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Friday, August 27, 2010

FALLING WEDGE PATTERN – Part 2: Important Characteristics

Go back to Part 1: Falling Wedge Formation

Important Characteristics of Falling Wedge Pattern

Existing Trend:
There should be an established existing trend (either uptrend or downtrend). As mentioned before, Falling Wedge, which has a bullish bias, can be categorised as a reversal or continuation pattern.
As a reversal pattern, Falling Wedge normally occurs after an established downtrend. The slope of Falling Wedge will be downward, which is in the same direction as the prevailing trend.
As a continuation pattern, Falling Wedge occurs after following an uptrend. The slope of Falling Wedge will still be downward, but this slope will be against the prevailing uptrend.

Shape of Falling Wedge:
* There should be at least 4 reversal points to draw two converging lines, i.e. two successively lower peaks (highs) forming a downward sloping upper line and two successively lower troughs (lows) forming a downward sloping lower line. The descending upper line acts as resistance, while the descending lower line as support.
The more times the price tests each level, particularly on the upper side (resistance), the higher quality the wedge pattern is thought to be.
* The upper line (resistance) should have a sharper slope (more negative slope) than the lower line (support). If the lines were extended to the right, both lines would converge and slanted in a downward direction.
* There should be some distance between the two peaks as well as the two troughs.
In other words, prices should increase and hit the descending upper line then decline for at least twice (forming at least two peaks). Prices should drop and hit the descending lower line then bounce up for at least twice (forming at least two troughs).

Volume should be diminishing; heavy at the beginning and contracts as the pattern develops.
However, when breakout occurs, there should be a significant increase in volume.
Monitoring the existence of significantly higher volume to confirm a valid breakout for Falling Wedge is more crucial than for Rising Wedge.
Without a significant surge in volume, the upward breakout above the resistance of Falling Wedge would lack conviction and be more vulnerable to failure.

This pattern is generally a longer term pattern. It takes from about 3 to 6 months to form.
If the pattern duration is less than 3 weeks, it can be considered as a pennant.

Breakout Direction:
For Falling Wedge, the breakout usually happens to the upside, hence it is considered as a bullish pattern. However, the breakout might also occur to the downside.

Breakout Confirmation:
Sometimes, the price may also make a deceptive/invalid breakout whereby it touches above the upper (resistance), but then it moves back down again & resumes downtrend.
One possible way to prevent this is by having certain criteria to confirm if the breakout is a valid one.
A minimum penetration criteria for a breakout should be the price closes ABOVE the upper (resistance) line, not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the upper (resistance) line depending on the stock’s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.

Potential Price Target:
For Wedge pattern, there is no price target, as it is difficult to project specific potential price target in this pattern.

Return to Breakout Level:
After the breakout occurs, the price may sometimes return to the breakout level for an immediate test of this new resistance before continuing their moves in the direction of the breakout. (Remember that the support now has turned into new resistance level).
However, the prices should not re-enter the wedge and move outside the opposite line of the breakout line. When this happens, it means the pattern has failed or considered in invalid.

To find out more about other Chart Patterns, please refer to:
Learning Charts Patterns

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Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Option Greek
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value