Jan Kodier is the portfolio manager for the European assets of the company «АХА Investment Managers» in Paris.
Rising wedge and falling wedge
If you take a long term, then the model «falling wedge» we meet much less often, than traditional reversal patterns, like an inverted model «head-shoulders» or double / triple base, but they are excellent warnings of the end of a downtrend.
Model building and basic principles
Unlike flags and rectangles, the wedge has two converging straight lines — support and resistance line. Both lines are slanted up or down. We believe, that support and resistance lines, constructed by only two points is quite enough, to qualify the model «wedge». A rising or falling wedge can continue all the way to its top.
In all the examples below, to identify models «wedge» open / close prices are used, not extreme values, achieved during the trading session. This allows more «purely» estimate price charts during volatile sessions. In the diagram 1 shows the daily stock chart «Nokia», which shows a good example of an intraday rising wedge. Pay attention to divergence, formed by the slow Stochastic at the end of the pattern.
Although usually «wedge» is considered, as a reversal pattern. it can also act as a continuation model. In the diagram 4 an excellent example of a continuation pattern is shown «Rising Wedge» on the Topix chart in 2007.
Model risks
Model success rate «wedge» (respectively, as a percentage of bearish / bullish breakouts for upward downtrend variants of the pattern) is high enough, but trading on it is not so easy. The main reason for this is the difficulty in predicting the breakout point due to the instability of this model.. For example, trader думает, that the price has broken the lower trendline of the rising wedge, and accordingly bets on a likely sharp decline in price. Однако, models «wedge» especially vulnerable to rapid price reversals. In the case of our rising wedge (cm. диаграмму 3), the price may reach the former lower support line, which now acts as a resistance line. Avoiding a mistake does not only mean cutting a recently opened short position, but also trade long again. If a pullback occurs after a rising wedge breakout (quick turn up), then the appropriate solution would be: partially neutralize a short position: re-draw a less steep lower trendline, acting as support, to take into account possible false breakouts; reopen a short position, as soon as this new trend line is broken downward For greater reliability, you can additionally use technical indicators — bearish divergences work especially effectively (see details. below).
Price targets
Based on our experience, after the breakthrough of the model «wedge», the price almost always goes in the expected direction. Besides, the duration of the pattern completion before the breakout usually determines the magnitude of the subsequent trend — especially long rising wedge, usually, warns us of an impending large bearish move. Another difficulty is related to setting a price target.. Unlike other graphic models, like «треугольника» or «head-shoulders», which have clear benchmarks for price targets, models «wedge» often include false and / or multiple breakouts, which leads to the need to correct trend lines. If we are dealing with a continuation model — for example, «Falling Wedge» after a clear bullish trend, then you can calculate the degree of motion to the model and extrapolate it to the top of the model, as soon as the wedge is broken (as for model «flag» or «вымпел»). On the other hand, if you expect, that the wedge will be a reversal pattern, then such measures are ineffective. In this case, best price targets provide Fibonacci retracements.
Asymmetric Command
Human psychology suggests, that market lows form at the end of longer periods. This is why the reversal «Falling Wedge» takes longer, than reversal «Rising Wedge». That is why after a long period of pessimism in the market, it is not advisable to rely on upside breakouts «Falling Wedge», Except in the following cases, when it happens against the backdrop of very bad news. Очевидно. what if the market doesn't react to more bad news. then, probably, he is ready for strong growth.
In the diagram 5 shown «falling wedge» with the development of a bullish reversal, formed on the daily chart of the USDJPY currency pair. note, that the support line of the model is provided by only two points. We see, that it was best to wait for a short-term pullback after a few days, after model completion (green arrow), before opening a long position.
Model confirmation
As usual in technical analysis, the reliability of the model is better to confirm, using additional methods. Elliott Wave research can be very helpful here, since the continuation models «wedge» often seen in waves 2 And 4. Wedge can also be found in the wave 5 — in this case, is he. essentially, is a reversal warning.
Conceptually, they match perfectly with exhaustion situations. common to most waves 5 — new highs are forming (in the case of a rising wedge), but in a more gradual way, with decreasing volumes and decreasing variability.
Volume Analysis
When analyzing models «wedge» it is very important to closely monitor the volume. Volume can help clarify whether, is the current consolidation model «Ascending Triangle» or «Rising Wedge». In the model «rising wedge» volumes, achieved at each consecutive maximum, tend to decrease. IN «Ascending Triangle» volumes will be higher on growth days, than on days of decline. When volume decreases during rising waves in a narrow range, we get a strong warning of a bearish reversal..
Oscillators
Using technical indicators — this is another method to avoid false signals from the outside «Wedge». They will not help you avoid fast reversals., but can help with the timing of entry and exit from the market. Usually, momentum indicators work best with reversal patterns, and trend following indicators are better with continuation patterns.
For reversal patterns, Slow Stochastic can be especially effective. to track divergences between price and indicator, receive line crossing signals %D и %DS. and generally watch out for the exit from the overbought / oversold zones.
The MACD indicator is also very helpful in confirming the pattern. «wedge». Chart b shows the daily SPX chart after the 1987 stock market crash.. He demonstrates a great example of a reversal pattern. «falling wedge», which is confirmed by a very clear divergence between price and MACD indicator.
Trading Rules
- Timing. In the case of the «wedge» it is not easy to calculate the breakout point, because unlike triangles, there is no deadline for model completion. Model formation «wedge» may well last all the way to the top, without losing its relevance.
- Breakthroughs. Breakout may be false, therefore, one should look for confirmation in the price movement — например. the formation of two candles outside the boundaries of the wedge. Keep track of volume and technical indicators, to assess the degree of reliability of the price movement. If volume fails to follow price, then the probability of a breakout increases. In this case, it is advisable to set a stop order a few pips below the previous breakout level after «Rising Wedge».
- Price target. It's not worth setting a price target, just based on this model. Even though. what are the summer goals to determine in the case of the continuation (by extrapolation), they do not demonstrate sufficient effectiveness.
- Model reliability. In the case of a model «wedge» we need a certain tolerance. False breakouts happen quite often, and therefore requires a repeated change in the trend line. Monitoring volume is critical, to assess the chances of a false breakout.
- Risk limitation. Finally, it is necessary to ensure the limitation of losses, when it comes to reversal patterns «wedge» — stop orders must be placed clearly above (below) extreme value, achieved in the process of forming the model. It should be remembered that, that there should be more room to maneuver, than for any other graphical model.
A source: article «Unique model» from Forex Magazine.
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