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Falling Wedge Reversal Lesson
Wednesday, April 26, 2006

Lesson in Falling Wedge Reversal Patterns
 
I want to go over falling wedge reversal patterns.  The reason I want to cover this is because it is a difficult pattern to trade.  Furthermore, this pattern is showing up all over the place in the Recognia stock pattern scan.  Also please refer to the Recognia definitions of falling wedge reversals that I have posted below.
 
There are two types of falling wedge reversals.  The first type, is a falling wedge reversal.  The second  type, is a bullish continuation wedge pattern.  According to stockcharts.com the definition of a falling wedge is stated below.
 
Falling Wedge Reversal
 
"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. In contrast to symmetrical triangles, which have no definitive slope and no bias, falling wedges definitely slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout. " per stock charts.com

Furthermore, a falling wedge reversal occurs only after a stock has already topped.  A falling wedge pattern is a pullback or correction type pattern off of the highs.  A reversal off of the newly formed lows in the wedge will occur only when price moves out of the wedge and retests the wedge thus showing potential for a reversal.  Falling wedge reversals will typically retrace to the 50% / 65% Fibonacci retracement level.  Please refer to the chart of MTH.  For example since MTH has broken out of the wedge the price target remains at the 50% to 65% retracement area of 74.56 to $81.142.  Often I will update a chart as a falling wedge reversal chart as a worst case scenario to go to the 50% retracement area.

Continuation Falling Wedge Reversal

"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." per stock charts.com

In contrast to falling wedge reversals, Continuation Wedges are bullish because they are indicative of a failed topping pattern. These occur when a stock retraces up to the Fibonacci 72% retracement level of a prior move.  It is impossible to tell when that will occur until a stock actually does it. This price action then announces that the pattern is a continuation wedge. You have to have empirical evidence of that occurring. The stock has to retrace to the 72% level.  

I am using MTH as an example for this pattern because we are in it, and it is also a front runner for the housing sector.  It has historically performed better than any other housing stock. It will front run to the upside and vice versa.  Remember to manage your trade on the way up at resistance points at $69.0 and $75.00. 

Furthermore, there is nothing wrong with managing a trade to the point where you have enough profit that you are then trading the stock with the house's money.  For example, lets assume that MTH does retrace up to the72% level, well selling and taking profits along the way will keep you in the stock because you managed your trade correctly. Falling Wedges can be mentally exhausting patterns to trade.  You have to have both the mental and financial wherewithal to trade and stay in these types of patterns.  When they work, they are extremely rewarding patterns.  More examples of falling wedges are AAPL and GOOG.  


Falling Wedge Reversal

 

Falling Wedge Continuation Pattern


Implication


A Continuation Wedge (Bullish) is considered a bullish signal. It indicates a possible continuation of the current uptrend.


Description


A Continuation Wedge (Bullish) consists of two converging trend lines. The trend lines are slanted downward. Unlike the Triangles where the apex is pointed to the right, the apex of this pattern is slanted downwards at an angle. This is because prices edge steadily lower in a converging pattern i.e. there are lower highs and lower lows. A bullish signal occurs when prices break above the upper trendline.

Over the weeks or months that this pattern forms the trend appears downward but the long-term range is still upward. Volume should diminish as the pattern forms.

Falling Wedge

Trading Considerations


Pattern Duration
Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to move to the Target. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.


Target Price
The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.


Criteria that Supports


Volume
Volume should diminish as the pattern forms.


Criteria that Refutes


Moving Average
The penetration of the 200-day Moving Average by the price is a false bear signal.


Rising or Stable Volume
Volume should diminish as the pattern forms. If volume remains the same or increases this signal is less reliable.


Underlying Behavior


In this pattern prices edge steadily lower in a converging pattern i.e. there are lower highs and lower lows indicating that bears are winning over bulls. However, at the breakout point the bulls emerge the victors and the price rises.


Although it appears things are changing and the "BULL" is lurking, this pattern is typically "corrective" in nature to a larger trend or pattern. These wedges can typically retrace 50-65% of the FALL before it resumes the primary trend.


Statistics
Percent of successful formations – 81% Average rise of successful formations – 46% Likely rise – 20% Failure rate - 37% Average time to throwback completion – 11 days

 

Falling Wedge