MAILBAG QUESTION:

"I have been studying Apple (AAPL) chart, as an example of a broadening wedge breakout, obviously it could end in a variety of ways. Also, my core holding is has broken out of a broadening bottom, i was just wondering if there is any further information available on this unusual pattern, beyond Dr.Lo's analysis?"

MY RESPONSE:

I would say that, while the break out from Apple's downward sloping wedge pattern (per its weekly chart), 'could' end in a variety of ways as you say, the breakout from the declining wedge suggests a bullish outcome.

As to the broadening pattern, be it an apparent bottom or apparent broadening top, I have more information and I hope you are perusing my Trader's Corner articles to see this follow up to your question.

Both the broadening bottom (or broadening top) AND the 'wedge' patterns are usually chart formations that suggest significant trend reversals ahead.

WEDGE PATTERNS

As noted by our OIN Subscriber, Apple's weekly chart has traced out a well-defined downward sloping wedge, which has been followed by a bullish upside breakout above the apex of the wedge.

The opposite of patterns that tend to predict continuation of a trend, after a pause or consolidation, are ones that tend to predict upcoming reversals of the dominant trend. Of these, very well known are double tops and bottoms and Head and Shoulder's tops and bottoms. One seen less often but that is predictive for a bottom or top is the wedge pattern.

BEARISH RISING WEDGE:

In a rising 'wedge', prices move gradually higher but upper and lower trendlines that converge or 'narrow in' are traced out with a pattern of higher highs and lower lows. One such example, taken from my historical chart database was seen in the Dow Index. I'm not going to go into this pattern beyond showing it. (My primary focus today is on APPL's bullish falling wedge.)

There is a 'measuring' rule of thumb for a downside objective in the bearish rising wedge seen above; i.e., prices should decline to the start of the formation, or the lowest low as a "minimum" downside objective.

Within a few weeks after the period shown above (mid-October, 2002) the Dow Index had fallen to a low in the 72.5 area. Note: the week of that low DJX Closed at 78.5.

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 typically are more points than this 'minimum' number for drawing the two converging lines.

BULLISH RISING WEDGE:

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 in my next chart.

Unlike the daily chart seen above, a wedge pattern can also form over a lengthily period such as seen with the downward sloping (and presumably bullish) wedge seen with Apple's weekly chart here:

There is one rule-of-thumb measurement suggesting that after an upside move above the wedge, prices could rebound at a 'minimum' back to the high point of the downward sloping trendlines that comprise the wedge pattern (seen above) is back to Apple's prior highest closing high; e.g., 700 on a weekly chart basis.

According to Thomas Bulkowski, in his Encyclopedia of Chart Patterns, an even higher percent of bullish falling wedges result in upside breakouts, relative to declines implied by bearish rising wedges. A 'failure' rate of this pattern (one NOT resulting in a good-sized counter-trend rebound) is only 10%.

Bulkowski also suggests that of the falling wedges he studied in stocks, the average upside rebound (after a breakout above the trendline) was around 43%, with the "most likely" rise between 20 and 30%. The upside breakout in Apple was at 442. Assuming a rise of 25%-40% from the breakout point, his work suggests a possible eventual upside objective to 552-632.

The foregoing suggests being ready to buy an upside breakout of the declining wedge as soon as it occurs.

BROADENING BOTTOMS

The reference made to "Dr. Lo" above refers to research of Dr. Andrew Lo at MIT which suggested that 5 technical/chart patterns had sufficient predictive value to be statistically significant; i.e., they had a level of future predictive value as defined in technical analysis lore that was greater than any random chance occurrence. The 5 are:

1. The Head & Shoulders top or bottom pattern

2. Double tops

3. Rectangle Tops

4. Rectangle Bottoms

5. The Broadening BOTTOM formation.

There are broadening bottoms AND broadening tops but the broadening bottom formation is the one that the MIT group found to have a better than chance predictive outcome.

The broadening formation is often a reversal pattern because, unlike the compression effect of the 'triangle' formation, occurring when buyers and sellers get more and more finely matched, the broadening formation could be considered 'decompression' so to speak. The price volatility of higher highs and lower lows occurs because buyers and sellers of a stock or stock index get less certain what the correct valuation (price) of a stock or index should be. This dynamic more often accompanies a reversal in the direction of the trend.

One peculiarity about a 'broadening' formation: the 'megaphone' shaped pattern is the SAME in either instance. It can be labeled an expected broadening BOTTOM when the trend that preceded the pattern is DOWN and a possible broadening TOP when the preceding trend was UP.

The following historical highlighted chart is from my (Essential Technical Analysis) book. A broadening bottom in a stock, KLA-Tencor Corp. is seen next:

The broadening bottom is where the price trend that preceded the pattern is downward and a sideways series of price swings develop that form a series of higher upswing highs and lower downswing lows; there is one upward and one downward sloping trendline. There should be at least 2-3 prices swings that result in the 2-3 lows and highs that allow drawing of the trendlines.

A breakout from the broadening bottom exists when prices advance about the highest high in the formation 'within' the megaphone outline. The measuring implication for the height of the next leg is the same regardless of whether the breakout direction is up or down. The measuring implication for a broadening bottom is for a 'minimum' objective equal to the height of the formation at its widest point added to the 'breakout point'; i.e., the breakout point is the price point at which prices advance above the upper trendline as seen above.

The price objective rule of thumb for broadening formations in general is not as reliable as for the Head and Shoulders or Rectangle pattern. If the breakout is to the upside, a subsequent gain is in the 20-30 percent range. Some studies suggest 20% as an average gain after such an upside breakout.

A MORE RECENT EXAMPLE - BROADENING BOTTOM


GOOD TRADING SUCCESS!