The Study Of Stock Market Through Technical Analysis

Lesson -> The Dow Theory through Trading Range

18.1 -What is the Trading Range?

The range concept is an extension of the triple and double formation. Stocks attempt to reach the same price levels multiple times over a long period of time. This is sometimes called the sideways market. Sideways drift is when the price fluctuates in a narrow range but does not form a trend. The price will move in a range if both buyers and sellers don't feel confident about the direction of the market. This is why long-term investors often find this period frustrating.

The range offers multiple trading opportunities (long and short), with acceptable accuracy for short-term traders. The downside is limited by resistance, and the upside by support. It is also known as a trading market, or a market that offers both buyers and sellers enough opportunities.

The chart below shows the stock's behavior in a typical range.

You can see that the stock traded within the range, hitting the same level at both the upper (Rs.165), and lower (Rs.128) multiple times. The width of the range is the area between the upper level and the lower level. In such a situation, one of the easiest trades you can initiate is to buy at the lower level and then sell at the higher level. The trade can go both ways, with the trader choosing to shorten at a higher level while repurchasing at the lower level.

The chart shown above is an example of Dow Theory and candlestick patterns blending. Notice the candles enclosed in a circle starting from left.

  1. This pattern of bullish engulfing is a sign that things are moving along.
  2. Morning doji star suggesting along
  3. A bearish engulfing pattern suggests a short
  4. The bearish harami pattern suggests a shorter life span

These trades are ideal for short-term traders. They offer easy to spot trading opportunities that have a high chance of being profitable. The range's duration can vary from a few weeks up to several years. The range's width will increase in length if it is longer.

18.2 -The breakout in Range

Stocks can break out of the range if they have been in the range for a while. It is important to understand why stocks trade within the range before we get into this.

Two reasons stock can trade within the range are:

  1. These triggers can be quarterly/annual results announcements, new product launches and geographic expansions, change of management, joint ventures or mergers, as long as there aren't any meaningful fundamental triggers. The stock trades in a trading range if there is nothing exciting or negative about the company. These trading ranges can be very long-lasting, depending on the circumstances.
  2. Stocks can move in any direction depending on whether the outcome of an announcement is made in anticipation. The stock will move into the range until the announcement is made. Sellers and buyers would hesitate to take action until then. In such situations, the range can only last for a short time until the event is announced.

After being within the range, the stock can leave the range. A range breakout is more often than not a sign of a new trend. The nature of the trigger and the outcome of the event will determine the direction that the stock will move. The breakout and the trading opportunities it offers are more important than the trigger.

Traders will take a long trade when the stock price crosses the resistance levels. They will then go short once the support level is broken.

The range can be described as an enclosed chamber that builds pressure with each day. The pressure will release with great force if there is a small vent. This is how breakouts occur. The trader must be aware of the notion of a false breakout.

False breakout occurs when the trigger isn't strong enough to pull the stock into a specific direction. A false breakout is when the trigger fails to pull the stock in a particular direction and retail market participants become impatient. False range breakouts are usually low in volume, indicating that there is not smart money involved. The stock will usually fall back within the range after a false breakout.

True breakouts have two distinctive characteristics:

  1. The volumes are large and
  2. The momentum (rate at which prices change) after the breakout is high.

Take a look at this chart:


The stock tried to break out from the range three times. The stock failed to break out of the range on its first two attempts. The first breakout was characterized by low volumes and low momentum (beginning from left). Although the 2 nd breakout had impressive volumes, it lacked momentum.

The 3 rd breakout did not have the traditional breakout attributes. High volumes and high momentum.

18.3- How to Trade with Range breakouts? 

Stock traders buy the stock when the stock breaks out from the range in good volumes. Volumes that are high confirm only one prerequisite for a range breakout. The trader cannot predict if momentum (second prerequisite), will continue to build. The trader should have a stoploss in place for range breakout trades.

Let's say that the stock trades in a range of Rs.128 to Rs.165. The stock surges above Rs.165, and trades now at Rs.170. A trader should then take a position in 170 with a stoploss of Rs.165.

Alternately, suppose that the stock breaks out at Rs.128 and trades at R.123. A trader may initiate a short position at Rs.123, and Rs.128 can be used as the stoploss.

If the breakout is true, traders should expect a stock move that is less than the range's width. For example, if the breakout happens at Rs.168, then the minimum target is 43 points. The range's width equals 168 +125 = 43. This would mean a target price at Rs.168+43 = 211.

18.4 -A brief to Flag Formation

Flag formation is usually when the stock price experiences a sustained rally that ends with a sharp or almost vertical increase. Flag patterns can be described as a large move followed by a brief correction. The correction phase would see the price move in a straight line. Flag pattern is a rectangular or parallelogram-shaped flag pattern. They have the appearance of a flag hanging from a pole. Price declines can last between five and fifteen trading sessions.


These two events (i.e. price rise, and price fall) are correlated to form a flag formation. Flag formation occurs when these two events (i.e. price rise and price fall) occur consecutively. A flag formation causes stock to surge suddenly and continue its upward climb.

Flag formation is a second opportunity for traders who missed the chance to purchase the stock. The trader must be quick to take the position, as the stock can move up quickly. The sudden upward movement is evident in the chart.

The logic behind flag formation is quite simple. Market participants have the opportunity to make profits due to the steep rise in stock prices. Retail participants, who are satisfied with recent stock gains, will often book profits by selling stock. This causes a drop in stock prices. Volumes are lower because only retail participants are selling. Stock sentiment is positive because the smart money remains invested in it. This is a great opportunity for traders to purchase the stock and the price rises quickly.

18.5 - Understading the Return to Risk Ratio (RRR).

The concept of reward-to-risk ratio (RRR), is a general one and does not apply to Dow Theory. This topic could have been discussed under "Trading systems and risk management". RRR is applicable to all types of trading, whether it's technical analysis-based trades or fundamentals-based investments. We will now discuss RRR.

It is easy to calculate the reward-to-risk ratio. Take a look at the details of this long-term short trade.
Entry: 55.75
Stop loss: 53.55
Target: 57.20

It seems that the trade is acceptable, even though it is short-term. Let's examine this more closely:

What risk is taken by the trader? - [Entry-Stoploss] = 55.75-53.552.2

What reward is the trader expecting? - [Exit-Entry] = 57.2 - 55.751.45

The trader risks 2.2 points for a reward worth 1.45 points. In other words, the ratio of reward to risk is 1.45/2.2 = 0.65. This trade is clearly not great.

A rich RRR is a hallmark of a good trade. This means that for every Rs.1 you put at risk, your expected return on trade should be at minimum Rs.1.3/-. It is just not worth it.

Consider this example:
Entry: 107
Stop loss: 102
Target: 114

The trader is taking a risk of Rs.5/- (107) - 102 for an expected return of Rs.7/– (114 -107). In this instance, the RRR is 7/5 = 1. The trader assumes Rs.1 of risk and expects Rs.1.4 in return. Not a bad deal.

Each trader should determine the minimum RRR threshold based on their risk appetite. Personally, I would not say that I enjoy trades with RRRs below 1.5. A RRR of 1 is acceptable for some traders. This means that for every Rs.1 they take on, they can expect a return of Rs.1. Others prefer the RRR be at least 1.25. Ultra-suave traders would prefer a RRR of at least 1.25, meaning that for every Rs.1/– of risk, they would expect at most Rs.2 in remuneration.

Trades must meet the RRR requirements of the trader. A trade that has a low RRR will not be profitable. If RRR is not met, even an attractive trade must be abandoned as it is not worth the risk.

This hypothetical scenario will give you an idea of how it might look.

The top of a trade has seen the formation of a bearish engulfing structure. Double top formation is also possible at the point where the bearish-engulfing pattern forms. These volumes are stunning as they are at least 30% higher than the 10-day average volumes. The chart shows medium-term support, near the bearish engulfing pattern high.

Everything seems to be in sync with a quick trade. Let's say that the trade details are as follows:
Entry: 765.67
Stop loss: 772.85
Target: 758.5
Risk: 7.18 (772.85-765.67) i.e. [Stoploss-Entry]
Reward: 7.17 (765.67-758.5) i.e. [Entry-Exit]
RRR: 7.17/7.18 = 1.0

As I stated earlier, I have a strict RRR requirement of at minimum 1.5. Even though this trade looks fantastic, I'd be happy to let it go and continue to look for the next opportunity.

RRR, as you might have guessed by now is a spot on the checklist.

18.6 - The Final Checklist

Now that we have covered all aspects of technical analysis, it is time to go back through the checklist and complete it. You may have noticed that Dow Theory is included in the checklist. It provides confirmation for the trade and serves as a reminder.

  1. A recognizable pattern should be formed by the stock.
  2. S&R should be used to confirm the trade. The stoploss price should not exceed S&R.
    1. The support should be at the bottom of a long trade.
    2. The resistance should be the support for a short trade.
  3. Volumes should be confirmed
    1. Buy and sell volumes should be above the average
    2. Low volumes aren't encouraging so don't hesitate to trade when volumes are low.
  4. Take the Dow Theory perspective on the trade.
    1. Trends in primary and secondary
    2. Formations of ranges: Double, triple and even quadruple
    3. Recognizable Dow formation
  5. It is important to confirm the accuracy of indicators
    1. If your plan of action is confirmed by indicators, increase the trade size
    2. If the indicators are not positive, continue with the original plan
  6. The RRR should be acceptable
    1. Consider your risk appetite to determine your RRR threshold
    2. A complete beginner should have the RRR as high as it can be. This provides safety margin.
    3. Active traders should have a minimum RRR of 1.5

Always consider the Dow Theory perspective when identifying a trading opportunity. If you take a long trade that is based on candlesticks as an example, then consider what the primary and second trend are suggesting. If the primary trend is bullish then that would be a positive sign. However, if the secondary trend is not in line with the primary, you might want to reconsider your long trade.

You will see a significant improvement in your trading if you adhere to the checklist and fully understand its importance. Make sure you follow the above checklist every time you trade. You will not be able to trade on loose or unscientific logic, even if you do.

18.7 -Anything left?

This module has covered many aspects technical analysis.The following topics will give a strong base. It is possible that you feel there are other patterns or indicators that need to be explored. Varsity may not have discussed a particular indicator or pattern, but it was for a specific purpose. You can rest assured that Technical analysis is your best friend.

You can develop a solid TA-based thinking framework if you are able to spend time on each topic. Next, we'll explore the concepts behind trading psychology, risk management and backtesting strategies.

The next chapter will cover some practical aspects that can help you get started with Technical Analysis.


  1. When the stock fluctuates between two price points, it is called a range.
  2. Traders can either buy at the lowest price or sell at a higher point.
  3. Stocks are in a range because of a specific reason, such as a lack of fundamental triggers or expectation.
  4. Stocks can move out of this range. A breakout is marked by high volumes and sharp price increases.
  5. Flag formation is a way to buy stocks if the trader missed an opportunity.
  6. The RRR is an important parameter in trade evaluation. Based on your risk appetite, establish a minimum RRR threshold
  7. Before initiating a trade the trader needs to look at the opportunity through the Dow Theory perspective.