The Falling Wedge
The Falling Wedge is a bullish chart pattern that is formed with a wide formation at the top and contracts as the pattern matures. The overall price action forms a down-sloping wedge as the support and resistance trend lines converge.
Contrary to the symmetrical triangle, which shows no obvious slope (bullish/bearish bias), falling wedges show an obvious slope to the downside and hold a bullish bias. Though the pattern is typically a signal of reversal, continuation of the downtrend is still a possibility.
When present as a continuation pattern, the falling wedge will slope to the downside, but the down-slope will typically be found within an uptrend. An example is shown below on SPY's 5 min chart:
When present in as a reversal pattern, the falling wedge will slope to the downside within a downtrend. Regardless of continuation or reversal, falling wedges are considered bullish patterns. Below is an example of a reversal, also shown on SPY's 5 min chart:
Established Trend: To qualify as a reversal pattern, there must be a prior trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low. These patterns can be found in nearly every time frame.
Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line. Each reaction high should be lower than each previous high. Both the support and resistance lines are label on PYPL's daily chart below:
Lower Support Line: At least two reaction lows are required to form the lower support line. Each reaction low should be lower than each previous low.
Range Contraction: The range contraction of the falling wedge is similar to that of the rising wedge, but with a flip of the chart. The upper resistance line and lower support line converge to form a downward sloped cone as the pattern matures. If there is no slope in the overall formation, it may be a symmetrical triangle. Each reaction low still penetrates the previous low, but this penetration becomes shallower. The shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line.
Resistance Break: Bullish confirmation of the pattern does not come until the resistance line is broken in convincing fashion. It is sometimes considered prudent to wait for a break above the previous reaction high for further confirmation. Similar to other pattern breaks, once the pattern is broken, there can sometimes be a correction to retest the former resistance, now turned support. The same PYPL's daily chart can be used to show an example of a retest.
Volume: While volume is not vital during the formation of the falling wedge, it is an essential ingredient to confirm a falling wedge breakout. If the volume is weak, the breakout will lack conviction and be vulnerable to failure. Avoid going long if the volume is weak.
Conclusion
As with the rising wedge, the falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. When lower highs and lower lows form, as in a falling wedge, a security remains in a downtrend. The falling wedge is designed to spot a decrease in downside momentum and alert technician analysts to a potential trend reversal. Even though selling pressure may be diminishing, demand does not win out until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis such as the MACD, RSI and Moving Averages to confirm signals.
Labels: Technical Analysis
