Wedge Formation

The wedge formation is a close relative of the triangle and the pennant formations. It resembles both the shape and the development time of the triangles, but it really looks and behaves like a pennant without a pole. The wedge is markedly sloped, and the breakout occurs in the direction opposite to its slope (see Figure), but similar to the direction of the original trend. The signal we receive from the wedge formation is direction only. There is no reliable price objective. Depending on the trend direction, there are two types of wedges: falling (see Figure ) and rising.
Falling Wedge
Falling wedge in a downtrend is a decline to a new low on strong volume, several weeks of range-bound trade characterized by lower lows and lower highs with contracting volume, followed by a sharp break higher on strong volume.It is important to note, unlike all other chart patterns, valid falling wedge patterns can be either continuation or reversal patterns.Falling wedges in downtrends are usually part of larger reversal trends so the implications for the pattern are modest.
Technical targets are derived by adding the height of pattern to the eventual breakout level. The breakout level will be determined by a trend line drawn from the area of initial consolidation through the reaction high.
• Falling wedges can be either reversal or continuation patterns. When they occur in downtrends they are always reversal patterns.
• Because falling wedges are generally just the starting points for larger reversal patterns, the implied technical targets are modest.
• Volume is key in falling wedge patterns in a downtrend. Volume should increase on the initial watershed decline but dwindle through the remainder of the pattern. As the breakout occurs volume should surge.
• Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level. If the stock closes above this level (now support) for any reason the pattern becomes invalid.
 
Like most distribution patterns, the Falling Wedge is mostly about deception. There is every reason to believe that the stock is merely consolidating before making a new leg lower but a massive rally ensues. Falling wedge patterns always begin when a darling stock has fallen from favor. The initial weakness may be due to an earnings warning, a product delay, lawsuit or any number of negative developments but the impact of this news is always sufficient to lead most stock holders to panic. The result is what technical traders call a watershed decline — a near vertical drop in huge volume.
For many sessions after this drop the stock will usually meander in a narrow trading range as investors attempt to catch their breath Some investors that have been "spooked" by the big decline feel compelled to exit but their own tendencies will not allow them to sell a position for a loss — so they simply stand aside and hope to sell the stock into strength. Others become so demoralized that they are willing to sell at any price, they just want to get out. Still others look at the recent decline and deluge of poor fundamental news as evidence that the stock is headed much lower and begin adding new short
positions.
It is this latter group of investors that become most vulnerable in the falling wedge in a downtrend. It is important to note that the initial "spike" in volume in the formation of a falling wedge is always about longer-term investors building new positions into the weakness. Days later the stock moves to a new low but volume begins to wane and it becomes very clear that the stock is trying to find a happy balance between buyers and sellers, prices stabilize. Slowly, the stock begins to work higher but volume remains exceptionally light.
During this rally the fundamental news is generally quite sparse. As the stock reaches a plateau (reaction high) more negative fundamental news hits the wires and the stock begins to move lower yet again, pushing to a second new low.
However this decline is accompanied by very light volume. Those that purchased the stock at higher prices and have not yet sold refuse to liquidate their positions despite the bad news. Days later the lack of new selling leads to price stabilization.
Several days later volume begins to pick-up and price rallies. Analysts weigh-in with negative comments but the stock continues to move higher on increased volume. As the stock pushes through the reaction high short sellers panic and a large
move higher ensues. Several weeks later the stock trades back to intermediate term resistance. The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price action
forms a cone that slopes down as the reaction highs and reaction lows converge. Falling wedges slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout. The falling wedge can also fit into the
continuation category. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing uptrend. As a reversal pattern, the falling wedge slopes down and with the prevailing trend. Regardless of the
type (reversal or continuation), falling wedges are regarded as bullish patterns.
 
1. Prior 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. The pattern usually forms over a 3-6 month period and the preceding downtrend should be at least 3 months old.
2. Upper resistance line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be lower than the previous highs.
3. Lower support line: At least two reaction lows are required to form the lower support line. Each reaction low should be lower than the previous lows.
4. Contraction: The upper resistance line and lower support line converge to form a cone as the pattern matures. The reaction lows still penetrate the previous lows, but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line.
5. Resistance Break: Bullish confirmation of the pattern does not come until the resistance line is broken in convincing fashion. It is sometimes prudent to wait for a break above the previous reaction high for further confirmation. Once resistance is broken, there can sometimes be a correction to test the newfound support level.
6. Volume: While volume is not particularly important on rising wedges, it is an essential ingredient to confirm a falling wedge breakout. Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure. 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 technicians 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 to confirm signals.
 
Rising Wedge
Rising Wedge in an uptrend is a rally to a new high on strong volume, several weeks of narrowing, range-bound trade characterized by higher highs and higher lows with contracting volume, followed by a sharp break lower on strong volume Rising Wedges in uptrends are usually part of larger reversal trends so the implications for the pattern are modest.
Technical targets are derived by subtracting the height of the pattern from the eventual breakout level. The breakout level is determined by drawing a trend line drawn from the area of initial consolidation through the reaction high.
• Rising wedges can be either reversal or continuation patterns. When they occur in an uptrend they are always reversal patterns.
• Because rising wedges are generally just the starting points for larger reversal patterns, the implied technical targets are modest.
• Volume is key in rising wedge patterns in uptrends. Volume should increase on the initial surge to new highs but dwindle through the remainder of the pattern. As the breakout occurs volume should surge.
• Downside breakouts often lead to small 2-3% declines followed by an immediate test of the breakout level. If the stock closes above this level (now resistance) for any reason the pattern becomes invalid.
Like all reversal patterns, the Rising Wedge in an uptrend is ultimately about deception. At first and perhaps even second glance, the stock may appear to be doing all of the right things, making a series of higher highs and higher lows. The flow of news is unanimously positive and Wall Street analysts fall over one another to raise estimates and price targets, yet in reality, the stock is being distributed from strong hands (longer-term investors) to weak hands (short-term speculators and less astute investors).
The pattern begins when a much loved stock moves to a new high after an extended advance on good volume. To be sure, momentum investing and all around euphoria contribute to the surge in stock price but by most accounts the fundamental outlook is solid. As the stock makes a new high something peculiar occurs. Instead of volume surging, it actually begins to contract and price falters, making a reaction low. Wall Street analysts conclude that the stock is merely having a well deserved short term consolidation after a lengthy advance and in the days ahead they reiterate "buy" ratings. Once again the stock surges to a new high but volume slows even further and very quickly price begins to fade.
At this time the news flow is excellent. The company may be raising guidance, unveiling new products, winning contracts and/or setting stock splits. In short, it is easy to be bullish — especially when most investors share that sentiment. But beneath the surface something is happening, the stock is being distributed, longer-term investors are using every piece of good news to reduce positions.
As the stock falters for a second time the low achieved is well above the reaction low and the chart begins to take on the appearance of a wedge. After several sessions of consolidation more good news hits the news wires and the stock surges to yet another new high. As was the case during the previous two rallies, volume contracts. Then, abruptly price begins to falter. Wall Street analysts remain steadfast because there have been no fundamental developments to account for the weakness. Several firms reiterate "buy" ratings, advising clients to use the weakness to build positions but in reality, longerterm investors are continuing to sell. This time the new bullish talk has little impact and price begins to free fall.
The bullish talk and positive news flow continue but it is just a matter of time before the parameters of the wedge pattern are violated. Soon after, support at the reaction low is violated. Several days after the first negative news item hits the wires and speculators and recent investors begin to panic, price plummets. Several weeks later the stock trades back to intermediate term resistance.