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More on 'Wedge' patterns

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OIN SUBSCRIBER QUESTION: "I see that there has been a move higher in the market mostly after you pointed out some bullish possibilities suggested by the charts. Can you show more examples of what you wrote about previously and what this relates to in the market?"

RESPONSE: I was writing about the so-called wedge pattern and it's not a real common pattern and has two varieties, one 'rising' and one 'falling'. However, by going through just the Dow stocks, I can find several examples of bullish falling wedge and the bearish rising wedge. Examples in the indexes are less common, but there are recent examples of declining wedge patterns that suggest the market could work higher over coming weeks and months.

What does the pattern relate to? When prices are rising OR falling in a stock or an index over many weeks and months but the range between highs and lows narrows in substantially, we wind up with a wedge type shape like a piece of pie only the pie-shape points up or down.

The rising wedge pattern relates to what I would call price 'contraction', which suggests that buying and selling interests have become more in balance. When this happens buying may be waning considerably and the stock or overall market quite overvalued. Since the trend has been going UP, it also suggests that the stock or index is subject to a downside reversal, so is a bearish pattern; i.e., suggests potential for price momentum to shift from up to down.

The falling wedge pattern relates to what I would call price 'compression' although these words (contraction and compression) are pretty much interchangeable but just have a different flavor. In the compression or narrowing of the price range between highs and lows in a declining trend, again comes the thought that buying and selling forces are becoming balanced. When this happens the visual depiction of it on a chart suggests that selling is drying up and the stock or overall market may have become quite undervalued and is susceptible to an upside reversal.

Patterns in stocks and the major market indexes are seen over and over during the years and decades and 'technically' oriented traders and investors begin to study the past outcomes AFTER a certain pattern forms. One study of patterns seen in stocks and of course there are many more price history and examples provided by the myriad stocks. A book by an investor and trader named Tom Bulkowski in a book called The Encyclopedia of Chart Patterns.

Tom lists the characteristics of a wedge pattern. There should be multiple 'touches' to the opposing trendlines, at least 3 touches to one trendline and 2 to the other. The opposing trendlines that are pointing in the same direction have different slopes but are sloped such that over time they will touch (the apex). We often project out into the 'future', beyond where prices are currently, to see where the two trendlines would intersect.

Price objectives implied by the rising or falling wedge patterns are the key thing and get triggered by a decisive upside or downside penetration of the lower trendline in the case of a rising wedge OR the upper trendline in the case of a falling wedge. The anticipated/potential trend reversal is going to be in the OPPOSITE direction of the way the wedge slopes and occurs usually at least half way or more between where the (wedge) pattern STARTS and the APEX.

A common objective for the upside or downside reversal is for the new trend to climb or fall back to the starting point of the wedge pattern.

Bullish FALLING wedges tend to have better predictability in terms of meeting the aforementioned objective. The average rise in the stocks that Bulkowski studied was 43% as measured from the breakout point or upside penetration of the upper trendline, with the most likely rise being between 20 and 30%.

The average fall in the stocks Bulkowski studied having bearish RISING wedges when they had a 'successful' outcome or decline of 19%, as measured from the 'breakout' point or downside penetration of the lower trendline; the most likely fall was 15%. However, in the examples of bullish rising wedges I looked at in the 30 Dow stocks over the past couple of years saw prices at least fall back to the 'start' of the wedge formation, including an example in the Nasdaq 100 tracking stock QQQQ.

RECENT FALLING WEDGE PATTERNS IN THE INDEXES

S&P 500 (SPX)

My charts reflect the close of yesterday (Monday, 12/8), as today's (Tuesday, 12/9) session is still in process. While the market is off today, with the S&P off 20+ points, the outcome of any 'unfolding' 'wedge' type patterns will be traced out over many days, weeks and possibly months. One day's price action isn't going to change the principles I'm discussing. When I first wrote about the bullish implications of the falling wedge pattern highlighted in SPX below, I thought that the initial upside penetration of the upper trendline (in the yellow circle) was going to 'prove' that this falling wedge had bullish implications and we'd see prices rise over time, probably substantially. However, the initial 'breakout' was on the low volume Friday after Thanksgiving. Subsequent price action has been bullish. We'll see where we wind up however over time!

[Image 1]

S&P 100 (OEX)

The reason to repeat the closely linked OEX chart next is that I also wanted to highlight that faltering price action AFTER the initial and 'false' breakout came after traders also showed quite high bullish sentiment and this development hasn't often led to sustained rallies. The result is a somewhat 'mixed' picture between chart pattern and one key indicator. However, price patterns tend to 'trump' indicators on balance.

[Image 2]

NASDAQ 100 (NDX)

A substantial rebound has occurred in the Nasdaq after the recent decisive upside penetration of the upper trendline of the falling wedge.

[Image 3]

BEARISH RISING WEDGES

I discussed the potential for a RETURN to the start of a wedge pattern, in this case a decline to at least the beginning of the bearish rising wedge pattern seen below in Wal-Mart (WMT); WMT went lower of course than the level light blue line marking a 'minimum' objective for the downside move in the stock. The 'apex' of the triangle has to be assumed here but you can envision how the two trendlines will converge out toward the end of the year. A 'CLASSIC' example in terms of the steepness of the rising wedge is provided in the chart following.

[Image 4]

My next chart is an INDEX example in terms of the NDX tracking stock QQQQ. The stock eventually traded down to 25 and far surpassing a 'minimum' downside objective implied by the bearish rising wedge. By the way, due to the limitations of the small screen shot here, the upper trendline has some points or some prior highs not seen on the left hand side.

[Image 5]

BULLISH FALLING WEDGES

Since the topic at hand is more on the BULLISH implications of the FALLING wedge pattern, I'll show more examples of this pattern.

Campbell Soup (CPB) saw an upside breakout above the upper trendline of the bullish falling wedge that eventually carried to a level at least equal to the start of the wedge pattern as noted at the light blue level line. CPB went higher of course, but not a lot higher; interesting, yes?!

[Image 6]

It remains to be seen where JP Morgan Chase (JPM) in the above chart chart will wind up if this current rally continues. After the decisive upside penetration of the upper line of the bullish falling wedge, there is the implication that JMP could work its way back up to 50 over time.

The examples provided below by Kraft Foods (KFT) and Verizon (VZ) after having traced out falling wedge patterns and then breaking out to the upside, suggest potential for further sustained rallies ahead for the stocks. In the case of VZ, the potential for a rebound back to the start of the bullish wedge pattern (at 36), has almost been realized already.

[Image 7]



GOOD TRADING SUCCESS!

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