MY MAILBAG:

"Can you explain more on what looked bullish on the Dow chart? What you wrote about I dont get what a WEDGE represents or why it shows up. It wasnt any trouble to see the 3 times since January rallies failed to make headway making the market look toppy."

MY RESPONSE:

Since I've been writing this series on the basics of technical analysis, going into the basics of the (bullish) falling wedge or the (bearish) rising wedge would be a good topic for my Trader's Corner this week. Especially since what looks like a current falling bullish wedge has been/is being traced out on the major index charts. The so-called 'wedge', which is one of a group of reversal patterns, doesn't occur all that much, but when it does it usually precedes a substantial reversal move. The pattern can put you on alert for high potential trade.

REVERSAL PATTERNS:

Reversal chart patterns are the OPPOSITE of the group that tends to forecast the continuation of a trend, perhaps after a sideways pause; e.g., the rectangle. Reversal type patterns tend to predict (just as they are named) or warn of upcoming trend reversals.

Of course, very well know of the reversal patterns, are double tops and double bottoms or the Head & Shoulder's Top or Bottom formations. There has been speculation in recent weeks that the market had formed a large Head and Shoulder's Top pattern, dating from highs and then a retreat from those highs (the initial 'Left Shoulder') dating from January.

I have been debunking the interpretation on longer-term charts as that of a broad Head & Shoulder's Top pattern for various reasons, which were detailed in a recent Trader's Corner . This is not to say that a major top couldn't have formed since I could be wrong on my interpretation. I don't think so of course or I wouldn't put it out there and I also think I've found a more compelling story or chart interpretation.

BULLISH FALLING WEDGES:

The wedge pattern of a bullish 'falling' type tends to develop after an uptrend has been underway for some time, such as for many months and the market or stock encounters its first big correction. Where there are some big price swings back and forth, but within a pattern of falling relative rally highs and sell off lows. I said in my last Index Wrap that the Dow and (unusually) the Russell 2000 (RUT) showed the most distinct falling bullish wedges. As of today, mid-week, it appears that INDU has achieved an initially upside penetration of the top end of its falling wedge pattern traced out on my first chart and suggesting substantial more upside to come.

In a 'wedge', prices move gradually higher or lower but in a pattern where trendlines drawn through the various relative highs or lows slant in the same direction up or down and where the two trendlines 'narrow in'/converge when the lines are extended out into the future. 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 looks like may be happening with the current market, as represented here by the Dow 30 (INDU). The two down trendlines would converge and form the apex of the triangular wedge some weeks in the future.

Both a falling or rising wedge should have at least 5 'touches' to the down or up-sloping trendlines forming the opposite sides of the wedge; e.g., 3 along one side and 2 along the other. This can be seen on the INDU chart above as well as on other major indexes. The volume trend should be declining. When prices achieve a decisive penetration of the upper trendline there is generally a good-sized advance that follows.

'Confirmation' of an upside breakout in the case of the current Dow chart hasn't occurred yet. It would if INDU goes on to pierce the prior high Close (10450) and/or the prior intraday high at 10594. This is an important related point. It's still possible that prices sink again below the upper trendline and chop around within the boundaries of the two down-sloping trendlines.

My next chart is a past example of a stock that reversed from a bullish falling wedge type pattern. A 'minimum' upside objective for a move to at least the beginning of the wedge formation is also noted on the chart. The same type 'measurement' would project an eventual move in INDU back to its prior high.

BEARISH RISING WEDGES:

In a rising wedge prices move gradually higher and its two converging trendlines slope UP in a pattern of higher highs and lower lows. This was seen in 'rising wedge' pattern from my historical chart database, this one of the Dow Index (DJX). The Dow Index ended up in the 75 area by October of the year shown, which fulfilled a 'minimum' downside objective. More on that next.

The rule of thumb in measuring a downside objective for a bearish rising wedge is to look for a price target around the start of the formation, or the lowest low that started the wedge. as seen just above DJX ended up trading down to the 75 area by October.

The reverse measurement is done for a bullish falling wedge; i.e., look for a 'minimum' upside objective back to the high that was the starting point of the wedge; e.g., back to 11,200 area in the Dow, per my first chart above.

To create a wedge, there should be at least 2-3 upswing highs and downswing lows that comprise the points through which the trendlines are drawn. There are often more points than this, but be suspect of LESS than 5 'touches' to the converging trendlines.

A wedge pattern can also form over a lengthily period such as shown below of a wedge pattern that formed over a couple of years in American Express (AXP).

What is being suggested in the rising, bearish wedge is that buying is being met with stronger and stronger selling as prices edge higher. Just as in the bullish falling wedge; what is 'behind' the pattern is that selling is being met with stronger and stronger buying which is why the sharp upward bounces keep happening.

When prices fall below the lower up trendline of a rising wedge pattern, a trend reversal is suggested. Prices may rebound to the trendline again, but should not get back above it. Place a liquidating exiting stop order just above the broken trendline, if a bearish position is established on the downside break.

When one index has a bearish rising wedge, you will probably see the pattern in the related indices and some bellwether stocks as well. The same wedge pattern as seen above with DJX was showing up in some individual stock charts. This is the case with Cisco Systems (CSCO), a Nasdaq bellwether, as seen below in the same time frame as was shown 2 charts up for the Dow. CSCO ended up at lows in the 9.5 area a few months after the period shown below.

With the CSCO chart seen above we have related technical indicators to help 'confirm; a likely top, besides the double top at 15. Notably, volume was FALLING as prices were RISING, a classic price/volume bearish divergence.


GOOD TRADING SUCCESS!