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Tighten up that Wedgie

There are three forms of triangles - symmetrical, ascending and descending. Symmetrical triangles have a resistance line that slopes downward and a support line that slopes upward and the slope of each line is equal. The top resistance line in an ascending triangle is flat, while the support line slopes up to meet it. Descending triangles have a flat support line as their base while the top resistance slopes downward. Lines connecting the boundary regions intersect at the triangle apex and generally have diminishing volume over time. However, one of the most powerful triangle price patterns in technical analysis is a triangle but does not have any of the characteristics I just described. This triangle is called a wedge. No not the kind that you get when your pants are too tight but the kind that can tell us a story of possible future price movement.

There are two kinds of wedges, the falling bullish wedge and the rising bearish wedge. Let's look at each one of them.

Bullish Falling Wedge

The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This forms a cone that slopes downward as the swing highs and lows converge. This wedge is different from the symmetrical triangle, which has no definitive slope and no bias, whereas falling wedges definitely slope down giving it a bullish bias.

The falling wedge can be a continuation pattern or a reversal depending on the previous trend. If the slope is against the prevailing uptrend it is a continuation pattern but a reversal pattern if the slope matches the prevailing trend. Regardless of the type (reversal or continuation), falling wedges are considered bullish.

Lets look the characteristics of a falling wedge:

1. Prevailing Trend: If a falling wedge forms after a market decline then the wedge is a reversal pattern. If it forms after a rally then the wedge is a continuation pattern. If you encounter a falling wedge after a decline, the preceding trend should be at least 3 months old and in an ideal world, the falling wedge will mark the final low.

2. Resistance Line: is formed from at least two swing highs and the second lower than the first, ideally you will see three or more.

3. Support Line: is formed from at least two swing lows and the second lower than the first, ideally you will see three or more.

4. Cone: Both the upper resistance line and the lower support line are trending downwards but the slope of the resistance line is greater than the slope of the support line. Eventually these two lines converge on one another to form a cone.

5. Pattern Confirmation: You will not get a confirmation of this pattern until the upper resistance line is broken. It is sometimes prudent to wait for a break of the previous swing high because once resistance is broken there can be a reaction decline to test the newfound support level.

6. Volume: An essential ingredient to this bullish pattern is volume. You need to have volume expanding as the pattern forms then drop off as it matures.

7. Other Indicators Confirm: Although this pattern by itself is powerful, if other indicators are bullish as well it becomes all the more potent.

The DX is the U.S. Dollar Index computed using a trade-weighted geometric average of six currencies and gives us an excellent example of a falling wedge so let's use it to examine each of the criterion for the falling wedge.

1. Prevailing Trend: The preceding trend should be at least 3 months old and ideally, the reversal falling wedge will mark the final low. The wedge on the DX chart is after a market decline so is a reversal pattern. The decline started in July 2004 and was 6 months old by the time the wedge started its formation. The last swing low of the pattern was the final low.

2. Resistance: You need to see at least two swing highs and the second lower than the first, ideally you will see three or more. I see at least 6 touches of the upper resistance line and four swing highs each one lower than the previous one.

3. Support: You need to see at least two swing lows and the second lower than the first, ideally you will see three or more. I see three swing lows.

4. Cone: Upper resistance line and the lower support line converge on one another to form a cone. From the chart above the cone is pretty obvious. Notice the slope of the resistance line is greater than the slope of the support line.

5. Pattern Confirmation: You will not get a confirmation of this pattern until the upper resistance line is broken. On January 3rd DX breaks the resistance line and the pattern is confirmed. The fact that it did not retest the resistance line is a testament to the strength of the move.

6. Volume: You need to have volume expanding as the pattern forms then drop off as it matures. As you can see from the chart above the volume expanded while the pattern was forming but dropped off dramatically as the pattern matured.

7. Other Indicators Confirm: If other indicators are bullish as well this pattern becomes all the more potent. Notice the bullish positive MACD and RSI divergences giving you more reason to believe the bottom of this decline was coming to an end.

The falling wedge can be difficult chart pattern to recognize but I think relatively easy to trade. The difficulty arises when lower highs and lower lows form a downtrend and your eye picks up on the downtrend. But the falling wedge is designed to identify a decrease in the downside momentum and alerts us to the potential trend reversal. But even though selling pressure may be diminishing, the pattern itself is not confirmed until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis to confirm signals.

Bearish Rising Wedge

The rising wedge is a bearish pattern that begins wide at the bottom and tapers as price moves higher and the trading range narrows. The rising wedge is both a reversal pattern and a continuation pattern as well. As a continuation pattern, the rising wedge will still slope up, but the slope will be against the prevailing downtrend and as a reversal pattern, the rising wedge will slope up but with the prevailing trend. Whichever type you encounter - reversal or continuation - the rising wedge is bearish.

Lets look the rising wedge's characteristics:

1. Prevailing Trend: If a rising wedge forms after a market advance then the wedge is a reversal pattern but in order to qualify as a reversal pattern, there must be a prior trend to reverse. This trend should be at least 3 months old and ideally, the wedge will contain the final high. If it forms after a decline then the wedge is a continuation pattern.

2. Resistance Line: is formed by joining at least two swing highs and the second higher than the previous, ideally you will see three or more.

3. Support Line: is formed by joining at least two swing lows and the second higher than the previous, ideally you will see three or more.

4. Cone: Both the upper resistance line and the lower support line are trending upwards but the support line's slope is greater than the resistance's line giving the wedge the upward slope. Eventually these two lines converge on one another to form a cone.

5. Pattern Confirmation: You will not get a confirmation of this pattern until the lower support line is broken. It is sometimes prudent to wait for a break of the previous swing low because once support is broken there can be a reaction rally to test the newfound resistance level.

6. Volume: Ideally volume will contract as the wedge matures then expand on the support line break.

7. Other Indicators Confirm: Although this pattern by itself is powerful, if other indicators are bearish as well it becomes all the more potent.

So let's look at the rising wedge a little closer. The best example I could find was the wedge that formed on the total market index, $DWC. For most of 2004, DWC was making lower highs and lower lows then on July 13th it hit a bottom and started a bullish rally that many thought could challenge 2000 highs. But if you were a wedge watcher you would have known this rally was going to be cut short at least for a while. Here's the rest of the story.

1. Prevailing Trend: If a rising wedge forms after a market advance then the wedge is a reversal pattern but in order to qualify as a reversal pattern, there must be a prior trend to reverse. The prevailing trend started in July of 2004 and the wedge formed in December.

2. Resistance Line: You need to see at least two swing highs and the second higher than the previous, ideally you will see three or more. There were multiple touches of the resistance line and each one a tad higher than the last.

3. Support Line: You need to see at least two swing lows and the second higher than the previous, ideally you will see three or more. I see 3 swing lows forming the support line and each low higher than the last.

4. Cone: The upper resistance line and the lower support line trend upwards and eventually converge on one another to form a cone. Looking at the chart the support line's slope is definitely greater than the resistance line and eventually they converge to form a cone.

5. Pattern Confirmation: You will not get a confirmation of this pattern until the lower support line is broken. January 3rd DWC breaks the pattern to the downside however not on real heavy volume but heavier than the volume in the apex of the cone.

6. Volume: Ideally volume will contract as the wedge matures then expand on the support line break. Towards the apex of the cone the volume drops off dramatically telling you the pattern is in its final stages.

7. Other Indicators Confirm: Although this pattern by itself is powerful, if other indicators are bearish as well it becomes all the more potent. Both the MACD and RSI have bearish negative divergences confirming the bearish rising wedge.

The rising wedge can be one of the most difficult chart patterns to accurately recognize but like the falling is easy to trade. The loss of upside momentum on each successive high gives the pattern its bearish bias however, the series of higher highs and higher lows keeps the trend inherently bearish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely.

A final word, always be careful when analyzing price charts using technical analysis and be selective in labeling a particular area of prices as a wedge. The pattern should meet all of the criteria discussed above. When first learning about these shapes, it is easy to make the mistake of seeing wedges everywhere.

Remember - plan your trade and trade your plan.
 

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