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WEDGE Patterns and the recent Dow retreat

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The wedge chart pattern is the topic at hand today, but first I wanted to share a reply made to an e-mail from an OIN Subscriber:

SUBSCRIBER QUESTION:
When you suggest buying calls or puts at certain support and resistance levels, what month and strike do you like to buy?Do you buy front month options and do you go into ITM-OTM or ATM?

RESPONSE:
The way I trade, tending to buy markets at their more infrequent extremes, such as when the index in question is quite oversold or overbought, I usually want to go out beyond the lead month options if there is only a 2-3 weeks left to expiration. I prefer to have 4-6 weeks left to expiration and be able to stay with a trend, if one develops in the direction I anticipated.

If I think we're at a bottom, I tend to buy At The Money (ATM) or slightly Out of The Money (OTM) calls. If I think the market is at a top, it becomes a bit trickier.

Bottoms are "easier" in a sense. Selling tends to be more of a once or twice decision among the sellers. Whereas there is piecemeal buying of stocks on the way up, selling tends to be more emotional and investors/traders exit frequently all at once - sell everything, get me out of the market kind of thing. This dynamic creates a bottom that is often a one-time spike low - of course, sometimes you get a retest of the low and get a double bottom or a slightly lower low, then it rallies.

Tops can take longer to form and in an advancing trend a rally can keep going for some time - this is where you see rolling tops. The indexes tend to "hang" up there and it makes timing of put purchases a bit different. Because of this I may buy half the number of puts I want to end up with and have room to buy more, so I end up with an average price for the whole lot. I am more inclined to buy ATM or In The Money (ITM) puts. Again, I will tend to go out a month or so.

I have begged you lately to please e-mail with questions and feedback about anything I write about in my Wednesday Trader's Corner article or in my Sunday Index Trader!? Please do let me know what you're thinking!!

WEDGE PATTERNS -

I described in my most recent Index Trader article (3/13/05), relative to the Dow 30 (INDU), what I saw as a rising "wedge" pattern on its daily price chart. There are two converging trendlines involved in a wedge pattern, either rising or falling rising in this case.

The wedge pattern often signals a trend reversal ahead and there has been a significant correction since INDU hit the topmost trendline see chart below.


The validation to the RISING wedge as a significant top comes when the lower trendline is pierced, especially on a closing basis.

I will detail what the wedge formation is and how it might predict future market action - click here to see the recent Index Trader article where I used the fact of the above pattern as a key indicator for a likely top.  

The Dow had led the market up and the bearish rising wedge was well formed. The move to a new high in the Dow around 11,000 lulled many into thinking that the market was beginning a second up leg.

Wedge patterns are usually "reversal" patterns, meaning the existing trend is susceptible to a trend reversal. One such pattern - while not seen all that often - which tends to be predictive for a bottom or top, is called a "wedge".

The wedge pattern of a "rising" bearish type is usually seen after an uptrend has been underway for a while, say for a few months.

BULLISH FALLING WEDGES AND BEARISH RISING WEDGES -

In a rising wedge, prices move gradually higher and form converging trendlines and a "narrowing in" pattern of higher highs and lower lows, such as seen on the left in the Dow chart below from earlier a few months back -


The upward sloping or bearish wedge is normally bearish in
its implications for future price action.

There is a "measuring" rule of thumb for a price objective also - above, in the case of the bearish rising wedge, prices should decline to the start of the formation, or at least to the lowest prior low - this is only a "minimum" downside objective.

The wedge pattern should have at least 2-3 upswing highs and downswing lows that comprise the points through which the trendlines are drawn the more points than this minimum number the better, in terms of drawing two well-defined converging
lines.

What is being suggested in the rising, bearish wedge is that buying is being met with stronger and stronger selling as prices edge higher. When prices fall below the lower up trendline that of a rising wedge pattern, a trend reversal is suggested prices may rebound to the trendline again, but will typically not get back above it.

A declining or falling wedge is typically a bullish pattern as it suggests that selling is being met with increasing buying. Eventually, this sets the stage for an upside reversal as can be seen by the second wedge formation in the Dow chart shown above, and again here -


ANOTHER EXAMPLE ...
Again, from a few months back: a Bearish Falling Wedge

On the chart below, I applied the measuring rule of thumb for a price objective, where the prices should at least advance to the start of the formation, or to the highest prior top at the START of the wedge formation - this is only a "minimum" upside objective.


Back in the September December period, the S&P 500 Index (SPX) traced out a rising wedge pattern, suggesting a possible fall ahead -


Breaking of the lower trendline of the wedge pattern highlighted in the S&P 500 above was useful for buying puts for a short-term trade - but formation of a rising wedge pattern as seen above, did not lead to a MAJOR reversal, although SPX seems to be having a real struggle to get much above where it got to at the top (apex) of the prior wedge. So, the pattern may have signaled a top, but not in the way that I would have expected.

Sometimes a pattern that could be a wedge, but doesn't yet have many "touches" to either or both trendlines (to give better definition) but that you think MIGHT be a developing wedge, will prove not to be it will be "negated" so to speak, by prices breaking out in a direction opposite the expectation, as was the case in the Dow back in the fall


NOTE -
To Option Investor Subscribers - Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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