trends, lasting weeks to months and offering trading opportunities.
Minor trends are daily market fluctuations caused by short-term supply and demand changes, often seen as market noise.
The Dow theory includes market phases: the accumulation phase (informed investors buy after a decline), the markup phase (increased investor activity and rising prices), and the distribution phase (institutional investors sell at market highs), followed by a potential market reversal.

Chapter 8: Trading Chart Patterns

In this chapter, we will explore different chart patterns that visually represent the battle between buyers and sellers. These patterns help determine if a market is trending higher, lower, or sideways.

Chart patterns can be divided into two broad categories: reversal patterns and continuation patterns. Reversal patterns indicate a trend change, whereas continuation patterns indicate that the price trend will continue after a brief consolidation.

Continuation Patterns

Continuation chart patterns indicate that the current trend will likely continue, up or down. They form during a pause in the market and suggest that after a brief consolidation, the price would resume its previous direction. Understanding these patterns helps traders take advantage of ongoing market movements and manage their trades better.

Now, we will discuss the first continuation pattern, the triangles.

Triangles

The triangle chart pattern is named because it looks like a triangle. There are three types of triangles: ascending, descending, and symmetrical. These patterns form when the price is in a consolidation, and the price direction before the consolidation can give clues about future market movements.

Symmetrical Triangle

This continuation chart pattern sometimes called a coil, contains at least two lower highs and two higher lows. When these points are connected with lines, they converge as they extend, forming a symmetrical triangle.

As you can see, a symmetrical triangle is formed by connecting lower highs and higher lows. Here is the formation process of a symmetrical triangle:

The market is in either an uptrend or a downtrend before the symmetrical triangle starts to form.
Prices start to make lower highs and higher lows, creating two converging trendlines that form a symmetrical triangle. As the pattern develops, trading volume typically decreases, indicating a consolidation phase.
The two trendlines converge towards an apex, where the price movement becomes more constricted.
The pattern is confirmed when the price breaks out of the triangle, either upward or downward, typically accompanied by an increase in volume. This breakout signals the direction of the following significant price move.

How to trade a symmetrical triangle?

Entry: Enter a trade at the opening of the next candle after the price breaks out of the symmetrical triangle.
Confirmation: The symmetrical triangle is confirmed when the price breaks out of the triangle with higher trading volume, showing the new trend’s direction.
Stop Loss: Place a stop loss just below the lower trendline (for an upward breakout) or just above the upper trendline (for a downward breakout) to limit potential losses if the trade moves against you.

Ascending Triangle

An ascending triangle appears when two or more nearly identical highs form a horizontal resistance line while higher lows create an ascending support line. This pattern suggests increasing buying strength and looks like a right triangle. It often signals that a breakout above the resistance line may occur, indicating a possible upward trend continuation.

Here’s how it can be plotted on a price chart:

The formation process of an ascending triangle:

Prices start to make higher lows while facing resistance at a consistently high level, creating a horizontal upper trendline and an upward-sloping lower trendline that forms the ascending triangle.
As the pattern develops, trading volume typically decreases, indicating a consolidation phase.
The two trendlines converge towards an apex, where the price movement becomes more constricted.
The pattern is confirmed when the price breaks out above the horizontal resistance line, typically accompanied by an increase in volume. This breakout signals a continuation of the previous uptrend.

How to trade an ascending triangle?

Entry: Enter the trade at the opening of the next candle after the price breaks above the horizontal resistance line of the ascending triangle.
Confirmation: The ascending triangle is confirmed when the price breaks out above the resistance line with a bullish candle and higher trading volume, indicating the new trend’s direction.
Stop Loss: Place a stop loss just below the upward-sloping trendline to limit potential losses if the trade moves against you.

Descending Triangle

This pattern also looks like a right-angle triangle. Two or more similar lows create a horizontal line at the bottom. Two or more lower highs create a descending trend line above that meets the horizontal line as it goes down. Here’s a descending triangle plotted on a price chart:

The market psychology behind a descending triangle is as follows:

The market usually has a downtrend before the descending triangle starts to form.
Prices make lower highs while the lows stay consistently low, creating a flat bottom line and a sloping top line that forms the descending triangle.
As the pattern develops, trading volume usually decreases, showing a period of consolidation.
The two lines converge towards a point where the price movement becomes tighter.
The pattern is confirmed when the price breaks below the flat bottom line, usually with higher volume. This breakout signals that the downtrend will likely continue.

How to trade a descending triangle?

Entry: Enter the trade at the opening of the next candle after the price breaks out below the horizontal support line of the descending triangle.
Confirmation: The descending triangle is confirmed when the price breaks out below the support line with a bearish candle and higher trading volume, indicating the new trend’s direction.
Stop Loss: Place a stop loss just above the downward-sloping trendline to limit potential losses if the trade moves against you.

Flags

Now, we’ll explore another interesting chart pattern – the flag.

Flags are chart patterns made up of two parts – a steep rise or decline in prices, followed by a short period of consolidation. They are of two types – bullish and bearish. Here’s how they look:

Bullish Flag

This pattern forms when a stock’s price rises sharply. Flag patterns start with a big move-up and a short correction period. This correction happens between two parallel lines, making a shape like a flag on a pole.

The psychology for bullish flag formation is as follows:

The stock experiences a sharp, steep rise in prices.
After this big move-up, prices enter a short correction phase.
This correction happens between two parallel lines, forming a flag shape.
The pattern is confirmed when prices break out of the flag, usually continuing in the direction of the initial steep rise, indicating a potential trend continuation.

How can we trade a bullish flag?

The trade setup is as follows:

Entry: Enter the trade at the breakout above the upper parallel line, which is at ₹1,650 in the case of the above chart.
Stop Loss: Set the stop loss below the lower parallel line, which is at ₹1,600 here.
Target: Aim for a target by adding the flagpole height (approximately 340 points) to the breakout point (1,650), giving a target of around ₹1,990.

Bullish Penants

Similar to a bullish flag, there is also a bullish pennant pattern. Both start with a steep move but differ in structure in that the bullish pennant forms a triangle rather than a flag shape. Here’s an example to help illustrate this pattern.

In the above image, you can see the continuous formation of a bullish pennant flag.

Trading a bullish pennant is very similar to trading a bullish flag. To trade a bullish pennant, go long on the stock when the price breaks above the converging trendline. The target is set based on the height of the flagpole, and the stop-loss is placed just below the lower trendline of the pennant.

Bearish Flag

This pattern forms when a stock experiences a sharp, steep rise in price. Bullish flag patterns start with a big up-move, followed by a short period of consolidation. This consolidation happens between two parallel lines, forming a shape like a flag on a pole.

The psychology for bearish flag formation is as follows:

The stock experiences a sharp, steep drop in prices.
After this big move down, prices enter a short correction phase.
This correction happens between two parallel lines, forming a flag shape.
The pattern is confirmed when prices break out of the flag, usually continuing in the direction of the initial steep drop, indicating a potential trend continuation.

Here is the pictorial representation of it

How can we trade bearish flag?

Entry: Enter the trade at the breakout below the lower parallel line.
Stop Loss: Set the stop loss just above the upper parallel line.
Target: Aim for a target by subtracting the height of the flagpole from the breakout point.

Bearish Penants

The bearish pennant is converse to the bullish penant. Similar to bearish flags, pennants form a small symmetrical triangle shape where two converging trendlines meet, indicating a period of consolidation before the previous bearish trend resumes.

Trading a bearish pennant involves taking a short position when the price breaks below the converging trendlines. The target price is determined by the distance of the initial sharp decline, and the stop loss should be set just above the upper trendline of the pennant. As the downward trend continues, this approach helps manage risk while aiming for potential profit.

Reversal Chart Patterns

Reversal chart patterns appear on price charts and tell us that a price trend might change direction. After a long rise or fall in prices, these patterns suggest the trend could end and move the opposite way. Traders look for these patterns to decide when to buy or sell, expecting a change in market direction.

Let’s look at the first reversal chart pattern: the head and shoulder pattern.

Head and Shoulders

The head and shoulders pattern looks like a person’s head and shoulders on a price chart. It has three peaks, with the middle one being the farthest.

There are two types of head and shoulders: head and shoulders sometimes, also referred to as head and shoulders top. Another is inverse head and shoulders, or head and shoulders bottom.

Here’s a pictorial representation:

Head and shoulders top

A head and shoulders top reversal pattern forms after an uptrend and signals a potential trend reversal upon completion. The pattern consists of three successive peaks: the middle peak, known as the head, is the highest, while the two outside peaks, called the shoulders, are lower and roughly equal in height.

The formation process behind the head and shoulders top:

The market is in an uptrend, and prices rise to a new high, forming the first peak (left shoulder) before pulling back slightly.
After the pullback, prices rise again to form a higher peak (head), but then declines again, hitting the previous support level.
Prices rise once more but fail to reach the height of the head, forming the third peak (right shoulder). The pattern is confirmed when prices fall below the neckline, drawn by connecting the lows after each peak, signaling a potential trend reversal from bullish to bearish.

How to trade head and shoulders top?

Entry: Enter a short trade when the price breaks below the neckline with increased volume.
Target: Set the target price by subtracting the height from the head to the neckline from the breakout point below the neckline.
Stop Loss: Place the stop loss above the right shoulder to limit potential losses if the breakout fails.

Head and shoulders bottom

The opposite of the head and shoulders top is the head and shoulders bottom. It is also known as the inverse head and shoulders pattern. Here, the formation occurs after a downtrend, indicating a potential reversal to an uptrend. As it completes, the pattern shifts market sentiment from bearish to bullish, signaling a possible upward movement in prices.

The formation process of the head and shoulder bottom is as follows:

The market is in a downtrend, and prices fall to a new low, forming the first trough (left shoulder) before rebounding slightly.
After the rebound, prices fall again to form a lower trough (head) but then rise, hitting the previous resistance level.
Prices fall once more but do not reach the depth of the head, forming the third trough (right shoulder). The pattern is confirmed when prices rise above the neckline, drawn by connecting the highs after each trough, signaling a potential trend reversal from bearish to bullish.

How to trade head and shoulders bottom?

Entry: Enter a long trade when the price breaks above the neckline with increased volume.
Target: Set the target price by adding the height from the head to the neckline to the breakout point above the neckline.
Stop Loss: Place the stop loss below the right shoulder to limit potential losses if the breakout fails.

Double Bottom And Double Top Patterns

A double bottom and double top are potential trend reversal patterns. They occur when a stock moves in a pattern resembling the letter “W” (double bottom) or the letter “M” (double top), something like this:

Double Bottom

A double bottom is a bullish reversal pattern. The stock first drops to a low point and then rises to a resistance level. It drops to the low point again forming a support before finally moving up from the downtrend.

Here is a pictorial representation of a double-bottom pattern.

The formation process of double bottom is

The market is in a downtrend, and prices fall to a new low before finding support and rebounding slightly.
After the initial rebound, prices rise but hit resistance and pull back, forming a peak between the two low points.
Prices decline again, but the selling pressure weakens, and the market forms a second low around the same level as the first low point.
The pattern is confirmed when prices rise above the peak formed between the two highs, signaling a potential trend reversal from bearish to bullish.

A tribple bottom occurs when the price touches the support three times before breaking the resistance. Here’s how it looks on a chart:

In fact, the price breaking out after a triple bottom gives a stronger rally than the one after a double bottom.

Now, we will look at the opposite of the double bottom, which is the double top.

Double Top

A double top is a bearish reversal pattern. The stock first rises to a high point and then falls to a support level. It rises to a high point again before finally moving down from the uptrend.

Here is a pictorial representation of a double-top pattern.

The process of forming a double bottom is as follows:

The market is in an uptrend, and prices rise to a new high before hitting resistance and pulling back slightly.
After the pullback, prices fall but find support, forming a low point between the two highs.
Prices rise again, but the buying pressure weakens, and the market forms a second high at about the same level as the first high.
The pattern is confirmed when prices fall below the low point between the two highs, signaling a potential trend reversal from bullish to bearish.

How to trade the double bottom and double top patterns?

Double bottom and double top patterns can be handy in trading when identified correctly. For a double top, measure the distance from the top of the “M” to the neckline to set a target and place a stop loss above the neckline. Enter a short trade when the neckline breaks.

For a double bottom, place a stop loss below the neckline and enter a long trade when the neckline breaks upward. These patterns work well, but careful and patient analysis is needed to avoid mistakes.

Let’s demonstrate with an example.

Here is a chart of HDFC bank formation of a double-bottom pattern:

For the above chart, we can enter a long trade, as the double bottom indicates a potential bullish reversal pattern. We can set our stop loss at the preceding support level and target a price move by measuring the distance between the neckline and the support level.

Conversely, here’s a possible trade after a triple top pattern is formed. For a triple top, place a stop loss above the neckline and enter a short trade when the neckline breaks downward.

Chapter 9: Indicators - Part 1

Now that we’ve covered chart patterns, let’s discuss indicators.

Indicators are tools developed by successful traders as independent trading systems. They are based on a preset logic and help traders enhance their technical analysis, including candlesticks, volume, support, and resistance levels. Indicators assist in making trading decisions by helping with buying, selling, confirming trends, and sometimes predicting future trends.

There are two main types of indicators: lagging and leading. A leading indicator predicts future price movements, often signaling a reversal or a new trend before it happens. However, they are only sometimes accurate, and knowing how to use them effectively requires experience and practice. Lagging indicators, on the other hand, are used to confirm trends. They usually generate a signal after a trend begins but have a better accuracy rate than leading indicators.

In this chapter, we will discuss one famous lagging indicator, the moving average, and how to trade using it. Let’s go!

The moving average

The moving average indicator is very similar to the ‘average’ we learned in school: the sum of observations divided by the total number of observations. Let’s recall with a simple example—let’s calculate the average weight of five men.

Man	Weight (in kg)
Ravi	71
Kishore	75
Bhuvan	55
Vignu	55
Manohar	65

The average of the above observation = (71 + 75 + 55 + 55 + 65) / 5 = 64.20 kg.

Similarly, if we calculate the average of the closing prices of a particular stock over a specific period, it’s called the stock’s simple moving average (SMA). Let’s calculate a stock’s 5-day moving average based on its closing prices of the past 5 days.

Day	Closing Price
Day-1	414
Day-2	416
Day-3	419
Day-4	423
Day-5	444
Average	423.20

The average closing price is the sum of all closing prices over a certain number of days divided by the number of days. When this average is plotted over time, it results in a simple moving average. Hence, the simple moving average is nothing but the changing average of the stock price on a particular day. It can be represented by a line whose movement can be compared with the stock’s price.

Its lookback period can be changed as per a trader’s requirement. In the above example, the five-day moving average for the share price is 423.32. A moving average smooths out price data to give a clearer view of the stock’s trend over time.

As seen in the chart, the blue line above the candlesticks is the simple moving average, showing the stock’s overall trend.

Another type of moving average is the exponential moving average (EMA), which reacts heavily to recent price changes. Let’s learn about it in more detail.

The exponential moving average

An exponential moving average (EMA) is a type of moving average that gives more weight to recent prices. The EMA is often used in technical analysis to spot trends and potential reversals.

Here is the calculation of a 5-period EMA based on closing prices:

Day	Closing Price
Day-1	100
Day-2	102
Day-3	104
Day-4	106
Day-5	108

Step 1: Calculate the Simple Moving Average (SMA) for the first five days

SMA = (100 + 102 + 104 + 106 + 108) / 5 = 104

This SMA serves as the starting point for the EMA.

Step 2: Calculate the multiplier for weighting the EMA

Multiplier = 2 / (5 + 1) = 0.3333

Step 3: Calculate the EMA for Day 6 using a hypothetical price

Let’s say the closing price for Day 6 is 110.

EMA = (Closing price – Previous EMA) * Multiplier + Previous EMA

For Day 6:
EMA = (110 – 104) * 0.3333 + 104 = 2 + 104 = 106

So, the EMA for Day 6 is 106.

When this calculation for each day is plotted over time, it results in an exponential moving average. It can be represented by a line whose movement can be compared with the stock’s price.

Here too, the lookback period can be changed as per a trader’s requirement. An exponential moving average gives a weighted average of the stock price to give a clearer view of the stock’s trend over time and also signals potential reversals.

How to trade moving averages

A simple moving average (SMA) smooths out price data to help identify longer-term trends, though it needs to catch up and capture quick changes. To better capture these changes and make more timely trading decisions, traders often use the exponential moving average (EMA), which gives more weight to recent prices.

The exponential moving average is a lagging indicator it is used in several ways:

Identifying trends

Imagine you’re trading a stock, and the 50-day EMA is rising. This suggests an upward trend, so you might consider buying the stock or holding your existing position.

Here is an example of a 9-period exponential moving average. As the 9-day EMA rises, the stock’s upward trend continues.

Identifying support and resistance levels

Sometimes, stock prices may frequently bounce off their 20-day EMA, which acts as a support level. The price falling below the EMA might signal a selling opportunity.

We can see that the 9-day EMA first acted as a resistance and later as a support, similar to what happened with Tata Power.

Using moving average crossovers

Combining two EMAs can be used as a trend reversal signal in trading, especially with moving average crossovers.

A moving average crossover occurs when one moving average crosses over another moving average, each having different lookback periods. Bullish and bearish trading signals can be developed depending on the direction of the two average lines.

Let’s look at the most famous crossovers.

Golden Crossover: This occurs when a short-term EMA, like the 50-day EMA, crosses above a long-term EMA, such as the 200-day EMA. It signals a potential bullish trend reversal.

As we can see, after the golden crossover happened, there was a bullish trend for an extended period.

Death Crossover: This happens when a short-term EMA crosses below a long-term EMA. It suggests a potential bearish trend reversal.

As we can see, after the death crossover, there was an extended bearish trend.

Not all moving average signals should be relied on…

In sideways markets, moving averages can give many buy and sell signals, often leading to small gains or losses.
It’s hard to know which trade will be the big winner, so it’s best to take all the trades suggested by the moving average system. One big winning trade can cover all the losses and provide good profits.

Summary

Indicators help traders understand market trends, gauge strength, and find entry/exit points using market data like price and volume.
There are two main types of indicators: lagging, like moving averages, and leading, which predicts future movements.
A moving average (MA) smooths out price data to show trends over time; simple moving averages (SMA) use equal weighting, while exponential moving averages (EMA) give more weight to recent prices.
SMAs are useful for identifying long-term trends but may miss quick changes; EMAs react faster and help make timely trading decisions.
A golden crossover occurs when a short-term EMA crosses above a long-term EMA, indicating a potential bullish trend. A death crossover happens when a short-term EMA crosses below a long-term EMA, signaling a potential bearish trend.
In sideways markets, moving averages can produce many signals with small gains or losses; following all signals can maximize potential gains.

Chapter 10: Indicators - Part 2

In the previous chapter, we explored the moving average, a well-known indicator for identifying trends and reversals in stocks. We’ll delve into other essential indicators like the RSI, MACD, Bollinger Bands, and Supertrend. Traders widely use these tools, which are crucial for gaining a deeper understanding of market dynamics.

For a quick recap, leading indicators give signals before the trend changes or continues, helping to predict future movements. In contrast, lagging indicators follow the price movement and are usually used to confirm trends rather than predict them.

RSI - Relative Strength Index

The relative strength index (RSI) is a leading momentum indicator developed by J. Welles Wilder. Its primary use is to identify overbought and oversold signals, meaning it helps spot potential trend reversals. The RSI oscillates between 0 and 100, and based on the latest indicator reading, the expectations for the markets are set.

The relative strength index (RSI) is a highly effective tool, especially when stocks are trading within sideways or non-trending ranges. This is because markets often move sideways, making it crucial to identify potential turning points.

The formula for calculating the RSI:

RSI = 100 – [100 / (1+RS)]
Where RS = Average Gain / Average Loss

Let’s calculate the RSI of the following dataset.

Sr. No.	Closing Price	Points Gained	Points Lost
1	120	0	0
2	123	3	0
3	119	0	4
4	122	3	0
5	121	0	1
6	124	3	0
7	122	0	2
8	125	3	0
9	128	3	0
10	127	0	1
11	126	0	1
12	130	4	0
13	132	2	0
14	135	3	0

In the above table, points gained/lost denote the number of points gained/lost concerning the previous day’s close. For example, if today’s close is 104 and yesterday’s close was 100, points earned would be 4, and points lost would be 0. Similarly, if today’s close was 104 and the previous day’s close was 107, the points gained would be 0, and the points lost would be 3. Please note that the losses are computed as positive values (in absolute terms).

We used 14 data points for the calculation, which is the default period setting for the RSI indicator in most trading softwares. This is also called the ‘look-back period.’ If you are analyzing hourly charts, the default period is 14 hours; if you are analyzing daily charts, the default period is 14 days.

The first step is to calculate ‘RS,’. As you can see in the formula, RS is the ratio of average points gained by the average points lost.

Average points gained = 24 / 14
Average points loss = 10 / 14

Relative strength (RS) = 1.714 / 0.643 = 2.667

Plugging in the value of RS into the RSI formula:

RSI = 100 – 100 / (1+2.667)
RSI = 100 – 100 / 3.67
RSI = 100 – 27.7273
RSI = 72.73

The overbought region occurs when the RSI shows significant buying pressure compared to recent trends, often signaled by the RSI rising above 70. This typically indicates that the upward momentum may soon slow down. Conversely, the oversold region, marked by the RSI falling below 30, indicates intense selling pressure, suggesting that the downward trend might end.

How to trade relative strength index?

Trading with the relative strength index (RSI) is straightforward. The RSI ranges from 0 to 100, and technical analysts typically use the 30 and 70 levels as thresholds for generating buy and sell signals.

Buy signal: Look for long opportunities when the RSI is in the oversold range (below 30) or moving out of it.
Sell signal: Look for short opportunities when the RSI is in the overbought range (above 70) or moving out of it.

On a trading terminal, the RSI indicator will look like this:

The RSI is just an indication of a stock being overbought or oversold. It is not a guarantee for price reversal. Different types of traders use RSI differently. We suggest you apply other technical analysis concepts like candlesticks, moving averages, the Dow theory, etc. to identify and take a trade, with RSI being one of the parameters for doing so.

MACD - Moving Average Convergence Divergence

The MACD is a lagging indicator, a momentum oscillator primarily used to trade trends, unlike the RSI, which identifies overbought and oversold zones. The MACD helps investors spot price trends, gauge trend momentum, and find market entry points for buying or selling.

It is constructed using two different exponential moving averages, one of which is a moving average of the other. This combination helps highlight changes in trend direction and momentum.

Here is an example of MACD on the daily chart of Infosys Ltd.:

As you can see, the graph displays two moving averages. Here, one is the MACD line, calculated by subtracting the 26-period EMA from the 12-period EMA. The other line, called the signal line, is the 9-day EMA of the MACD line. In the above chart, the blue line represents the MACD line and the red line represents the signal line.

Below these lines, a histogram represents the difference between the MACD line and the signal line. The histogram is positive when the MACD line is above the signal line, indicating bullish momentum, and negative when it’s below, indicating bearish momentum. The positive histogram, above the zero line and green in color, indicates bullish momentum. Conversely, when the histogram is below the zero line and red, it signals bearish momentum. Here is another MACD example showing periods of bullish and bearish momentum:

How to trade the MACD?

Trading with the moving average convergence divergence (MACD) indicator is also straightforward.

Buy signal: Go long when the MACD line crosses above the signal line. This indicates that bullish momentum is gaining strength.
Sell signal: Go short when the MACD line crosses below the signal line. This suggests that bearish momentum is increasing.

Supertrend

The Supertrend is a technical analysis indicator that helps traders identify market trends. This indicator combines the average true range (ATR) with a multiplier to calculate its value. Here’s how:

ATR, or the Average True Range, measures an asset’s average price movement over time, indicating its volatility. It helps the Supertrend enhance its sensitivity and accuracy in detecting trends. The formula for its calculation is ATR = [(Prior ATR x 13) + Current TR] / 14
The multiplier is a constant value that traders and investors employ to make the indicator more or less sensitive to price movements.

The formula for calculating the Supertrend:

Supertrend = [(High + Low) / 2 + (Multiplier) ∗ (ATR)

The ATR length affects its sensitivity and signal frequency. Short periods increase sensitivity and signals; longer periods provide fewer but more reliable signals. In most trading platforms, the default ATR period is set to 10, and the multiplier is set to 3.

Here’s how the indicator appears when applied to a chart:

How to use the Supertrend indicator?

The line and shadows with changing green and red colors represent the Supertend indicator. It is interpreted as follows:

When the Supertrend goes below the closing price, it turns, indicating a bullish trend.
When the Supertrend goes above the closing price, it turns red, indicating a bearish trend.

Use the Supertrend indicator during solid uptrends or downtrends to effectively identify market trends. However, the Supertrend indicator is unsuitable for sideways markets because the price trades in a narrow range and can generate false signals or “whipsaws” in sideways or choppy markets, leading to potential losses.

It makes a superb choice for swing trading because it offers reliable entry and exit signals over a medium-term timeframe of several days or weeks. The indicator helps identify the prevailing market trend, making it easier to decide when to enter or exit a trade, maximizing potential gains from sustained price movements.

Long trade

When the Supertrend indicator turns green, buy the stock at its closing price of that particular day.
Keep the line of the Supertrend as the stop loss. As the price moves, the Supertrend line adjusts accordingly.
If the Supertrend line turns from green to red, it may be considered a signal to exit the extended position.

Short trade

When the Supertrend indicator turns red, sell the stock at the opening price of that particular day.
Set the stop loss at the Supertrend line, and as the price moves, the Supertrend line will adjust accordingly.
If the Supertrend line turns from red to green, it may be considered a signal to exit the extended position.

Bollinger Bands

Firstly, let’s talk about why volatility matters when we’re trading stocks. Imagine we’re fishermen living by the seaside.

We head out to sea with other fishermen every day to catch fish. But here’s the thing: we might face problems if we don’t pay attention to the weather, like high waves or fog. It’s like driving in heavy rain without knowing what’s coming – risky!

Think of fishing as trading stocks. Just like we need to know the ocean conditions for fishing, we need to understand market volatility for trading. Volatility means how much prices are going up and down. If we ignore this, we might lose money, like fishing on a stormy day.

Knowing about volatility can help us decide when to buy or sell stocks.

The Bollinger Bands are a great way to understand the volatility of a stock or index, it is made of three components:

The middle line, which is the 20-day simple moving average of the closing prices.
An upper band – this is the +2 standard deviation of the middle line.
A lower band – this is the -2 standard deviation of the middle line.

Standard deviation is a statistical concept that measures how much a particular variable deviates from its average. In finance, the standard deviation of a stock’s price represents its volatility. For example, if a stock has a standard deviation of 12%, it means the stock’s price typically fluctuates by 12% from its average price.

Here is a pictorial representation of the Bollinger Bands indicator on the daily price chart of Wipro:

In the above chart, the three values of Bollinger bands as of August 1, 2024 are:

Current Market Price: 521.85
Upper Bollinger Band: 574.46
Middle Bollinger Band: 532.84
Lower Bollinger Band: 491.22

How to trade using Bollinger Bands?

Long trade: Consider going long when the price touches or moves below the lower Bollinger Band. This may indicate that the asset is oversold, and a potential upward reversal could be expected.
Short trade: Consider going short when the price touches or moves above the upper Bollinger Band. This may suggest that the asset is overbought, and a potential downward reversal could occur.

Summary

Indicators like the RSI, MACD, Bollinger Bands, and Supertrend help traders understand market trends, momentum, and entry/exit points.
RSI (Relative Strength Index) is a momentum indicator that identifies overbought and oversold conditions, helping spot potential reversals.
MACD (Moving Average Convergence Divergence) identifies trends and momentum by comparing two moving averages.
Supertrend helps identify the market trend based on the average true range (ATR) and a multiplier.
Bollinger Bands consist of a middle SMA and two standard deviation lines, helping differentiate between volatile and non-volatile market periods.
Indicators like these can generate buy and sell signals, identify trends, and provide insights into market volatility, aiding traders in making informed decisions.
The effectiveness of these indicators can vary depending on market conditions; they are often more reliable in trending markets and may produce false or less accurate signals in sideways markets.

Chapter 11: Indicators - Part 3

In this chapter, we’ll explore additional indicators such as ADX, CPR, ATR, and VWAP. These tools are valuable for assessing market strength, identifying key price levels, and making informed trading decisions.

Average Directional Index

The average directional index (ADX), created by the legendary Welles Wilder in 1978, is a popular technical indicator for identifying strength. Understanding the strength of trends is essential in trading and investing, and the ADX provides valuable insights into these aspects. This is why it has become one of the most widely used technical indicators in trading.

ADX quantifies the strength of a trend. The calculations are based on a moving average of price range expansion over a specific period, typically set to 14 bars by default, though other periods can be used.

Calculation of the ADX will be as follows:
Calculate +DM (Positive Directional Movement) and -DM (Negative Directional Movement):

+DM = Current High – Previous High (if positive and more significant than -DM)
-DM = Previous Low – Current Low (if positive and more significant than +DM)
Use +DM if the difference between the current high and the previous high is greater than the difference between the last low and the current low.
Use -DM if the difference between the prior low and the current low is greater than between the current high and the previous high.

Calculate True Range (TR):
TR is the greatest of the following three:

Current High – Current Low
The absolute value of Current High – Previous Close
The absolute value of Current Low – Previous Close

Smooth the 14-period averages of +DM, -DM, and TR; it is nothing but a calculation of previous averages.

First, calculate the sum (smoothing) of the first 14 readings of TR, +DM, and -DM. This gives the initial smoothed values.

To find the next smoothed value, use this formula:

Next 14th day TR = Previous 14TR – (Previous 14TR / 14) + Current TR
Apply the same formula to +DM and -DM.

Calculate +DI and -DI:

+DI = (Smoothed +DM / Smoothed TR) * 100
-DI = (Smoothed -DM / Smoothed TR) * 100

Calculate Directional Movement Index (DMI):
DMI = [|(+DI) – (-DI)|] / (+DI + -DI) * 100

Calculate ADX:
First, average the DMI values over 14 periods to get the initial ADX value. To continue, use the formula:
ADX = ((Previous ADX * 13) + Current DMI) / 14

Knowing the exact formula of a technical indicator is optional, as most trading software has this built-in. The main focus is on the signals it provides. Now, let’s explore how the ADX can help generate trading signals.

How to trade with the ADX indicator?

The ADX is a momentum-based indicator. When the ADX value rises, it indicates the trend strengthening, whether bullish or bearish. Conversely, if the ADX value decreases, it suggests that the trend’s strength is weakening.

ADX has a value ranging from 0 to 100. Here is a table summarizing the values:

ADX Value	Trend Strength
0-25	Non-trending market or range-bound market
25-50	Strong trend
50-75	Powerful trend
75-100	Solid trend (rarely happens and can be considered unsustainable)

Based on the ADX value, we can determine whether the trend’s strength is bullish or bearish. When plotted on a chart, the ADX indicator will look something like this:

In the chart above, an ADX value of 65 indicates a strong trend, suggesting that Infosys has experienced a significant up-move, and the rally is likely to continue.

Central Pivot Range

Also known as the CPR, this technical indicator is handy for intraday trading, as it helps identify key price points for setting up trades. It’s built on the concepts of support and resistance, which we have learnt in earlier chapters.

It has three components:

1. Pivot
2. Bottom Central Pivot (BC)
3. Top Central Pivot (TC)

These are relatively easy to calculate:

Pivot = (High + Low + Close) / 3
Bottom CPR = (High + Low) / 2
Top CPR = (Pivot – BC) + Pivot

CPR (Central Pivot Range) offers notable advantages by providing traders with precise entry and exit points. It helps set up stop-loss levels and determine key price points. The upper and lower ranges derived from the central pivot point allow for the placement of stop-loss orders at predetermined levels, which enhances risk management and helps traders make informed decisions.

Here are how the CPR lines look when plotted on a price chart:

How to trade using the CPR indicator?

As we know, CPR (Central Pivot Range) consists of three levels: TC (Top Central), BC (Bottom Central), and Pivot.

If the current market price is above the top central line, it indicates a buying opportunity, like the chart above.

Another scenario occurs when the current market price is trading below the bottom central line. This situation suggests a shorting opportunity.

Now, let’s move on to another indicator, the ATR (Average True Range).

Average True Range

The ATR (Average True Range) is a technical indicator used to measure market volatility. It is typically calculated over 14 periods, which can be intraday, daily, weekly, or monthly, depending on the time frame you’re looking at.

ATR is very useful for setting stop-loss levels and targets, as it signals changes in market volatility. The calculation typically uses 14 periods as the lookback.

The formula for the ATR is

ATR = (Previous ATR * (n – 1) + True Range) / n
Where “n” is the number of periods (usually 14).

Step 1: Calculate the True Range (TR) for each day:

True Range is the greatest of the following:

Current High – Current Low
The absolute value of Current High – Previous Close
The absolute value of Current Low – Previous Close

For Day2:
Current High – Current Low = 104 – 99 = 5
|Current High – Previous Close| = |104 – 100| = 4
|Current Low – Previous Close| = |99 – 100| = 1
TR = max(5, 4, 1) = 5

For Day-3:
Current High – Current Low = 105 – 101 = 4
|Current High – Previous Close| = |105 – 103| = 2
|Current Low – Previous Close| = |101 – 103| = 2
TR = max(4, 2, 2) = 4

Continue this for each day until you have the TR values of all 14 days.

Step 2: Calculate the initial ATR using the first 14 days

ATR is the average of the True Ranges over a set number of days, typically 14 days.
Initial ATR = (Sum of first 14 TR values) / 14

Step 3: Calculate subsequent ATR values

Once the initial ATR is calculated, use the following formula for subsequent days:
ATR = [(Previous ATR * (n – 1)) + Current TR] / n
where n is the number of periods
Example Calculation:
Let’s say the first 14 TR values sum to 70, giving an initial ATR of 5. For Day-15:
TR (Day-15) = 6 (hypothetical value)
ATR = [(5 * (14 – 1)) + 6] / 14
ATR = [(5 * 13) + 6] / 14
ATR = (65 + 6) / 14
ATR = 71 / 14
ATR = 5.07

This ATR value of 5.07 represents the average true range over the past 14 days, indicating the market’s volatility.

The higher the ATR, the higher the volatility, and the lower the ATR, the lower the volatility.

How to trade using the Average True Range?

Check the ATR value to understand the stock’s volatility.

Setting Stop-Losses

Long Position: If you’re buying a stock, you can use the ATR to set the stop-loss at a level below the entry price. A standard method is to use 2 x ATR. For example, if the ATR is 2 and you enter a trade at ₹100, set the stop-loss at ₹96 [100 – (2 x 2)].
Short Position: If you’re selling a stock (shorting), you can use the ATR to set the stop-loss above the entry price. If you enter at ₹100 with an ATR of 2, place the stop-loss at ₹104 [100 + (2 x 2)].

Let’s understand with an example.

Based on the chart provided, the current ATR (Average True Range) value for Wipro Ltd. is approximately 14.49. Here’s how you can use this ATR for a long trade in the stock:

Entry Point: Suppose you enter a long trade at the current price of Rs. 521.55.
Stop Loss: Use the ATR to set your stop-loss level. A standard method is to place the stop-loss at 2 x ATR below the entry price.

ATR = 14.49
Stop Loss = Entry Price – (2 x ATR)
Stop Loss = 521.55 – (2 x 14.49)
Stop Loss = 521.55 – 28.98 = ₹492.57

Using the ATR, we can similarly calculate the stop loss for a short position. However, it’s crucial to take positions based on overall market sentiment. You can combine your knowledge of candlestick patterns and other technical indicators to do this effectively.

Volume Weighted Average Price

As you gain experience trading, you’ll realize how crucial volume is in confirming trends. This technical indicator, the volume-weighted average price (VWAP), combines volume with price. It represents the average price of a stock, weighted by the trading volume.

Similar to the moving average, the VWAP calculation experiences a lag because it relies on historical data. This characteristic makes it more suitable for intraday trading.

The formula for VWAP is

VWAP = ∑ (Volume x Price) / ∑Volume

Where:
– Price is the typical price for the period, calculated as (High+Low+Close)/3
– Volume indicates the number of shares traded during that period

ATR = (Previous ATR * (n – 1) + True Range) / n
Where “n” is the number of periods (usually 14).

Let’s assume we have the following data for a stock:

Period	High	Low	Close	Volume
1	105	100	102	200
2	107	101	104	150
3	110	103	109	250

Step 1: Calculate TP (Typical Price) for each period:

TP (1) = (105 + 100 + 102) / 3 = 102.33
TP (2) = (107 + 101 + 104) / 3 = 104.00
TP (3) = (110 + 103 + 109) / 3 = 107.33

Step 2: Calculate TPV (Typical Price x Volume) for each period:

TPV (1) = 102.33 x 200 = 20466
TPV (2) = 104 x 150 = 15600
TPV (3) = 107.33 x 250 = 26832.5

Step 3: Calculate cumulative TPV and cumulative Volume:

Cumulative TPV = 20466 + 15600 + 26832.5 = 62898.5
Cumulative Volume = 200 + 150 + 250 = 600

Step 4: Calculate VWAP:

VWAP = Cumulative TPV / Cumulative Volume
VWAP = 62898.5 / 600 = 104.831

The VWAP for these three periods is 104.83. This value gives the average price the stock has traded, weighted by the trading volume

How to trade the VWAP?

VWAP is commonly used to identify the trend direction. Simply put, if the current price is above the VWAP line, it indicates a bullish trend, suggesting buying opportunities. Conversely, if the current price is below the VWAP line, it indicates a bearish trend, suggesting selling or shorting opportunities.

Entry and Exit Points:

Buying (Long Position)

Entry: Consider buying when the price crosses above the VWAP line. This suggests the stock is gaining strength.
Stop Loss: Place the stop loss slightly below the VWAP line to protect against downside risk if the price drops back below the VWAP.

Selling (Short Position)

Entry: Consider selling or shorting when the price crosses below the VWAP line. This indicates that the stock may be weakening.
Stop Loss: Place the stop loss slightly above the VWAP line to protect against the risk of the price rising back above the VWAP.

Let’s look at an example by analysing the chart of Infosys with the VWAP indicator.

Current Price: ₹1,868.45
VWAP: ₹1,873.33

Analysis based on VWAP
Since the current price is above the current VWAP, a long position should be considered. A stop loss should be set slightly below the VWAP level to protect against a downside move, for example, at ₹1,870.

Summary

ADX (Average Directional Index) measures trend strength. Ranging from 0-100, a rising ADX indicates a strong trend, while a falling ADX signals a weakening trend.
CPR (Central Pivot Range) helps identify key price levels and set stop losses. It includes Pivot, Top Central (TC), and Bottom Central (BC) lines. A price above TC is suggestive of buying opportunities, while a price below BC is suggestive of selling opportunities.
ATR (Average True Range) measures market volatility. It is helpful for setting stop loss levels and entry points, with higher ATR levels indicating higher volatility.
VWAP (Volume Weighted Average Price) combines price and volume to determine the average trading price. A price greater than the VWAP is considered bullish and a price lesser than the VWAP is considered bearish.

Chapter 12: Entering & Exiting a Trade

In this final chapter, we’ll outline a simple process for utilizing technical analysis in trading. Whether new to the markets or experienced, structuring your trade correctly can improve your trading decisions. We’ll also discuss choosing the right timeframe based on your objectives.

We aim to provide a step-by-step guide on integrating the learned concepts into your trading strategy. You’ll navigate the markets more effectively by learning when to enter or exit trades, setting stop-loss levels, and identifying market trends. We’ll also cover risk management.

Defining your objective & selecting the right time frame

Three factors that significantly shape our trading objectives are:

Financial objectives
Time commitment
Risk tolerance

Financial objectives

Are you viewing the stock market as a long-term investment or aiming to achieve a certain income level through trading? Your financial objectives influence your trading strategies and risk management selection, helping you set realistic, achievable goals. Whether you seek steady, long-term growth or quick, short-term returns, your goals will define your approach to the market.

Time commitment

Only some people can sit in front of a screen from the market open until 3:30 PM; we all have different schedules and responsibilities. This factor will largely determine your trading style—intraday, swing, or long-term investing. Understanding your available time will help you choose a trading approach that aligns with your lifestyle and daily commitments.

Risk tolerance

Lastly, your risk tolerance plays a significant role in shaping your objectives. If you have low-risk tolerance, then safer, long-term investments focusing on capital preservation is a good option. On the other hand, if you are comfortable with higher risk, pursuing an aggressive trading strategy aiming for higher returns would be more suitable. Understanding your risk tolerance will ensure your trading style aligns with your comfort level and financial stability.

Choosing the appropriate time frame becomes relatively straightforward if you decide on an objective in trading because they are closely linked. For instance, if someone aims to make quick profits, they prefer shorter time frames, such as intraday or swing trading. This involves frequent trading within minutes, hours, or days, requiring a more active and immediate approach. On the other hand, if the goal is steady growth and capital preservation, a longer time frame, such as positional trading or long-term investing, might be more suitable. This approach involves holding positions for weeks, months, or even years, focusing on fundamental analysis and broader market trends.

Here is a summary of all the timeframes and how much time should be ideally dedicated to them:

Trading Time Frame	Description	Ideal Time Dedication
Scalping	Very short-term trading, holding positions for seconds to minutes. Focus on small price movements.	Full-time, constant monitoring is required throughout the trading session.
Intraday Trading	Trading within a single trading day. Positions are closed before the market closes.	Several hours daily; requires monitoring throughout the day, especially during market opening and closing.
Swing Trading	Holding positions for several days to a few weeks. Capitalizes on short- to medium-term trends.	Moderate; typically, 1-2 hours per day for market analysis and monitoring open positions.
Position Trading	Holding positions for weeks to months. Based on longer-term trends and fundamental analysis.	Limited daily monitoring; more intensive analysis during weekends or after market hours, around 2-3 hours per week.
Long-Term Investing	Holding positions for years. Focus on fundamental analysis and long-term growth.	Minimal daily attention; mainly requires a few hours per month for portfolio review and rebalancing, plus regular updates on financial news and company performance.

As a thumb rule, the higher the timeframe, the more reliable the trading signal is. For example, a bullish engulfing pattern in a 15-minute timeframe is far more trustworthy than a bullish engulfing pattern in a 5-minute timeframe. Keeping this in perspective, one has to choose a timeframe based on the intended length of the trade.

Lookback Period

As a beginner, it can be unclear how many candles to consider for trading. The lookback period is the number of candles you review before trading. For instance, a lookback period of two weeks means you analyze today’s candle within the context of the past two weeks of data. This helps you understand today’s price action with respect to past market movements, giving you insight into shorter-term trends and potential price patterns.

For swing trading opportunities, an ideal lookback period is between 6 months to 1 year. This timeframe provides a comprehensive view of market trends and potential setups, helping you make well-informed trading decisions. In contrast, for scalping, focusing on the last five days of data is more effective, as it allows you to capture the most recent price movements and respond quickly to market changes.

Trading Style	Lookback Period	Purpose
Scalping	Last 5 days	Capture the most recent price movements for quick response.
Intraday Trading	1-3 weeks	Identify short-term trends and key levels within the trading day.
Swing Trading	6 months – 1 year	Comprehensive view of market trends and potential setups.
Position Trading	1-2 years	Analyze longer-term trends and major support/resistance levels.
Long-Term Investing	3-5 years	Focus on long-term trends and major support/resistance zones.

When plotting support and resistance levels, extending the lookback period to at least two years is essential. This longer timeframe helps identify significant historical levels that could influence current price action, ensuring a more accurate analysis of potential market behavior.

⁠Trading Universe

There are ~5,000 stocks listed on the Bombay Stock Exchange (BSE) and ~2,600 on the National Stock Exchange (NSE). It’s well known that scanning for opportunities across thousands of stocks daily can be overwhelming. Over time, narrowing down on a set of stocks you feel comfortable trading in is essential. This set of stocks becomes your “Trading Universe.” By focusing on this specific universe, you can more effectively scan for and identify potential trading opportunities daily, making the process more manageable and focused.

Here are some key pointers to keep in mind while defining a trading universe:

1. Make sure the stock you’re trading in is liquid. You need someone to sell when you’re buying and buy when you’re selling.

One way to ensure this is to gauge the bid-ask spread; the less spread, the more liquid the stock is.
Another way would be to check the volume, i.e., the number of shares traded. Many traders set minimum criteria of considering only those stocks with a daily volume of at least 50,000.

2. Ensure the stock is in the ‘EQ’, i.e., equity segment, which allows for day trading. Stocks that are part of the F&O segment are subject to getting banned for intraday trading. While day trading isn’t recommended for beginners, sometimes you may start a trade intending to hold it longer but find that your target is reached on the same day. In such cases, closing the position within the day is okay, which is possible with ‘EQ’ segment stocks.

3. Try avoiding operator-driven stocks. Unfortunately, there is no quantifiable method for identifying operator-driven stocks. Staying updated with the latest news can help you avoid such stocks.

It is recommended that you start with the Nifty 500 as your opportunity universe, especially for swing and positional trading, as most stocks in this index comply with the above 3 criteria.

Nifty 500 is a stock market index in India that showcases the top 500 companies listed on the National Stock Exchange (NSE). These companies are chosen based on their market capitalization, which measures a company’s value in the stock market. To calculate market capitalization, you multiply the company’s current share price by the total number of its outstanding shares.

Nifty 500 has various stocks from all the sectors IT, financial services etc.,

Trading process

Let’s discuss how to select stocks for trading, similar to applying filters while finding your favourite product on an online marketplace.

Assuming we are swing traders, let’s recap defining our objectives, shortlisting a stock, and taking a trade. This means that:

Our objective is to make quick returns over a few days or weeks
We would have to give 1-2 hours per day for market analysis
We can tolerate moderate risk
Our trading universe would be the Nifty 50
Our lookback would be between 6 months to 1 year. We would be looking at the past 1-2 years while plotting the support and resistance level

Here’s a good process you can follow:

First, create a watchlist from the Nifty 500 universe. Recall that we need liquid stocks not part of the ‘F&O’ segment. We can add more conditions to trim our watchlist further. We feel confident trading on a positive day, so we will add another criterion of the stock being bullish on the current day. You can use other filters as well. Some examples are choosing stocks trading with above-average volumes on that day, looking at stocks from a specific sector, or using indicators, like only shortlisting stocks whose RSI is above 70.Many stock scanning tools will help you filter stocks based on your criteria. We created the following scanner to shortlist stocks as per the criteria we mentioned: https://chartink.com/screener/nifty-500-swing-trading-beginner.
Next, look at the stocks’ charts that the scanner shortlists. As of this writing, our scanner has shortlisted 43 stocks.
While looking at the stock charts, try plotting the support and resistance levels. Remember, a lookback period of 1-2 years is deal for this.
Next, look at the latest 15-20 candles. Is the stock forming higher highs or lower lows, or is the trend looking like it’s changing direction? Once we know the stock’s momentum, notice the latest 3-4 candles. Is there a candlestick or chart pattern being formed?
If you find any recognizable pattern, shortlist this stock for further investigation.

The final step is to analyze all the shortlisted stocks from our trading universe that exhibit recognizable patterns. Once we identify such patterns, we will delve deeper into each stock, trying to decode the pattern and understand it better. Here’s an example:

We have to see how reliable the pattern is. For instance, if we spot a head and shoulders pattern, we will examine the symmetry and proportion of the shoulders and head to determine the pattern’s reliability.
The prior trend is crucial for any pattern. For a bullish pattern to be valid, the preceding trend should be downward. Conversely, for a bearish pattern to hold, the preceding trend should be upward.
If all these are in place, we can analyze the chart further.
Another critical factor to look at is the volume. It should be at least higher than the 10-day average. This confirms that the stock or index has strong momentum. Realize that for large caps, it is unusual to spot a stock trading at 2X of its average on a good trading day, whereas it is common for mid-caps and small caps to trade at even 3X to 5X of their average volumes on good trading days.
If both the candlestick pattern and volume confirm the trade, we then check the support level for a long trade and the resistance level for a short trade.
These levels should align as closely as possible with the stop-loss defined by the candlestick pattern. If the support or resistance level is more than 5% away from the stop-loss, we would be hesitant to continue evaluating that chart and rather move on to the next one.
If steps 1 to 6 are satisfactory, we will calculate the risk-to-reward ratio (RRR). To calculate the RRR, we would first establish the target by plotting the support/resistance level or by defining the target depending on the candlestick or chart pattern we decided to trade on. The minimum risk-to-reward ratio should be at least 1.5.
Finally, we look at some indicators to get a confirmation for the trade. It is good to look at moving averages and the RSI indicator.

Sometimes, we may not find any stocks that pass our checklist. In such cases, avoiding trading on those days is the best course of action. Remember, not making a loss is also a form of profit.

After placing a trade, you should wait until the target is reached or the stop-loss is triggered. It’s an excellent practice to trail our stop-loss as the trade progresses. We should avoid making changes if the trade meets all our checklist criteria. Trusting the well-planned trade increases the likelihood of success, so it’s essential to remain patient and confident.

Managing your trades

After successfully entering a trade, the next crucial step is to manage our trades while holding our positions effectively. This involves three key components: risk management, capital deployment, and trailing our stop loss. Let’s delve into these aspects to ensure a well-rounded trading strategy.

Risk management

Firstly, we must decide how much capital we will risk per trade. This depends on our risk tolerance. A good way to quantify the risk tolerance is by deciding the total amount we will lose per trade. Assuming our risk tolerance is 1%-2%, if we are trading with a capital of ₹1,00,000, we should be comfortable losing ₹1,000 to ₹2,000 in a single trade. Setting up the stop loss is crucial, and we should use our technical analysis concepts. We can determine the stop loss using support and resistance levels, the Central Pivot Range (CPR), or any method that suits us best.

Secondly, let’s look at position sizing, i.e., how much capital should be deployed for each trade. This helps to identify the number of shares or contracts to buy or sell so that you can manage risk and maximize potential returns.

Here’s a good formula:
Position Size = (Account Equity * Risk Percentage) / (Entry Price – Stop Loss Price)

where,
– Account Equity: The total amount of money you have in your trading account
– Risk Percentage: The small portion of your money you are willing to lose on one trade (usually 1-2%)
– Entry Price: The price at which you buy the stock
– Stop Loss Price: The price at which you will sell the stock to prevent further losses

Here is a simple example.

Assume we decide to buy shares of Reliance Industries. The current price (Entry Price) is ₹2,000 per share, and based on technical analysis, we set our stop loss at ₹1,950 (Stop Loss Price) to limit our potential loss to ₹50 per share.

Using the position sizing formula:

Position Size= (AccountEquity * Risk Percentage) / (Entry Price − Stop Loss Price)

Position size = (1,00,000 * 0.02) / (2,000−1,950)

Position size = 1,00,000 * 0.02) / (2,000 – 1,950)

Position size= 2,000 / 50

Position size= 40
So, we should buy 40 shares of Reliance Industries. If the stock hits our stop loss price of ₹1,950, we will lose only ₹2,000, which is within our risk tolerance.

Thirdly, we need to set a target based on the risk-to-reward ratio. A common practice is to ensure a ratio of at least 1.5:1. For every Rs 1 we risk, there should be a potential reward of 1.5.

Capital deployment

The next step is to focus on capital deployment. Proper capital deployment is essential to avoid putting too much money into one trade. Let’s look at how to use our capital effectively to make the most profit while keeping risks low.

Recall the famous saying by stock market king Warren Buffett,

In quote box – “Don’t put all your eggs in one basket.”

When we are trading, it is very important to keep focus on a manageable number of trades.

Imagine you’re a juggler. If you juggle too many balls, you’ll likely drop some. The same goes for trading. The key is to find a balance between having enough trades to diversify but not so many that you can’t keep up.

Start with just 1-2 trades at a time. As they become manageable, you can expand to 3-4 stocks. This will allow you to stay updated on each stock’s movements without feeling overwhelmed.

By focusing on fewer stocks, you can closely monitor news, earnings reports, and price movements. This allows you to make quick decisions because you know your stocks well. Additionally, tracking fewer stocks reduces stress and minimizes the chances of making mistakes.

In the morning, check pre-market news and identify any major events that might affect your stocks. During the day, monitor price movements and trading volumes. In the evening, review the day’s performance, update your trading journal, and adjust your strategy if needed.

Another effective way to manage our capital is by deploying it in phases rather than simultaneously entering a trade with the entire set capital.

For example, if trading with a capital of ₹1,00,000, we might initially deploy ₹75,000. If the trade continues to go our way, we can add another ₹10,000 and another ₹15,000, incrementally increasing our position based on our risk tolerance and trade confidence. This approach allows us to manage risk more effectively than going all-in with a single trade.

Although the profit on our total capital deployed in the trade may be lower, we are ensuring that capital is not making a loss, at the least.

Trailing stop losses

You must be familiar with the stop loss concept, which helps limit our losses if the stock price goes down. However, sometimes, a trade goes in our favor for a while before reversing and hitting our stop loss. To avoid this, it is better to use a trailing stop loss. This means adjusting our stop loss level upward as the stock price rises. We can’t do that randomly though. Strategically, here are five ways of how it can be done:

A standard method is to set a trailing stop loss at a certain percentage below the highest price reached (for long trades) or above the lowest price reached (for short trades). For example, if you had set a 5% stop loss rule when you entered at ₹100, the stop loss would be at ₹95. If the price goes to ₹105, the new stop loss would be 5% below ₹105, which is at ₹99.75.
You can also effectively implement trailing stop losses using the Average True Range (ATR). The ATR helps measure market volatility, and you can set a trailing stop at a multiple of the ATR value from the current price. A quick recap on using the ATR indicator might help.
Another method is to use moving averages as a dynamic stop loss level. By trailing the stop loss at the 20-day moving average, for example, you can follow the stock’s trend while allowing for normal price fluctuations. Both methods provide a systematic approach to protecting your profits and managing risk as the trade moves in your favor.
You can also move your stop loss to crucial support or resistance levels as the trade progresses. For instance, the Central Pivot Range (CPR) can help identify significant price levels where the stock may find support or resistance.
Fibonacci levels are also helpful in setting trailing stop losses, as they indicate potential reversal points based on the stock’s recent price movements. By adjusting your stop loss to these critical levels, you can better protect your profits and allow the trade to develop within the market’s natural fluctuations.

Fibonacci levels

These are key price points on a stock chart that indicate where the price might reverse or pause. These levels are based on a mathematical sequence and are used to identify potential support and resistance areas.

Nifty 500 has various stocks from all the sectors IT, financial services etc.,

Summary

Determine your trading style based on time commitment and financial goals, choosing time frames that align with your objectives.
For swing trading, use a lookback period of 6 months to 1 year; for scalping, focus on the last five days; and for drawing support and resistance levels, use at least two years.
Focus on a manageable set of stocks, ensuring they are liquid and in the ‘EQ’ segment; stick to Nifty 500 for simplicity and reliability.
Risk 1% to 2% of capital per trade and ensure a Risk-to-Reward Ratio (RRR) of at least 1.5:1.
Diversify across multiple stocks, use a phased entry style to manage risk effectively, and avoid putting all capital into a single trade.
Adjust the stop loss upwards as the stock price rises using ATR or moving averages to dynamically trail the stop loss. Set stop losses at critical support or resistance levels to protect profits.
Look for recognizable patterns and confirm with volume. Ensure that patterns align with prior trends. Check support and resistance levels relative to the stop loss. Calculate and confirm RRR before entering the trade.
Place trades based on the checklist criteria, avoid making changes once the trade is placed and remain patient and confident in your well-planned trades.
If no stocks pass the checklist, avoid trading that day and recognize that preventing losses is also a form of profit.

Fundamental Analysis Guide

Learn to analyze companies, read financial statements, and invest for the long term with our comprehensive guide on fundamental analysis.

Chapter 1: Introduction to Fundamental Analysis

How can you tell if a stock is worth its price? In this chapter, we will uncover how investors look beyond the stock price at its value to generate wealth in the long term. We will touch upon the concept of fundamental analysis and how to approach it.

"Price is what you pay, and value is what you get."

- Famed value investor Warren Buffett

The search for value makes a housewife, a businessman, a student, and a secretary an investor. Deep inside, everyone wants to convert ₹50,000 into ₹1 crore. But it requires time, patience, and an optimistic outlook.

Benjamin Graham, the father of value investing, said, “A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”

Investors use what is known as fundamental analysis to identify this “underlying value,” i.e., to look at a stock beyond its price at its business and management quality.

What is Fundamental Analysis?

By definition, being “fundamental” means being the basic constituent of a system, a foundation without which the entire system will collapse. For a human being, water, air, and food are the “fundamentals” of life.

Similarly, cash inflows (through revenue, investment, capital) and cash outflows (expenses, debt, investing in the business) are the fundamentals of any business. When the cash flows in and out smoothly, the fundamentals of a business stay strong. Driving this cash flow is the business model of a company. A business model defines how a company makes money, which products or services it will sell, to whom, and how (marketing, branding, and distribution). The model also defines the expenses and how the company will raise money to cover these expenses.

Fundamental analysis is understanding the fundamentals or vitals of a business: mapping their historical trend and comparing them with peers, analyzing the factors affecting these vitals, and determining what management is doing to keep them healthy.

What are the fundamentals of a business?

Let’s start with the question at the core of all business activities: What is the main objective of doing business? The answer is quite straightforward: to make profits by offering some form of value. To do this, you need to focus on the three basic fundamentals of any business:

Revenue, i.e., how a business makes money
Net profit, i.e., how much money is it able to keep
Cash flow, i.e., how much of this money is real

All business strategies aim to grow or diversify these three fundamentals to achieve their main objective. Be it Mahindra & Mahindra investing ₹26,000 crores in producing EVs, SUVs, and commercial vehicles or ITC demerging its hotel business, all strategies aim to boost revenue, profits, and cash flows. Even Vodafone Idea converted its ₹16,000 interest into equity to free up some cash flow to invest in 5G infrastructure and sustain its revenue.

Any problems in these three fundamentals can shake the foundation of a company.

One of the biggest examples of this is the 2024 Paytm crisis, when the RBI stopped all new deposits into the Paytm Payments Bank on March 15, 2024. This restriction directly impacted Paytm’s revenue, sending the shares down, whereas rivals PhonePe and Airtel Payments Bank’s revenues surged as they poached Paytm’s customers.

Intrinsic Value

Intrinsic value is the underlying value of a stock that investors calculate based on what they perceive about the company’s future cash flow potential. When you determine the intrinsic value of a stock, you can compare it with the current stock price to determine if the stock is overvalued or undervalued by the market.

You can use these core fundamentals to arrive at an intrinsic value that you believe justifies the company’s worth. The intrinsic value is determined using fundamental analysis to forecast the company’s future cash flows.

Why does one need fundamental analysis?

Let’s take the example of Eicher Motors, the maker of the famous Royal Enfield bikes. Today, you would have a rugged bike if you had invested ₹55,000 in a Royal Enfield in 2004. But if you had invested the same amount in Eicher Motors shares instead, today you would have ₹1.5 crores – enough to buy 37 of the Super Meteor 650 bikes, Royal Enfield’s most expensive model in India!

What happened in 2004 that fundamental investors saw, but the market didn’t?

30-year-old Siddhartha Lal took over as COO of Eicher Motors when the stock was trading at ₹17.5 a share and made a difficult choice: to prune its 15 businesses, where it was a mediocre player, into just two businesses where it had the potential to be the market leader. At ₹17.5, the stock was actually trading at double the price it was trading two years ago (₹8.4 in January 2002).

This ₹17.5 is the price you would have paid in 2004 to get one-share ownership in a company that went from selling 50,000 bikes in 2009 to 835,000 in 2024.

Focus on business growth; stock price appreciation will follow

Siddhartha Lal’s vision was to be the master of one instead of a jack of all trades. He put the company’s focus and resources on improving the Enfield bikes. A passionate biker, he knew what the customer wanted and ensured his team knew it. Riding the Enfield with his team for hundreds of kilometers, he identified places for improvement and soon perfected the bike.

Royal Enfield offered neither in a market obsessed with mileage and fuel efficiency. What it did offer was a stature and legacy, and that too at a premium price. The company capitalized on this legacy. It took four years for the company to pick up sales momentum. The company’s fundamentals improved as production costs reduced and sales volumes surged.

It was only in 2009 that Eicher Motors’ stock began taking a vertical jump from ₹20.84 to over ₹3,000 in 2018—ten straight years of the rally! While the stock saw a rough patch between 2018 and 2020, its fundamentals remained strong, and it rallied to ₹4,700.

Siddharth Lal spent four years refining the product and manufacturing, enhancing the company’s value by focusing on its strengths. The ₹17.5 price might have looked high in 2004. However, a fundamental investor looked beyond the stock price at the business and the management, who were focused on long-term growth and generating shareholder value. Even today (2024), the company is focused on Royal Enfield and VE commercial vehicles, a partnership with Volvo to make trucks.

This doesn’t mean only premium brands generate high returns. It also depends on their business strategy and focus and whether the potential growth estimate seems achievable.

This is one of the many examples of how fundamental analysis can create wealth for those who remain invested.

Fundamental analysis is all about knowing the ‘Why?’: Why do you want to invest in this sector or this stock? Why do you think your thesis will play out?

Technical Analysis vs Fundamental Analysis:

In the stock market, there are two types of people: Traders and Investors.

Traders use technical analysis to make a trade. They enter the market to buy low and sell high to make quick profits. They are on top of all the updates and deeply understand every asset class – gold, equity, currency, commodity – and the market dynamics.

They use a combination of technical analysis, number crunching, analyzing huge amounts of data sets, identifying chart patterns, and implementing market strategies. In technical analysis, a stock is just a ticker trading on the stock exchange, having price momentum and chart patterns. Traders need behavioral qualities like risk-taking, analytical thinking, and number-based decision-making to make a sound trade.

Then, some investors are in the market to generate wealth over the long term. They take time to find the stocks they feel confident about and stay invested for several years. News and events do not affect them as long as the company has what it takes to grow.

Traders and investors react to a situation differently. Take the Union Budget, which was announced by the government on February 1 every year, for instance.

Ashok is a trader and believes the Budget will focus more on defense. Hence, he buys defense stocks a week ahead of the budget and sells them after the budget is announced. Similarly, he buys space stocks before the Chandrayaan-3 launch and sells them after a successful launch. Here, Ashok’s objective is to generate returns in the short term. Technical analysis can help you time the market and grab opportunities to make quick returns on some events.

If your objective is to convert ₹50,000 into ₹1 crore, technical analysis alone won’t suffice. You also need to make long-term investments. Let your money spend time in the market. Long-term refers to a period of 5 years and above. A lot can happen in these 5 years. Hence, you need fundamental analysis to ensure the company stays relevant and grows long-term.

The Mindset of a Fundamental Investor

Anyone with basic business knowledge can become a fundamental investor. Warren Buffett’s 2023 letter to shareholders defines a fundamental investor in the most basic form. He gave the example of his sister Bertie, who isn’t an economic expert, an accountant, or even an MBA in Finance. But she is a person with common sense who understands many accounting terms, reads the newspaper daily, and observes human behavior. She can tell who is selling and who she can trust – all necessary traits for fundamental analysis.

There is a misconception that fundamental analysis needs data and high-level mathematical skills. A true fundamental analyst needs a business mindset. They need to think of a stock as their own company and understand what’s best for its growth. The math in the analysis is simple addition, subtraction, multiplication, and division. All you have to do is identify whether you are making a profit.

Though we will dive deeper into the concepts of fundamental analysis in further chapters, here’s how great investors do it:

Know how the company earns money – can it continue to earn money 10 years later?
Know how to read books of account – to build practical expectations of its future earnings and review the books to compare actual numbers with your expectations.
Willing to read and study – they are willing to understand the terms, logic, subjects, and skills. They read things beyond finance and never stop learning.
Can differentiate between ‘information’ and ‘influence’ – Fundamental investors have their own thoughts and opinions and aren’t easily influenced by what others say.
Are open to change – The future is unpredictable. Facts can change and one should change with them and adjust their investments accordingly.

The ‘funda’ of Fundamental Analysis:

In a nutshell, fundamental analysis is all about identifying and giving preference to a company’s business over the stock price. An investment decision based on sound and informed fundamental analysis can give you confidence to stay invested over the long term and generate wealth.

In this guide, we will learn how to do fundamental analysis from scratch, from studying the business and how it earns money to analyzing a company’s qualitative and quantitative aspects.

In Summary:

A stock is not just a ticker symbol or an electronic blip but an ownership interest in an actual business.
Fundamental analysis is understanding these three fundamentals: Revenue, Net Profit, and Cash Flow.
To perform fundamental analysis, you should know about the company, stay informed about its happenings, and make sense of the fundamental figures.
Traders use technical analysis to make short-term gains based on news and events. Investors use fundamental analysis to understand the company and invest to generate wealth in the long term.
Fundamental analysis doesn’t need you to know advanced maths or be a CA. You should be able to read and interpret a company’s financial statements and other qualitative aspects to understand if it can sustain and grow in the long term.

Chapter 2: It’s Your Business!

The first step in fundamental analysis is understanding the company’s business in which you want to invest. Business is a very broad term. In this chapter, we will understand how to research a company from an investor’s perspective. What aspects does an investor need to look for in a company’s business to make sense of its financial statements? Let’s understand…

The very beginning of fundamental analysis is knowing the business you are getting into. If you are looking to invest in a company (i.e., buy shares of that company), it is all about your business to know how the company makes money.

What exactly is “business” in the first place?

Richard Branson, co-founder of Virgin Group, said,

"A business is simply an idea to make other people’s lives better"

Making money in the process isn’t a bad thing, either. The business idea involves finding a need or a want in the market and testing whether people are willing to pay to fulfill this want or need.

Why should you understand a business?

As discussed in the previous chapter, a fundamental investor needs to think of a stock as their own company and understand what’s best for its growth.

When you know what the business does and how it makes money, you can make sense of the financial figures such as revenue and profits. You can build your understanding of the company’s potential to grow and sustain in a dynamic business environment.

To understand the business of a company you want to invest in, you need to understand:

The business model
The business growth cycle
The business environment a company operates in
Macroeconomic aspects that affect participants in the economy

The business model

A business model is a detailed plan of how the company intends to profit from the business idea. Some of the craziest business ideas that nobody thought would ever succeed include selling packaged drinking water (Bisleri) when it was freely available at public water coolers, creating a movie ticket booking app when one could easily book a ticket (Bookmyshow) at the counter, and using a prepaid wallet (PhonePe) when one could pay in cash or through net banking. However, their business models converted these ideas into profitable business ventures, and in a great way indeed. A business model tells you about:

The offering: The business model describes the product or service that the company offers, what need/want the offering aims to fulfill, how the offering is priced, packaged, and sold (marketing), who the target customer is and other details.

The business structure: The business model describes how the company plans to manufacture or source the materials, distribute and market the product or service, the cost incurred, how much investment the company needs, and where it will use it.

The growth potential: The business model also outlines the road to growth and expansion, stating how it plans to scale its operations.

There are various types of business models. The most common is a manufacturing model, where businesses produce and sell an item to the customer. Automotive companies, fast-moving consumer goods companies, and even mobile phone companies follow this traditional business model. Here’s a summary of the most common types of models:

Model	Examples	About the business model
Retailer model	Reliance Retail, DMart	The business buys finished goods from manufacturers or distributors and sells them directly to customers.
Subscription model	Netflix, Economic Times	The business offers products or services with recurring payments to lure them into long-term, loyal customers.
Freemium model	LinkedIn, Spotify	The business attracts customers by offering basic products (sample packs) or services for free to convert them into premium customers and unlock advanced features.
Marketplace model	Amazon and Flipkart	The business offers a marketplace, digital or physical (malls) that attracts customer footfall. It charges businesses for displaying their products/services on the marketplace platform.
Franchise model	Pizza Hut and McDonald’s	The business replicates a tried-and-tested business model in different locations. In return for a percentage of earnings, it provides incoming franchisees with a brand name, finance, promotion, and operating guidelines.

The company’s management can start with one business model and keep adding, innovating, and evolving its model with time, depending on its target audience’s changing needs and wants.
To give you a practical example of a successful business model that evolved with time and remained relevant, let’s talk about Apple.

Apple started out with the traditional manufacturing model, developing the brand and product (iPhone, Mac, Apple watch) and selling them to anyone looking for a secure computing experience and aesthetic value. Its business structure was to outsource its manufacturing and assembly to China to reduce production costs. There was a huge market to tap through geographic expansion, technology upgrades, and new product launches. This model helped Apple become the first stock to reach a $1 trillion market capitalization.

Market capitalization

A company’s share price is multiplied by the number of shares trading on the stock exchange. So if X Co. has 100 shares trading on the stock exchange at Rs. 5 per share, its market cap is Rs. 500. The total market value of all outstanding shares is Rs 500. The market cap determines a company’s size (large-cap, mid-cap, small-cap) and compares its performance with other companies of different sizes.

Where to find a company’s business model?

No set format or document exists where a company details its business model. It is at the company’s discretion how much it wants to reveal. However, a company’s Annual Report is the best place to begin. Apart from that, you can do your research by reading newsletters, analysts’ reports, CEO interviews, and detailed videos and podcasts to build your understanding of the company’s business model.

Fundamental research requires using multiple reference materials, annual reports, trustworthy news sources, and past news stories in business newspapers/magazines to build your understanding of the business.

The key skill of a fundamental investor is having their thought process and opinions formed on the foundation of the data and information they collect. They do their research rather than getting influenced by rumors.

How to analyze a business model?
Two companies can have the same business model and yet deliver different outcomes. This is because a business’s success or failure depends on how its management executes the business idea through the business model. For multiple reasons, one company could perform better than another with the same business model.

This is where the second step of understanding the business life cycle emerges.

Life-cycle of business

Imagine Amar and Ajay driving the same car, but Amar driving at 60km per hour and Ajay at 120 km per hour. Their performance (risk and reward) will differ in the short and long term. The same goes for a business cycle. Understanding the speed at which revenue and profit are growing can help you determine which phase of the business lifecycle the company is in.

A business’s lifecycle defines its progression in stages. Typically, there are five stages of a business lifecycle.

1. Launch stage

This is where the company is a startup trying and testing its business model. Its main objective is to attract customers through a value proposition and deliver the product/service. A company in this stage has low sales and high advertising and market expenses. It may also have low to no debt, as banks are skeptical of giving loans to startups whose business models have not yet proven to generate results.

Companies at this stage need more historical data to help analyze the company. Here, you have to rely more on qualitative analysis that focuses on the company’s owner(s), who are the whole and soul of the company. Startups generally get seed funding from relatives, friends, angel investors, and their own money.

2. Growth stage

Once the company has secured its existence and built a decent customer base and revenue stream, the owner focuses on survival. This is the stage where you know the business model is working, and now it has to survive in the business community. Hence, the focus extends to recovering costs and breaking even while growing revenue. The growth phase is the longest and most lucrative time for both the company and its investors.

Think of it like your school and college days. Just like you learned multiple subjects, developed hobbies, identified your strengths and weaknesses, and polished your skills, a business does the same in the growth stage.

This could be a crucial stage as many unforeseen events, ineffective management, new product failures, or risky decisions could strike and pull the company back into the survival stage. Many examples of growing companies were pulled back while they were at the peak of their growth.

Consider Yes Bank, a fundamentally strong bank run by the balanced combination of Rana Kapoor (the aggressive) and his brother-in-law Ashok Kapur (the conservative). After Ashok Kapur’s demise in 2008, the scales tilted heavily towards risky decisions as the bank started lending to companies under financial stress, including the Anil Ambani Group, Dewan Housing Finance Corporation, and the Zee Group. While these decisions resulted in significant growth in the short term, they also increased the risk of Yes Bank.

A 2015 UBS report found that such loans exceeded Yes Bank’s net worth. While the bank was growing aggressively, the business risk increased significantly, and it was only a matter of time before these stressed loans hit the fundamentals. Since RBI closely regulates banks, the regulator intervened in August 2018 and refused to extend Rana Kapoor’s tenure as the CEO, which was coming to an end in January 2019. A new CEO was instituted. From there began a series of unfortunate events that led to depositors withdrawing cash and a falling stock price, among other things.

3. Shake-out stage

This is the stage where a company moves towards its peak. It is growing revenue but at a slower rate. The company begins to see market saturation or new competitors taking over market share. This is where the cash flows grow faster than profits. Since many companies see money in the business, competition intensifies as too many players spring up to grab a slice of the profit pie.

Not many companies have reached this stage. Sometimes it is the nature of the business/industry and sometimes it is the constant fire-fighting within the company. But a business that reaches the shake-out stage has relatively lower business risk than those in the growth stage.

4. Maturity stage

This is the stage where a company has reached its peak. It is a market leader, and competition no longer affects it. IT giants like Infosys, TCS, and Wipro have achieved this stage. They have a strong history and high cash flows. However, sales stagnate and decline gradually at this stage unless a new category is entered.

The company has already implemented the growth plans mentioned in the business model. The challenge is to find the next growth factor. They are resourceful, have plenty of cash, a brand name, a loyal customer base, and the skill and talent to pursue the next growth expedition. Active management may revisit, review, and redesign the business model to adapt to change and find a new value proposition to extend its lifecycle.

5. Decline stage

Many companies, like Apple, stay in the maturity stage for a long time. However, some need help keeping up with the changing business environment and technological advancements, which pushes them into the decline stage. The company’s sales, profits, and cash flows fall faster as it loses its competitive edge. Then comes the point where the company exits the market.

However, a complete restructuring can turn a business from near bankruptcy to profitability. A turnaround can be made through a management reshuffle, a new business model, and a new beginning from the survival phase because a declining stock is as risky as a startup.

No guidebook can tell you which company is at which business lifecycle stage. You have to observe the qualitative (growth strategy, offerings) and quantitative (revenue and profit growth rate) fundamentals to identify the phase in which the business is operating.

Going back to our earlier example of Apple…

Apple rose to glory in 2007 on the back of its flagship iPhone. After 9 years of capturing the market, it reported its first decline in iPhone sales in August 2016 as the mobile phone market had reached a saturation point. People needed more time to be ready for a $1,000 price tag for a mobile phone. Moreover, the company needed to catch up on technology, making adding new features to the phone difficult.

Apple was at the maturity stage. It went back to the drawing board and adopted a service-based model. It used its existing iOS ecosystem to sell various subscriptions and services, such as Apple TV, iTunes, etc. and extended its lifecycle. This boosted its sales and revenue, bringing the stock to the $1 trillion market valuation.

In the meantime, it kept innovating new products. Apple Watch and Airpod extended its lifecycle and found the next $1 trillion valuation in August 2020. With the market fast saturating, Apple is continuously developing new products to find its next growth cycle. The company has a loyal customer base despite competition.

Understanding the business environmen

So far, we have focused on what goes on inside the business. However, a company operates in an economy where several players are present. The business interacts with these players directly or indirectly and maintains its momentum. While understanding the business, you also need to understand the industry the company operates in and how macroeconomic factors impact its growth and sustainability.

One of the most commonly used analysis frameworks is Porter’s 5 Forces. Michael Porter introduced this strategic analysis model in a 1979 article published in the Harvard Business Review. It is used to understand an industry’s competitive landscape.

Let’s look at each one.

1. Competitive rivalry: Here, you look at the intensity of the competition and where your company stands in comparison. Is it a market player or a new entrant? How many strong contenders are there for the market share?

Intense competition caused by price wars affects a company’s ability to charge a premium, increasing marketing costs to poach each other’s customers. Some good examples are Coca-Cola vs. Pepsi, McDonald’s vs. Burger King, and Airtel vs. Jio. Mild competition gives the company an edge to charge a premium and reduces customer retention stress. The focus shifts to supply and operations.

2. Potential for new entrants: Here, you look at how difficult it is to enter this business. Are there any barriers to entry, such as initial capital requirements and regulatory approvals? For instance, banks and hospitals are highly regulated, whereas telecom and airlines need huge initial capital, creating a barrier for new entrants. On the other hand, the restaurant industry has low entry barriers, making it highly competitive.

3. Threat of substitutes: A substitute, though not a directly competitive product, could reduce the overall demand for the product/service. For instance, mobile phones substituted landline phones, OTT platforms substituted Cable TV, and digital cameras substituted reel cameras. A substitute shifts the demand and reduces the overall market for the business. Sometimes, it can also cause an existential crisis for an industry. If the threat of substitution is high, you should examine the company’s strategy to innovate and grow with the trend. Kodak’s management’s inability to incorporate digital photography into its business model led to its downfall.

4. Bargaining power of supplier: The power to bargain comes when supply is abundant. If the supplier offers a niche product that is highly technical or has limited availability, the company could face higher inventory costs or a disruption in its operations due to a lack of supply.
Pratt & Whitney supplies jet engines to airlines worldwide and has strong bargaining power. A technical issue in its engines grounded several aircraft, costing airlines massive losses as they could not fly those planes despite high demand. Go First Airlines even filed for bankruptcy because of the engine issue. On the other hand, when supply is abundant, suppliers tend to lose, and the company benefits as they can buy at a huge discount.

5. Bargaining power of customer: A customer’s bargaining power defines how competitive the market is and how easy it is to switch. When customers have high bargaining power, as in the case of mobile phone services (Jio, Airtel, Vodafone Idea), there are price wars that affect companies’ profits. On the other hand, when customers have low bargaining power, such as petrol and electricity, the company’s profits are stable.

Tip

Studying a company is like preparing a presentation. The above three concepts—business model, business lifecycle, and business environment—can help you create a framework for your research. It tells you how to analyze the company’s business. As Charlie Munger beautifully puts it, “Understanding how to be a good investor makes you a better business manager and vice versa.” The initial understanding of the company will help you build a strong foundation for your analysis. It’s essential to stay updated on the current happenings in the business world. You can subscribe to business newspapers, set news alerts, and spend 30 minutes daily reading the news.

How a fundamental investor studies a business?

To be a fundamental investor, you need to think like the captain of a cricket team. First you need to observe and analyse all the players, their strengths and weaknesses, before selecting your final team (business model). But having selected the best possible team isn’t enough. What kind of a pitch are you playing on, are the weather conditions in your favour, is the outfield slow or fast – every last detail matters (business environment) as it affects your overall game.

Similarly, just zeroing in on a stock or company with a successful business model isn’t enough. You need to be aware and updated on the macroeconomic environment (consumer spending, government policies), competitors and business environment, and the core strengths of your company. Only when you have the complete picture can you design a game-winning strategy.
And even a sound, solid strategy can only help you make a good start. Once the game begins, its all about the score. As a batsman, you will have to face a volley of googlies, short balls and bouncers. You need to be sharp in analysing the bowler’s stride and length to tackle the ball coming your way – and you need to do all this as you stand at the crease (Business lifecycle).

Fortunately, for investors, there is a way of accessing and analysing a company’s scores before and after investing in a stock.

With the help of financial statements, which we will cover in the next chapter.

Summary

A business is an idea to fulfill a demand/need and make money in the process. A fundamental investor should know the business of the company they are investing in to make sense of the financial figures.
To understand a business, you need to do research about the company’s business model, business lifecycle and the business environment the company operates in.
To study a business model, look at the company’s product/service offerings, business structure, and growth plans. This information can be found in annual reports, business newspapers etc.
Any business has 5 stages – launch, growth, shake out, maturity, and decline. You can identify which stage the company is in by observing its sales, net profit and cash flow. The business stage can help determine the company’s business risk.
To study the business environment, you can start with Porter’s 5 forces: Competitive rivalry, Threat of new entrants, Threat of substitutes, Bargaining power of supplier, Bargaining power of customer.
A fundamental investor is like a team captain who studies the business model of the company to know its strengths, understands the business enviornment, and prepares his game plan. This preparation helps him invest with confidence across all stages of the business.

Chapter 3: Know Your Financial Statements

Once you know the game, it is time to understand your players, their performance, strengths, and weaknesses. This chapter will briefly introduce the financial statements and annual reports relevant to fundamental investors, explain their structure, and tell you where to find them.

We all love a good biopic, right? It’s the story of a person’s life condensed into two riveting hours. Exciting stories of interesting people are sometimes inspiring, sometimes emotional, but always enlightening.

What would you say if we told you that every company in the world, no matter how big or small, has produced its biopic? It is not just a vague, generic story but a detailed narration of all it has been through, achieved, or lost on its way to becoming the institution it is today. Don’t believe us? We’ve got proof!

Annual reports are a company’s biopic. Each company’s annual report is different from another because each company has other ambitions, ways of working, and targets. However, they all use a standard corporate production style, making them easier to review and compare.

Components of an annual report

Introduction to the company’s business: Just like how every character is introduced and their importance is established at the movie’s start, the annual report presents the company, its values, business segments, and its contribution.
Financial highlights: It’s like the movie trailer, where the company highlights the leading financial figures, key performance indicators, and ratios to give an investor a snapshot of the year it was. This data is presented in a visually appealing manner through colorful charts and graphs.
The Management Statement: It is a statement from the company’s top management (chairman) addressing the shareholders about the company’s achievements, focus, and outlook. If you read carefully, you will understand the involvement of the top management and how realistic the outlook is—whether the top management’s vision for the company is in sync with the strategy and numbers.

FYI: The 400-page annual report has an index for easy navigation. So you better check that out first.

Management Discussion & Analysis: These are like Behind-the-scenes interviews with the film director. Here, the company’s management (CEO, CFO) talks about the overall economic scenario, industry environment, challenges and outcomes, particular strategies, and how they performed in this environment as a company and as specific segments. They might even back their story with particular numbers and explain their importance.
Financial Statements: The main characters make the final entry in the form of tables and data in the standard format that complies with the Indian Accounting Standards (IAS). These reports are standardized so you can compare the numbers with those of competitors to understand the performance better. Unless the parameters are the same for all players, you can’t identify who is ahead and behind at the corporate box office.

Every company’s annual reports have three financial statements:

The Profit & Loss Statement – It’s your ‘common man’ protagonist telling you about a typical day in the life of a company: how much it sold, how much it spent during the period, and what was left at the end of the quarter/financial year.
The Cash Flow Statement – It’s the ‘money-minded’ protagonist who only talks cash and removes anything non-cash. It tells you how much money came in and went out and what is left.
The Balance Sheet – It is like a dated family photograph. The balance sheet tells you what the situation was like on that date. What the company owned and what it owed as of 31st March XXX.

In the later chapters, we will discuss our three protagonists in length and how they are intertwined to make a perfect business story.

6. 10-year Financial highlights: Once you have a clear idea of the company’s performance this year, the audit report provides a 10-year financial flashback to show a historical trend and how far it has come, followed by outlook or mid-term guidance.

Suppose you carefully skim through the annual report of any large-cap company, such as ITC, HDFC, or Reliance Industries. In that case, you will see a well-presented report telling the company’s story.

The Securities Exchange Board of India (SEBI) requires all companies listed on the stock exchange to follow Listing Obligations and Disclosure Requirements (LODR).

The SEBI requires companies to prepare and disclose financial statements in a prescribed format (Annexure - 1) every quarter of the financial year.

Here, we will pause and understand a few terms that will frequently appear throughout the module.

Financial year: For most Indian companies, the financial year is from April 1 to March 31. A financial year from April 1, 2023, to March 31, 2024, is written as FY 23-24 or FY24. However, some companies may have a different financial year. Until 2020, Nestle India followed the 1st January – 31st December financial year. However, it changed to the April-March FY format in 2024.

Quarter: A quarter is three months. A single FY has four quarters ending in June, September, December, and March.

Quarter	Months	Accompanying Financial figures
Q1	Apr-Jun	–
Q2	Jul-Sep	Half Yearly
Q3	Oct-Dec	Nine months
Q4	Jan-Mar	Full Year

Financial Statements – break up of quarterly statements

The process of releasing financial statements

The company prepares the financial results and submits them to the Board, Chief Executive Officer, and Chief Financial Officer for approval. Their approval certifies that the financial results do not contain any false or misleading statements or figures and do not omit any material fact that may make the statements or figures contained therein misleading.

Company’s Board

The board of directors is the company’s governing body. Shareholders elect these directors to oversee the company’s management, participate in major business decisions, and protect the interests of shareholders.

In other words, the financial statement contains data coming directly from the source and is, therefore, the most authentic information compared to a news report, which may contain data entry errors.

(i) Audited / Unaudited

The company has to get its reports audited by an external auditor. However, the stock exchange allows companies to submit audited or unaudited quarterly financial statements within 45 days of the end of the quarter. If the statements are unaudited, they should be approved by the Board. Hence, you may see two “Q1 FY 23-24 reports” of the same company – Audited and Unaudited.

Audited reports are more accurate as the figures in them have passed through the keen eyes of the auditor. The company will state the audited figures in the next report if there is a major discrepancy between audited and unaudited reports. The company clearly states which figures are audited and which are not. It uses the audited figures in all future correspondences.

In the above example, HDFC has stated the unaudited figures of 2023 and compared it with the audited figures for 2022.

(ii) Consolidated / Standalone

You might also have encountered multiple financial statements that look the same with a slight tweak—the headline states “Consolidated statement” and “Standalone statement.”

For some companies, the figures are almost similar, and for some, there is a significant gap. Why so?

Standalone statements are the financial figures of the parent company, while a consolidated statement includes the consolidated financial figures of the parent and its subsidiaries. Standalone and consolidated statistics are similar for companies with no subsidiaries, like ITC and Zomato.

For instance, Company A has a subsidiary X. In FY23, Company A reported a loss of Rs 100 crores, but X reported a profit of Rs 40 crores. Here, the standalone loss of Company A will be Rs 100 crore, whereas the consolidated loss of Company A will be Rs 60 crore (as it includes the Rs 40 crore profit of subsidiary X).

Which is a better statement - consolidated or standalone?

A consolidated statement gives a comprehensive view of the overall business. For instance, Reliance Industries’ (RIL) standalone figures are for its oil and chemical business. Jio and Reliance Retail are subsidiaries or Group companies of RIL.

Reliance Industries’ FY23 standalone total income was Rs. 5.53 lakh crore, while its consolidated total income was Rs. 9.03 lakh crore. This gap in standalone and consolidated figures widened as the total income of its telecom and retail businesses increased.

In this case, RIL’s consolidated figures give you a better understanding of the company’s financial health. However, the company also releases standalone figures for Jio, Reliance Retail, and other significant businesses. This will help you compare the performance of Jio with its rivals Airtel and Vodafone Idea.

The most authentic financial statement of a company is the audited consolidated statement. For a fundamental investor, it is THE Statement he/she needs. (Psst! Warren Buffett, Ray Dalion, and Peter Lynch, all famous billionaire investors, spent most of their time reading the annual reports and financial statements of the companies they had invested in or were interested in.)

Returning to the process…

The stock exchange allows listed companies to file and publish unaudited/audited financial statements within 45 days from the end of the quarter. These statements are found on the stock exchange’s website and the company’s Investor Relations page.

After the earnings are released on the exchange, major companies hold an ‘Earnings Call’ during which management presents the earnings to the media and shareholders. The Investor Relations page contains the earnings call transcript and the slide presentation (if any) used by the management during the call.

Some companies also issue a media release that gives a synopsis of the overall financial performance. This will cover the main points of the earnings.

Tip: The stock market is generally volatile during the earnings season. You might see high momentum in stocks before and after the earnings release.

NSE’s website: https://www.nseindia.com/companies-listing/corporate-filings-financial-results

Now that you know the various characters in a company’s biopic and their role, it is time for the story to begin.

Summary

The key to knowing your company is from its annual report and financial statements.
The annual report is like a company’s autobiography that tells its story about the year it was. Every annual report has standard components: A business overview, management disclosure and analysis, financial statements, and 10-year financial highlights.
Audited/Unaudited statements: The board, CEO, and CFO approve the unaudited statements, and the auditors review the audited ones for false or misleading statements and figures.
Standalone/Consolidated statements. The standalone statements depict the financial figures of the parent company, while the consolidated statement includes the economic figures of the parent and the Group of companies.
A company releases quarterly financial statements on the stock exchange and its Investor Relations segment within 45 days of the end of the quarter.

Chapter 4: How to Read a Profit and Loss Statement

In this chapter, we will examine hardcore fundamentals, reading the financial statement, determining where the figures came from, and making sense of each figure. When data speaks, a fundamental investor listens.

Now that we understand the general setting of our biopic, it’s time to get acquainted with each of the main characters and their individual stories.

First, the profit & loss statement.

Introducing the P&L statement

Some call it Statement of Income, some Statement of Earnings, and some Statement of Operations. They all end with a profit or a loss. This statement is the starting point of any company’s financials and can tell you a lot about its nature of operations, including how efficient or stressed the company is.

You can also make your P&L statement. It is similar to writing your household/daily expenses. It includes how you earn money and where you spend it. You prepare these records referring to the bank statements, credit card statements, receipts, bills, and invoices. Similarly, a company has a team of accountants and high-end software technology recording these transactions and accounting them in relevant categories.

Every business has one objective – to make profits. The P&L statement tells you how close or far the company is from achieving this objective.

To arrive at the profit, you need two things:

Revenue, which tells you which product/service is selling and which is not, and which product is the real cash cow.
Expenses tell you where you are spending more and how an increase in cost in a particular area could impact your business.

The process of deducting various expenses from the total revenue is reflected in the P&L statement.

Reading a P&L statement

To understand the story a P&L statement narrates, you must first understand how to read it.

So, put on your reading glasses, and let’s begin!

Here, we have taken an actual P&L statement for a large-cap company, ITC.

Headings

As discussed in the previous chapter, we will consider the consolidated statement. The headline specifies whether it is a standalone or consolidated statement and for which year. The left-hand column specifies the particular items, and their corresponding columns in the right state the total amount. The heading tells the period for which those figures are and their denomination.

The above case, the figures are in “Rs. crore” for FY22-23. These figures have been compared with the previous year’s figures.

Line items

Every row on the P&L Statement is called a line item. Most line items have “Financial Notes” or “Schedules,” which give the break-up of the financial figure. The P&L statement states the schedule/note number against the line item.

The first line item is Revenue from operations, also called the ‘top line.’ It tells you the value of sales the company made from its business. The second column, ‘Notes,’ reads 22A, 22B. You see the revenue breakdown when you go to “Notes to Consolidated financial statements” 22A, 22B.

In the above example, we will read the first line as follows:

ITC earned Rs. 76,518 crore in FY23 revenue, which is higher than last year’s Rs. 65,204 crore.

If you look at the notes, you will see that Cigarettes and Packaged Foods are two of its biggest revenue contributors.

You can read each line item on the P&L statement in the above format.

Why don’t you try reading the second line? Did you get it?

Now that we know how to read a line item, we will understand what each tells us about the company’s year.

Every P&L statement tells you something

Revenues

Revenue from operations: This is the revenue a company earns from its business operations, and it shows how well the business is doing sales-wise. The Notes will tell you which product is doing well and which is not.

If you look at the above example, ITC’s hotel business doubled its revenue, and all other segments reported good revenue growth except for other agri products. However, this segment forms a very small part of the company’s revenue. Hence, it had a minimal impact, and the company’s overall revenue surged.

Other Income: A company has other sources of income besides its business operations, such as interest/dividends on investments.

Expenses

This segment includes all types of expenses a company incurs to earn revenue from operations. It is divided into three segments: production cost, office cost, and finance cost.

Production cost: This cost will be high if your company is a manufacturing company. Some items included are:

Cost of materials – the cost incurred to buy raw or finished goods to manufacture the goods/services.
Stock-in-trade – the value of finished goods inventory a business holds for sale. For instance, a shopkeeper may hold 100 bags of sugar to sell in the market. The cost of those 100 bags of sugar is the stock-in-trade.
Inventory – the goods that are already stored in the warehouse. Apart from new purchases, you also look at the inventory changes to help you determine the cost of goods sold.

Excise duty – the tax the company pays the government for certain goods for production, licensing, and sale.

In the airlines industry, they have aircraft fuel expenses instead of cost of materials.

Office cost: This will be high if your company is a service company. It includes:

Employee benefits expense (salary, benefits, insurance, pension, etc.)
Other expenses include utility bills, maintenance, repairs, advertising, legal charges, consulting fees, etc.

Employee cost is the highest in the IT industry.

Finance cost: It includes all costs a company incurs to raise debt or equity such as financial advisor charges, processing fees, interest paid, share-based payments to employees.

Other expenses

Depreciation and amortization expense: This is related to capital cost, which is a significant amount spent to buy an asset or a substantial amount of loan taken.

Depreciation: Suppose company A buys a Rs. 10 lakh truck for business. The truck will keep working for 8-10 years (it is called the useful life of the truck). So how do you expense it? You cannot directly deduct Rs 10 lakh from your revenue as it will show a false picture of your operations. You will incur the Rs 10 lakh cost to buy the truck over its 10-year useful life. That deferring of the capital cost is called depreciation.
Amortization: It is the principal amount you repay on the loans taken. Remember, the interest on the loan is recorded in the finance cost.

Exceptional Items: These are one-off expenses a company incurs beyond the ordinary course of business. For instance, a company received capital gains from selling one of its land or laid off 100 employees for which it incurred a one-time severance pay. If this is high, you might want to look into the cause. However, they will not affect daily operations.

Tax expenses: It is the corporate tax the company pays to the government on the profit earned.

Each of these line items is like the pixels of a photograph. They come together in a predetermined format to give you a clear picture of how profitable a company’s operations are.

Key elements of a P&L statement

Knowing about every line item is essential when doing a detailed study of a company. However, if you are doing a general health check of the company, you can directly jump to the 3 significant elements of the P&L statement.

Revenue from operations
Profit before tax
Profit after tax

Revenue, as we discussed above, is the starting point of any business. It tells you how much demand your business has in the market. However, you should not look at the revenue figure in isolation. Compare it with historical data or with peers to identify trends.

The revenue trend can tell you much about its seasonality, cyclicality, or a one-off jump. For instance, electronics sales increase during the festive season (October – December). Hence, you might see a significant jump in sales due to a seasonal effect, which will vanish after January. Any one-off jumps or dips in revenue could be due to an incident or event, like a pandemic, boosted demand for sanitizers. And lastly, cyclicality occurs when there is an upgrade, like a PC upgrade cycle or consumer demand shift.

Profit or Loss is the outcome of the P&L statement. Hence, it is the most relevant part. Here, we have two types of profits:

Profit/Loss before tax (PBT) – It is the outcome after deducting all expenses except tax from the revenue. The tax expense is different for every company as it boils down to how tax-efficiently they process transactions. The PBT makes the company’s profits comparable with its peers.

Profit/Loss after tax (PAT) – This is also called net profit or bottom line of P&L. This is the after-tax amount left for shareholders after accounting for everything. When you divide this amount by the number of shares, you get earnings per share (EPS).

Every company strives to increase the above three metrics. All the strategies it undertakes, like expansion, new product launches, merger and acquisitions, etc., are designed to increase revenue sources and boost profits.

If you find anything out of place in the profitability picture, you can magnify the pixels and look more closely to identify what is causing the profit to rise or fall greater than anticipated.

Looking at the P&L statement through an investor’s lens

The P&L statement of every industry and company is different. Only after a thorough analysis of the P&L statement relative to peer companies and over time, will you be able to form a useful opinion on the same. Here is how a generic opinion might differ from a well-researched one:

General view	Fundamental lens
An FMCG company will show a high cost of materials as it spends significantly on agricultural goods.	In 2023, when uneven monsoons increased the cost of most agricultural goods, FMCG stocks fell as their cost of materials increased significantly, affecting their profit before tax.
An IT company will show high employee costs.	IT companies make major layoffs when their revenues are weak to reduce costs and maintain profitability.

Profit or loss – the two words that matter most to both companies and investors. It’s what the entire business world revolves around. No wonder then that the main hero of our company biopic is the P&L statement.

However, other supporting characters in our movie play key roles, too. It’s time to meet the next one now.

Summary

A profit & loss statement of a company tells you about the daily operations of a company. The end objective is to see what is left after deducting all expenses from the revenue.
A P&L statement has various line items, which are either revenue or expenses. Most of these line items have a detailed bifurcation in the “Financial Notes” or “Schedules.” The P&L statement states the Notes no. too, which you can refer to to understand how the company arrived at that value.
Revenue: This includes revenue from operations, which is the sales value generated by the business. It also includes other income, like interest and dividends earned from investments.
Expenses: These are broadly classified into production costs (cost of materials, inventory, and excise duty to produce goods), office costs (employee costs, rent, maintenance, legal, advertising, and other charges), and finance costs (interest paid on loans and fees paid to raise loan and equity capital).
Other expenses: These include depreciation and amortization, which are capital costs deferred over the life of the asset or loan to give a clear picture of daily operations. They also include exceptional items that are not part of daily operations and are just one-offs.
The key elements of P&L are revenue, profit before tax, and profit after tax. Profit drives the business, and any unexpected change in profit attracts attention to a company’s expenses.

Chapter 5: Going With the Cash Flow

So far, we have seen how a company earns a profit. But how much of this profit converts into cash? In this chapter, we will understand the concept of accrual accounting and how a cash flow statement tells you about a company’s financial health.

As the saying goes, behind every hard-working profit & loss statement is a smart working cash flow statement.

The profit & loss statement shows you all the work the company did. What it doesn’t tell you is whether the company received cash for the work it did. Work completed and billed is what is called ‘accrued revenue.’ To put it in layman’s terms, you sure have earned it, but have you been paid for it? That is the question.

While the P&L plays the hero onscreen, it has a sidekick who works behind the scenes and makes the P&L happen smoothly – the cash flow statement.

Why do you need a cash flow statement? Why can’t P&L just account for sales for which you received cash?

Because you have to give credit to the customer many times, every customer won’t buy a car on a full down payment. Electricity and gas bills are calculated after you have used the service. In all these instances, the business accrues revenue, and the customer pays later.

Now, you may wonder, but why report accrued revenue in the first place? Why not just account for sales for which you received cash? Because business doesn’t work that way.

Why does one report accrued revenue and not cash revenue?

Remember, the objective of a P&L statement is to calculate the profit/loss earned from your business operations. If you run a lemonade stand, you should know whether selling lemonade earns you any money or you are just losing money.

Let’s take a hypothetical scenario.

You run a lemonade stand and sell one glass of lemonade for ₹10. The cost incurred to make one glass is ₹4. Your profit is ₹6. That’s what the P&L statement tells you. Now, Jay walks in and gives you the order to deliver ten lemonades every day for 30 days and collect the money (₹3,000 = ₹100 x 30 days) at the end of the month. Here, you accrue ₹100 every day in revenue as you bear the cost of the ingredients or raw materials used to make the lemonade, such as lemon sugar, water, ice, and spices.

Since you have accounted for the revenue but have not received the cash, it piles up into a separate heading called “Accounts Receivables.”

Pay close attention to this “Accounts Receivables” as it plays a major role in the climax. Many scams take place in this segment.

When Jay’s Accounts Receivable (AR) reaches ₹3,000, he pays you, and your account with Jay is settled. You will report this cash as accounts receivable in your cash flow statement.

If Jay doesn’t pay the amount for three months, your AR keeps growing. But your P&L shows a profit of ₹1,800 (₹6 x 10 glasses x 30 days) per month despite not getting paid for it. It means a company can be profitable and still be low on cash as its cash is stuck in transit. You can sustain for one month or two months. But if the credit keeps growing and Jay doesn’t pay, it will affect your operations because you are bearing the cost of ₹1,200 (₹4 x 10 glasses x 30 days) per month to make those 300 glasses of lemonade.

Do you see why P&L needs a cash flow (CF) statement? Because it gives you the real picture of how much cash you are getting.

The cash flow statement plays a very important role in maintaining the finances of a company. If P&L are the muscles, cash flow is the oxygen. Hence, when cash flow reduces, your business operations get affected.

Even a profitable company can be burning cash. And even a loss-making company can have bundles of cash. To do this, you need to read the cash flow statement thoroughly.

Bird’s eye view of the cash flow statement

To read this statement, we need to understand how cash flows into the business.

Going back to our lemonade example.

The P&L brother wants to buy a bike worth ₹1 lakh to deliver lemonades. In what ways can he fund his bike?

Take a loan from the bank or family – Cash Flow From Financing or CFF
Use the cash he earned from selling lemonades – Cash Flow From Operations or CFO
Invest the operating cash in fixed deposits, stocks, and mutual funds and use the accumulated money to buy a bike – Cash Flow from Investing or CFI

Each method involves costs and tells you something about the lemonade stand.

Assuming you take a loan to buy a bike. Your lemonade stand’s cash flow statement will look something like this.

Sr. no	Particulars	Amount (₹)	Notes
1	Cash Flow from Operations
	Profit	5400	You start with the Profit
	Accounts Receivables	(9000)	Since you did not receive the cash, it will be deducted from your cash balance until Jay clears his dues.
	Net Cash from Operations	-3600
2	Cash Flow from Investing
	Purchase of Bike	(1,00,000)
	Net Cash from Investing	(1,00,000)
3	Cash Flow from Financing
	Loan	1,00,000
	Interest and Processing Fees	(1000)
	Net Cash from Financing	99,000

The above table is just a framework of a cash flow statement. It has other elements like net cash balance, which we will study later in the chapter.

In an ideal scenario, you would want your lemonade sales to earn you enough cash to cover your expenses and pay for the bike. The bike is an investment as it will allow you to sell more and earn more revenue and profit.

That’s how money makes money.

So far, we have seen a scenario where you sell 300 glasses of lemonade a month. Now imagine this business in lakhs and crores, with lemonade selling in huge volumes nationally and internationally. Imagine what the gap between the P&L statement and cash flow statement would look like then!

On a larger scale, the cash flow statement becomes even more important as your operations have to earn you enough cash for the business to sustain. Let’s read the cash flow statement of a real bigwig like ITC and see what it tells you.

What does operating cash flow tell you?

We will not get into the nitty-gritty of calculating operating cash flow. Remember, we are here to only read the statement, not make it.

Between the line “Profit before tax” and the line “Operating profit before working capital changes,” the company has deducted all non-operating expenses (which we discussed in the previous chapter).

Note: “()” indicates that the cash has gone out of the business and is reducing your cash balance. When reading the cash flow statement, put yourself in the company’s shoes and follow the cash trail, whether it is coming in or going out.

Our cash flow from operations begins with “Operating profit before working capital changes.”

ITC’s trade receivables increased to ₹884.21 crores in FY23 from ₹732.29 crores in FY22.
Inventories are the amount ITC pays to store the supplies for business operations. Its inventory cost more than doubled to ₹940.54 crore.
Trade payable is the amount ITC has yet to pay its suppliers. Since the cash has not left the business, this amount is positive. It is relatively flat compared to FY22.

In ITC’s case, it converted ₹25,894 crore profit into cash, which is much higher than its accounts receivables and inventories. It shows that the company’s operations are generating healthy positive cash flows to fund any credit sales and invest in the business.

What does investing cash flow tell you?

The word investing has to be taken in its literal sense. In our lemonade example, you purchased a bike as an investment to earn more money from deliveries. The purchase of any capital goods like property, equipment, and vehicles that will earn you income for a long time is considered an investment.

The above cash flow from investing activities is self-explanatory. Like you, even big companies invest surplus cash to earn dividends and interest.

However, the crux of this segment is to see how much the company is reinvesting in its business for expansion, acquisition, or any other activity that could help it earn more money because you are investing in ITC for the cash it earns from FMCG, hotel, agriculture, and paperboard business.

ITC spent ₹2,743 crore in the purchase of capital goods like plant, equipment, and property. This shows how the company is using its cash. If a company is acquiring another business, its investing cash flow will suddenly shoot up.

What does financing cash flow tell you?

The most crucial part of the cash flow statement for an investor is the financing cash flow. It shows you how much of the company’s cash is coming in or going out in debt and equity.

In our lemonade example, we saw that you funded the bike by taking a bank loan. When the loan passed, there was a significant cash inflow from financing activities as cash came into the business. However, the interest and principal paid on this loan will result in a cash outflow from financing activity.

In ITC’s case, you can see that the company spent ₹15,417 crore in paying dividends to shareholders in FY23 compared to ₹13,788 crore last year. This will also be considered as a cash outflow.

What does the cash flow statement tell you about the company?

All three elements combine to tell you whether your overall business increased or decreased your cash balance. That is where you get a positive cash flow or negative cash flow.

Here is ITC’s FY23 cash flow snapshot:

Particulars	Amount (₹ crore)
Net Cash from Operations	18,877.55
Net Cash from Investing	-5,732.29
Net Cash from Financing	-13,006.03
Net Cash Increase/(Decrease)	139.23

This means that in FY23, ITC increased its cash balance by ₹139.23 crore. The majority of its cash came from operations, which it used for investing and financing activities (majorly dividend payments).

ITC opened FY23 with a cash balance of ₹266.678 crore (which is the same as the closing balance of FY22). Its FY23 business activities increased its cash balance by ₹139.32 crore to ₹405.9 crore.

This was for ITC’s cash flow statement in a strong market. A company has to balance how much cash to keep and how much to use. If the market is uncertain, companies hoard more cash to keep cash flowing in the business.

(i) Phase of the business cycle

A cash flow can tell you a lot about which phase the business is in. We will go back to chapter 2 where we discussed the business phases.

A startup or company in the early stages of growth is likely to have negative cash flow from operations. Their investing cash flow is high as they reinvest the money to grow the business operations. If a company launches an IPO, its financing cash flow will be high.

Take Zomato, for instance. Zomato launched its IPO in July 2021. If you look at its cash flow from financing activities, there is a ₹90,000 million cash inflow from proceeds from equity shares. In the short term, it parked its IPO proceeds in bank deposits and liquid mutual funds and reinvested ₹590 million in the business.

On the other hand, a company in a mature stage will have high operating cash flow and low investing and financing cash flow, as in the case of ITC.

A company’s cash flow statement is much like an individual’s financial health – a person who recently started a job (only one source of income) versus a person at the peak of his/her career with multiple sources of income (salary, investments, side hustle).

But this is only one side of the coin.

(ii) Positive vs. negative net cash flow

Remember how we said that a profitable company could have negative cash flow and a loss-making company could have positive cash flow?

Throughout the year, adding up the operating, investing, and financing activities could either give positive or negative net cash flow, which is reflected in the cash flow statement.

And just like in literature, even in business, all that glitters is not gold.

Loss-making company with positive cash flow: In the above example of Zomato, it has a positive net cash balance of ₹1,190 million. But the company has been making losses. It reported a net loss of ₹12,225 million in FY22.

A company could also have a positive cash flow if it sold some assets like land, property, and a business segment. There will be positive investing cash, but this method needs to be more sustainable.

A profitable company with negative cash flow: A profitable company can also report negative cash flow if it has made a major investment, such as buying a plant or machinery or a major acquisition. Think of it this way: Ananya, a salaried employee earning ₹12 lakh per annum (Operating cash flow), buys a ₹1.5 crore house (Investing cash flow). So, her cash flow will be negative for that year. But that doesn’t affect her operating cash flow or her profits.

In today’s Buy Now, Pay Later world, the cash flow statement has become an ever more critical fundamental analysis.

When you look at the role our cash flow sidekick plays, it supports the P&L by providing finance from debt and equity and investing it in plant and machinery. In return, the P&L earns more cash from operations and thus continues the cycle.

Next up: The curious case of the Balance Sheet.

Summary

A P&L statement tells you how much business a company did (billed their clients for services or sales) and how much profit/loss it made from this activity. This is called ‘accrued earnings’.
The cash flow statement records the cash inflow and outflow of every transaction.
If a client did not pay for a service, it is recorded in Accounts Receivables and deducted from a company’s profits. Until the client pays for the service, it comes out of the company’s pockets and reduces its cash balance.
A cash flow statement is divided into three elements based on the source of cash. A business raises finance (debt, equity) to commence operations (cash flow from financing). It then invests in business to buy plant and equipment (cash flow from investing). Once the operations begin, cash is earned from the company (cash flow from operations).
Each cash flow element talks a lot about a company’s growth phase.
- A startup may have negative operating cash flow as it is making losses.
- A growth-stage company may have high negative investing cash flow as it is reinvesting the money in expansion.
- A mature company may have a high positive operating cash flow and low negative investing and financing cash flow.
All three elements tell you whether your overall business increased or decreased your cash balance. Add up the net cash from operations, investing, and financing, and you will either have a positive or negative net cash flow.
- A loss-making company can have positive cash flow if it raises money in an IPO or sells its land or business for cash.
- A profit-making company can have negative cash flow if it invests significantly in expansion, such as a new plant or acquisition.

Chapter 6: Finding Balance with the Balance Sheet

In this module, we will learn how the balance sheet takes inputs from the profit & loss account and cash flow statement and presents the overall financial report of a company. We will dive deeper into each segment of the Balance Sheet and what it infers to help you make informed decisions.

We are halfway through the journey of fundamental analysis. We have understood how to look at a company from the lens of a fundamental investor, skimming through its business model, annual report, and business operations.

While you should track the daily business routine, the company’s true worth is known from its balance sheet.

To put it in the Bollywood language,

In the movie Deewar, Amitabh Bachan says, ”Aaj mere paas bangla hai, gaadi hai, bank balance hai (Tangible assets),” and Shashi Kapoor replies, “.. mere paas maa hai (Intangible asset).”

This one statement doesn’t tell you how much they earn, but how much net worth is.

And that is what the balance sheet is all about.

The balance in ‘balance sheet’

Let’s say you have to calculate your net worth. You will list down all your financial achievements from the day you started earning. It includes everything you purchased under your name (clothes, jewelry, house, car, mutual funds, stocks) and how you financed your purchases from Day 1 of your earnings.

Going back to our lemonade example in the previous chapter, you can buy a bike either from your OWN money (your savings, money from family, payments you get from selling lemonade) or OWED money (loan from banks or creditors).

💡Remember that Assets = Liabilities + Equity

Hence, a balance sheet,

is a sheet listing down everything you own as assets and everything you owe as liabilities since you are liable to pay it in the near or far future.

should be balanced, meaning every asset you own should have a source of funding (Owner’s money or borrowed money). If the sheet doesn’t balance, it raises suspicion about where you got the money to buy the asset.

Note: The company is a separate legal entity. If you, the business owner, put your money into the business, the company is liable to pay you interest/returns for the money you invested. Hence, the owner’s money is owed money in the company’s balance sheet and is recorded under the head “Shareholders Equity.”

What does a balance sheet tell you?

Who and why would someone be interested in knowing your assets and liabilities?

Who – the business owners (shareholders), creditors, suppliers, investors, customers, and any other party with financial interest in your company.
Why – to know where the company is using the capital and if it can pay its bills and loans while making money for the owner (dividends etc).

Capital

In this context, capital is the money used for productive or investment purposes. When a business invests money to generate revenue/income or buy equipment that will help in generating revenue/income, that money is called capital.

A business is like a transaction. You always want your money’s worth and, if possible, something extra. Let’s take a daily life example. You purchase a mobile worth ₹1.5 lakh. Note that the sentence states “worth”. You know it’s basically the features and services for which you are paying ₹1.5 lakh. And you would be happy if you get something extra like an extended warranty or a 3-month subscription.

Loans and Investments are also transactions. When you give a loan to someone, you want to know where they are using the money and if they can repay the money with interest. When you invest in a company you should seek information on how they plan to use the money and if they can return you more than what you invested over a long term. This information can be obtained from the balance sheet.

Reading a balance sheet

The balance sheet begins with the business owner’s fund which they use to buy inventory and earn revenue. As the business expands, they raise capital from debt/equity to purchase assets and earn more income. This cycle continues and increases/ decreases the value of a business.

Let’s look at a balance sheet’s 3 segments:

Shareholder’s equity
Liabilities
Assets

We will take each part of the balance sheet and then join them to see how all 3 balance to make a complete balance sheet.

(i) Shareholder’s equity

Every business is self-funded at the start. The owner divides his/her ownership into shares (with a face value of ₹10) and sells them to investors to raise equity capital. When you buy equity shares of a company, you become part owner and share both the company’s profits and losses.

You might wonder why shares with a face value (FV) of ₹10 are listed on the stock exchange at different prices. That is where the shareholder’s equity comes in.

All companies start at the same price point ₹10/share. Over the years, the business operations create value through profits/losses which changes the value of the stock. If a company splits a stock, the FV reduces.

Below is the shareholder equity of Eicher Motors:

If you look carefully, there are two segments: “Equity share capital,” which is the face value of shares, and “Other equity,” which is the value the company created through its business. Let’s look at the details in Notes 17 and 18.

Eicher Motors has divided its ownership into 30 crore equity shares with FV of ₹1. However, it has only issued 27,34,81,570 shares so far. It can issue the balance shares as and when it needs more capital. The FV of Eicher Motor shares is ₹1/- as the company did a 1:10 stock split in February 2023. For every 1 share of Eicher Motors, shareholders got 10 shares, which reduced its FV from ₹10 to ₹1.

Note: A company does a stock split if its trading value on the stock exchange increases, making it difficult for retail investors to buy shares.

The value of “other equity” is higher as it shows the value the company generated over the years.

Line 3 – Securities Premium is the amount the company raised by selling its shares in the stock market at a premium to its FV.

Line 9 – Retained earnings. Every year the company earns net profit (the outcome of the P&L statement). It allocates this profit in various reserves and leaves the rest in retained earnings.

Reserves are like a pool of funds a company sets aside for a specific purpose.

Capital reserves are to fund future asset purchases, mergers, expansions etc.
General reserves are for general purposes such as additional inventory, marketing etc.

As all this money is earned and retained in the company, it increases the value of your equity share.

💡 Book value of equity share = Total value of equity ÷ Number of issued shares

Book value per share tells you how much money the company holds for every share. A strong company’s share generally trades at a price higher than its book value.

(ii) Liabilities

Liabilities are the company’s payment obligation in the next 365 days (current liabilities) and in the long term (non-current liabilities).

Financial liabilities are various types of loans that charge interest. Any principal amount of long-term loans to be repaid in the next 365 days is deducted from non-current liabilities and added to current liabilities. For instance, you took a ₹10 lakh loan for 10 years and you will be paying ₹50,000 of the principal amount in the next 12 months. Your current liabilities will appear as ₹50,000 and non-current liabilities as ₹9.5 lakhs.

This logic applies to all similar line items in current and non-current liabilities.

Provisions come from the term “provide for”. It is the amount the company sets aside for any upcoming payments, dues, or losses. It is mostly related to payments of employee benefits like bonuses and pensions.

Trade/Account Payables is the amount the company has to pay its suppliers and is associated with the daily business operations. It is a category specific to current liability.

All other line items are self-explanatory and show a company’s short and long-term obligations.

(iii) Assets

Liabilities tell you what the company has to pay. Assets tell you whether it has the liquidity to pay its liabilities.

💡 Liquidation: Liquidation is the process of converting an asset into cash.

Like liabilities, assets also have current and non-current assets. However, there is no 365-day rule in current assets. The classification is based on the liquidity of the asset.

Current assets

Current assets have specific line items like:

Cash and cash equivalents and bank balances are the most liquid assets. This line item is the outcome of the cash flow statement where we take the opening cash balance and adjust for the inflow and outflow of cash from operations, investing, and financing to determine the ending cash balance.

Trade/Accounts Receivables is the revenue the company recorded but did not receive complete payment for. These are the products sold on credit. As the company gets the payment, the Accounts Receivables amount reduces.

Inventories are the raw materials and goods stored by a company to sell in the market. Inventories can be at various stages: raw materials, work-in-progress/unfinished goods, and finished goods. Keeping the inventory requires warehousing costs and is crucial in daily operations. If an inventory gets damaged or becomes obsolete (i.e. the product lifecycle is over; for instance, medicines have passed their expiry date), the company has to write off the inventory by reporting a one-time expense.

For instance, a pharma company has an inventory worth ₹1 lakh and the medicine will expire in two days. They cannot sell this inventory anymore as it has become worthless. It will reduce the Inventory amount by ₹1 lakh from the Balance Sheet. This is called writing off the inventory. This amount of ₹1 lakh will appear as “write-off” expense in the P&L statement as the company bears the cost of obsolete inventory. Hence, companies must maintain a reasonable amount of inventory they can sell.

A company uses its current assets to pay its current liabilities. Hence, the company has to keep a fine balance between the two to ensure a smooth flow of cash in and out of the business.

Fixed assets

Any asset that is not easy to liquidate is fixed or illiquid. Some even call them “non-current assets” or “long-lived assets”.

Intangible assets are those things that you cannot touch and feel but have an economic value and help you get a royalty or premium. These include patents, intellectual property (IP), trademarks, copyrights, goodwill, etc. Many technology and pharma companies develop an intangible asset (patent). All the costs incurred to develop the product can be accumulated here as intangible assets.

In the case of Eicher Motors, it makes motorbikes and trucks. Hence, it capitalizes its product development cost in “Intangible assets under development”. This includes all the costs incurred till the bike and truck are tested and ready for mass production. When the company produces/manufactures the bike and truck, that cost is included in the P&L as the cost of goods sold.

Property, plant, and equipment (PPE) purchased to perform business operations are mentioned here. But if the company purchased a building as an investment (maybe to lease it to someone else), it will be categorized under Investments. The idea is to show the assets that are in use for business operations.

Depreciation and impairment

All fixed assets have a useful life during which they contribute towards generating revenue. For instance, Eicher Motors spends its largest capital on property, plant and equipment. This is a one-time cost of thousands of crores of rupees. How can you incorporate this cost into your business? That is where depreciation comes in.

Depreciation divides the capital cost throughout the useful life of the asset. In other words, depreciation is the expected wear and tear of the fixed asset over a fixed period.

Sometimes, an asset loses its value at a faster rate because of a natural calamity or an incident. At that time, the asset is impaired (weakened or damaged). Since the asset’s value has fallen below the book value (a value that appears on the Balance Sheet), the company reduces the asset price and tags the lost value as ‘Impairment’. The company adds the Impairment amount as an expense in the P&L statement as it has to bear the cost.

For instance, Ravi spent ₹8 lakhs on a taxi that will last 10 years. He has to earn this money back from the taxi fare.

Depreciation – He will divide the ₹8 lakh cost over a 10-year period as the “depreciation cost” and recover the amount. He will deduct the depreciation amount from the asset value and add it as an expense in the P&L statement.

Impairment – One day, his taxi met with an accident and the value of the car fell to ₹1 lakh. But in the books, the depreciated value of the car is ₹5 lakhs. Ravi will incur a ₹4 lakh impairment expense from his pocket, which will reduce his profit for that year.

These long-term assets will help the company earn money to pay long-term liabilities and give returns to shareholders. Here again, the company is balancing its assets to match the liability and transfer the balance amount to owners (Retained Earnings of Shareholder Equity).

Looking at the balance sheet as a whole

Now let’s join the three parts and look at the complete Balance Sheet.

Look at the above Balance Sheet from a liquidity POV. Eicher Motors has ₹3,683.2 crores in current assets, which is enough to pay its ₹3,234.5 crores in current liabilities.

The company’s total liabilities of ₹4,207 crore are significantly lower than its Shareholder Equity of ₹14,990 crore. This shows that the company has more Owned funds than Owed funds, which means its debts are at comfortable levels.

Where all the statements intertwine

Throughout the chapter, you must have noticed some elements of P&L and cash flow statements keep popping up. It is because these daily business operations have an impact on the overall value of the company.

All three of these stories – the P&L statement, cash flow statement, and balance sheet – are intertwining at certain intervals affecting each other.

The cycle of the P&L statement: A company makes a sale, incurs operating expenses and finance costs, deducts depreciation, and adds other income from investments to arrive at the net profit. Each of the five elements of the P&L statement affects a line item in the Balance Sheet.

P&L’s Impact on the Balance Sheet

Sales for which you didn’t receive the payments change Accounts Receivable (Current Asset) and Cash Flow From Operations (CFO).
Operating expenses change Accounts Payable (Current Liabilities), Inventory (Current Asset), and CFO.
Net Profit is added to your Reserves and Surplus and changes CFO.

Balance Sheet’s Impact on the P&L

The debt (Non-current liability) a company takes or repays changes its Finance cost (interest and processing fees) and Cash Flow From Financing.
The asset (Non-current assets) a company purchases or develops is gradually expensed as depreciation (P&L).
Investments (Assets) the company makes generate returns and interest that is added as Other Income (P&L) and affect Cash Flow From Investments (CFI).

💡Tip: This whole exercise is to help you visualize how one transaction affects several line items. Try reading 5-6 Financial statements of companies in different sectors. Visualizing the transactions comes with practice.

As the company’s story unfolds, the financial statements leave the climax open to debate. Every person analyses and interprets these statements differently. If everyone could see what Warren Buffett saw in the financial statements, he wouldn’t be the billionaire investor he is today.

Now that you can read and understand a financial statement, the next step is to analyze them.

Get ready to use all that you have learned so far to analyse a company in the coming chapters.

Summary

The balance sheet is a sheet that lists everything a business owns and owes and balances the two. Every asset is funded by a liability or business owner’s money.
A balance sheet is used by anyone with a financial interest in the company (shareholders, creditors, suppliers, employees) to know if the company can fulfill its payment obligations and make money for shareholders.
A balance sheet has three segments:
- Shareholder’s equity: It is the face value of the company’s equity shares and how reserves and surplus accumulated over the years enhance the book value per share. Even the owner’s fund is a liability for the company as it is obligated to give a share of its earnings to shareholders.
- Liabilities: They are loans and provisions payable in 365 days (current) and the long term (non-current liabilities).
- Assets: The current assets comprise cash, trade receivables, and inventories. If the inventory becomes obsolete or is damaged, it is written off and affects the company’s profits.
Fixed assets include intangible assets (patent and goodwill) and tangible assets (property, plant, and equipment). The wear and tear of assets is deducted as depreciation whereas the damage to the asset is deducted as impairment and affects the company’s net profit.
The balance sheet has to be balanced such that current assets are sufficient to meet the current liabilities. The equity and debt levels should also be balanced to ensure a smooth flow of cash in and out.

Chapter 7: Ratio Analysis Part 1: Finding Trends

This chapter will give an analytical view of financial statements. We will look at some popular financial ratios that show a connection between P&L and balance sheets to understand the trends within the company and its peer group. At the end of the chapter, you will know how to use ratios as clues to find anomalies.

We ended the last chapter by noting that financial statements are intertwined. The first half of the story begins with shareholders’ equity or debt used to buy assets to produce goods and services (operating expenses) and sell them (sales) with the intent to make a profit.

This profit is accumulated in reserves & surplus and sales on credit (yet to be paid for by the customer) are accumulated in accounts receivables.

You can analyze this interrelation between P&L and balance sheet using ratios.

What are ratios and how do you read them?

Ratios are a mathematical way of comparing two things that have a relation.

When we say the teacher-to-student ratio in a class is 1:10, it means that for every 10 students, there is 1 teacher. This 1:10 ratio can be applied to any volume – hundreds, thousands, millions, trillions. School A has 500 students and 50 teachers, whereas school B has 5 lakh students and 50,000 teachers. Both have the same ratio of 1:10. Ratios make such large numbers easily comparable.

Another way to look at ratios is through percentage, where you compare a portion with the whole. Suppose a pizza is divided into 8 slices, of which you eat 2. As the 2 slices were derived from those original 8 slices, your ratio would look something like this:

2/8, i.e., you ate 25% of the whole pizza.

Now that you know how to read ratios, we will look at some popular financial ratios and analyse them.

How to analyze data?

Remember, analysis is all about examining something in detail to discover more about it. The best way to start is to keep it simple. When you observe an object or behavior, you start with a base and see the trend over time and how it reacts to different situations.

For instance, the Zoom video calling app saw a sudden surge in demand during the pandemic as the world took to virtual meetings. The company raked in good moolah in that one year. Once the lockdown was over, the demand fell, competitors came in, and the company could not sustain its profits.

Zoom Communications	2018	2019	2020	2021	2022	2023
Net Profit Margin	-3%	2%	4%	25.40%	33.60%	2.40%

Another way to observe a company’s performance is by comparing it with its peers, i.e., comparing apples with apples. Even within apples, you should be specific about what you are comparing – are you comparing how red they are or their sweetness or size?

When you buy a phone, do you only consider the aesthetics and decide? No, you look at several parameters, such as battery life, camera quality, storage, quick charge, OS, and other features. But you won’t compare a button phone with a smartphone, even though both are phones.

For instance, if you compare a bowler to a batter based on batting skill, even though both are cricket players, you must factor in the difference. You must expect a bowler to give you a different run rate than your ace batter. But it is considered good if he gives you an average or above-average run rate.

This exercise adjusts your mindset to a fair analysis because ratios cannot be seen in isolation, and no absolute judgment can be derived just by looking at one ratio. You have to look at ratios in totality to get a clear 360-degree view of the situation before you make a decision.

Types of financial ratios

Financial ratios compare the balance sheet and P&L items to check a company’s financial skills on four fronts:

Operating Ratios – How efficiently the management is converting assets into revenue
Profitability Ratios – How much profit the management is generating from the capital and assets
Leverage Ratios – How efficiently the company is managing its debt and staying solvent
Valuation Ratios – Comparing the company’s book value with its stock price

💡Book Value: Book value per share tells you how much money the company holds for every share. A strong company’s share generally trades at a price higher than its book value.

As a fundamental investor, why do you need to know about these ratios to analyze the company’s trend over the years and compare it with peers?

Let’s say you invest ₹15 lakh in your friend’s business as an equity shareholder, becoming a part owner. You would want to know what he is doing with your money, wouldn’t you? Is he buying a vacation home or repaying his debt? Suppose he buys five tempos (for ₹3 lakhs each) for his logistics business. As part-owner, you would want to know how much revenue these tempos generate and whether they can cover their costs and generate profits. You would also want to know if your friend handles his debt without affecting your returns.

Wearing a business owner’s hat, let’s analyze each ratio. We will also share a basic formula, but you can tweak it according to the business and situation. There is no good or bad; the interpretation of these ratios is subjective to the company and situation. Hence, focus on understanding the logic behind the ratio, whether good or bad, not the computation.

You can look at operating and profitability ratios as follows:

The numerator is the skill you are testing
The denominator is the basis of your testing

Rogan Documentation

All Stock Market Guides

Articles

Technical Analysis Guide

Chapter 1: Introduction to Technical Analysis

Understanding Technical Analysis

Option 1: Research by yourself​

Option 2: Learn from other who've done it

From Fields to Finance: Picking Winners

Fundamental Analysis

Technical Analyst

Fundamental Analyst

Assumptions of Technical Analysis

All Time High

Technical Analysis Fits Everywhere

Types of Prices

Fundamental Analysis vs. Technical Analysis

Annual Report

Can Technical Analysis be Used Across Time Frames?

Intraday

When to Use Technical Analysis and When Not TO

When to use technical analysis

Volatile

Liquid Markets

When to not use technical analysis

Technical analysis doesn’t always work…

Summary

Chapter 2: Types of Stock Price Charts

Trade Summary

Why Traders Love Charts?

Security

Line Chart

Bar Chart

Lighting Up Your Trading Game with Candlesticks

Understanding a Candlestick

Interpreting Candlesticks

Some Other Useful Chart Types

Trading Time Frames: Your Secret Weapon

How to Pick Your Ideal Time Frame for Trading

Swing trader

Blending Time Frames for Trading Success

Summary

Chapter 3: Single Candlestick Patterns - Part 1

Candlestick Trading Rules

Buy strength, sell weakness

Be flexible with patterns

Marubozu

How does a bullish marubozu form?

How to trade a bullish marubozu?

Long

Bearish Marubozu

How does a bearish marubozu form?

How to trade a bearish marubozu?

When the Pattern Falls Short

Doji

How does a doji form?

Doji in an uptrend

Doji in a downtrend

Summary

Chapter 4: Single Candlestick Patterns - Part 2

Hammer

How does a hammer form?

How to trade a hammer?

Hanging Man

How does a hanging man form?

How to trade a hanging man?

Shooting Star

How does a shooting star form?

How to trade a shooting star?

Inverted Hammer

How does an inverted hammer form?

How to trade an inverted hammer?

Target Setting for Single Candlestick Patterns

Risk to Reward Ratio = Potential Gain / Potential Loss

Why Use the 1:1.5 Risk-to-Reward Ratio

Summary

Chapter 5: Two Candlestick Patterns

Engulfing Pattern

Bullish Engulfing Pattern

How does a bullish engulfing pattern form?

Option 1: Research by yourself