The Wedge Formation

THE WEDGE FORMATION

The wedge formation is similar to a symmetrical triangle both in terms of its shape and the amount of time it takes to form. Like the symmetrical triangle, it is identified by two converging trend­lines that come together at an apex. In terms of the amount of time it takes to form, the wedge usually lasts more than one month but not more than three months, putting it into the inter­mediate category.

What distinguishes the wedge is its noticeable slant. The wedge pattern has a noticeable slant either to the upside or the downside. As a rule, like the flag pattern, the wedge slants against the prevailing trend. Therefore, a falling wedge is considered bullish and a rising wedge is bearish. Notice in Figure 6.8a that the bullish wedge slants downward between two converging trendlines. In the downtrend in Figure 6.8b, the converging trendlines have an unmistakable upward slant.

Figure 6.8a Example of a bullish falling wedge. The wedge pattern has two converging trendlines, but slopes against the prevailing trend. A falling wedge is usually bullish.

Figure 6.8b Example of a bearish wedge. A bearish wedge should slope upward against the prevailing downtrend.

Wedges as Tops and Bottom Reversal Patterns

Wedges show up most often within the existing trend and usually constitute continuation patterns. The wedge can appear at tops or bottoms and signal a trend reversal. But that type of situation is much less common. Near the end of an uptrend, the chartist may observe a clearcut rising wedge. Because a continuation wedge in an uptrend should slope downward against the prevailing trend, the rising wedge is a clue to the chartist that this is a bearish and not a bullish pattern. At bottoms, a falling wedge would be a tip-off of a possible end of a bear trend.

Whether the wedge appears in the middle or the end of a market move, the market analyst should always be guided by the general maxim that a rising wedge is bearish and a falling wedge is bullish. (See Figure 6.8c.)

THE RECTANGLE FORMATION

The rectangle formation often goes by other names, but is usually easy to spot on a price chart. It represents a pause in the trend dur­ing which prices move sideways between two parallel horizontal lines. (See Figures 6.9a-c.)

The rectangle is sometimes referred to as a trading range or a congestion area. In Dow Theory parlance, it is referred to as a line. Whatever it is called, it usually represents just a consolidation period in the existing trend, and is usually resolved in the direction

Figure 6.8c Example of a bearish rising wedge. The two converging trendlines have a definite upward slant. The wedge slants against the prevailing trend. Therefore, a rising wedge id bearish, and a falling wedge is bullish.

Figure 6.9a Example of a bullish rectangle in an uptrend. This pattern is also called a trading range, and shows prices trading between two horizontal trendlines. It is also called a congestion area.

Figure 6.9b Example of a bearish rectangles. While rectangles are usually considered continuation patterns, the trader must always be alert for signs that it may turn into a reversal pattern such as a triple bottom.

Figure 6.9c A bullish rectangle. Compaq’s uptrend was interrupted for four months while it traded sideways. The break above the upper line in early May completed the pattern and resumed the uptrend. Rectangles are usually continuation patterns.

of the market trend that preceded its occurrence. In terms of forecasting value, it can be viewed as being similar to the sym­metrical triangle but with flat instead of converging trendlines.

A decisive close outside either the upper or lower bound­ary signals completion of the rectangle and points the direction of the trend. The market analyst must always be on the alert, how­ever, that the rectangular consolidation does not turn into a rever­sal pattern. In the uptrend shown in Figure 6.9a, for example, notice that the three peaks might initially be viewed as a possible triple top reversal pattern.

The Importance of the Volume Pattern

One important clue to watch for is the volume pattern. Because the price swings in both directions are fairly broad, the analyst should keep a close eye on which moves have the heavier volume. If the rallies are on heavier and the setbacks on lighter volume, then the formation is probably a continuation in the uptrend. If the heavier volume is on the downside, then it can be considered a warning of a possible trend reversal in the works.

Swings Within the Range Can Be Traded

Some chartists trade the swings within such a pattern by buying dips near the bottom and selling rallies near the top of the range. This technique enables the short term trader to take advantage of the well defined price boundaries, and profit from an otherwise trendless market. Because the positions are being taken at the extremes of the range, the risks are relatively small and well defined. If the trading range remains intact, this countertrend trading approach works quite well. When a breakout does occur, the trader not only exits the last losing trade immediately, but can reverse the previous position by initiating a new trade in the direction of the new trend. Oscillators are especially useful in side­ways trading markets, but less useful once the breakout has occurred for reasons discussed in Chapter 10.

Other traders assume the rectangle is a continuation pat­tern and take long positions near the lower end of the price band in an uptrend, or initiate short positions near the top of the range in downtrends. Others avoid such trendless markets altogether and await a clearcut breakout before committing their funds. Most trend-following systems perform very poorly during these periods of sideways and trendless market action.

Other Similarities and Differences

In terms of duration, the rectangle usually falls into the one to three month category, similar to triangles and wedges. The vol­ume pattern differs from other continuation patterns in the sense that the broad price swings prevent the usual dropoff in activity seen in other such patterns.

The most common measuring technique applied to the rectangle is based on the height of the price range. Measure the height of the trading range, from top to bottom, and then project that vertical distance from the breakout point. This method is similar to the other vertical measuring techniques already men­tioned, and is based on the volatility of the market. When we cover the count in point and figure charting, we'll say more on the question of horizontal price measurements.

Everything mentioned so far concerning volume on break­outs and the probability of return moves applies here as well. Because the upper and lower boundaries are horizontal and so well defined in the rectangle, support and resistance levels are more clearly evident. This means that, on upside breakouts, the top of the former price band should now provide solid support on any selloffs. After a downside breakout in downtrends, the bot­tom of the trading range (the previous support area) should now provide a solid ceiling over the market on any rally attempts.