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Chart Patterns - Reversal - Falling Wedge
Technically speaking, a 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.
Why Does It Happen?
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.
How are Technical Targets Derived?
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 Wedge for Nike
Riding a 58 percent increase in second quarter earnings it appeared as though Nike (NKE) common stock really was touched by the gods but things turned sour very quickly for the maker of athletic shoes and apparel. After reaching a high of $55.88 on December 16, the stock collapsed just two months later. It all began February 8, 2000 when a Nike spokesman announced that the company expected earnings to fall short of Wall Street expectations due to a decline in the number of retailers carrying Nike products. On that session the stock lost $8.75 to close at $37. In the ensuing sessions both Bank of America and Merrill Lynch joined the ranks of firms cutting estimates and making negative comments. By February 28 the stock was trading at just $26.81 on very low volume. By March 3 the stock had rebounded modestly to $30.25 on continued light volume. On March 6 the stock began to work lower again after the firm announced that it had reached a deal with American Golf Learning Centers. By March 9 the stock had reached a new low at $25.81 on very light volume. Then, unexpectedly the stock began to rally. Despite more negative talk from analysts, Nike shares rallied to $33.88 by March 16. After the close on March 17 Nike reported earnings that were at the high end of Wall Street expectations. By April 11 the stock was trading at $45.75.
Vital Signs
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.
Well that's it for reversal chart patterns, now let's move onto continuation chart patterns.
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