Narrowing Wedges - Advanced Analysis

20 paź 2021

In the last post in this series on chart patterns, we described the characteristics, rules, and causes of broadening wedges patterns (if you haven't seen it, see the related ideas below).

In this post, we shall perform an advanced analysis of a related pattern, narrowing wedges. We provide a description of each pattern and its implications.

That's the way it ends. The thin edge of the wedge.

- Bulkowski (1)

1. Narrowing Wedges

Narrowing Wedge patterns are reversal patterns that are characterized by price variations laying within one support and resistance and both having the same direction and narrowing over time. In a narrowing wedge, the apex is located at the end of the formation.

1.1 Rising Wedge



Rising wedges mostly occur during uptrends, with raising local maxima (higher highs) forming an upward sloping resistance and raising local minimas (higher lows) forming an upward slopping support. The slope of both the support and resistance should be significantly different from 0.

Bulkowski suggests the price should test the support and resistance 5 times.

Volume tends to decrease during the formation of such patterns.

Ascending wedges are bearish-biased, with breakouts mostly occurring downward. Downward breakouts are often followed by a decrease in price.



Example of rising wedge on Visa daily followed by a downward breakout.

1.2 Falling Wedges



Falling wedges mostly occur during downtrends, with declining local maxima (lower highs) forming a downward sloping resistance and declining local minima (lower lows) forming a downward slopping support. The slope of both the support and resistance should be significantly different from 0.

Like with rising wedges, Bulkowski suggests the price should test the support and resistance 5 times.

Volume tends to decrease during the formation of such pattern.

Descending wedges are bullish biased with breakouts mostly occurring upward. Upward breakouts are often followed by an increase in price.



Example of falling wedge on Trivago daily.

2. Measure Rule



The measure rule allows for the determination of where to set a take-profit/stop-loss after a breakout in a narrowing wedge formation. Rules differ from an upward to downward breakout of the formation.

When price breaks the support of a rising wedge, the take-profit is determined from the lowest low inside the formation. When the price breaks the resistance, the take-profit is determined by adding the height of the formation to the breakout point.

When price breaks the resistance of a falling wedge, the take-profit is determined from the highest high inside the formation. When the price breaks the support, the take-profit is determined by subtracting the height of the formation from the breakout point.

3. Some Observations

Technical analysts believe that narrowing wedges indicate a sentiment switch. The impulses within the formation have a decreasing amplitude over time, indicating a potential change in trend. The amplitude of the impulses decrease linearly over time.

The underlying trend in narrowing wedges formation is linear. Detrended prices within a narrowing wedge would highlight a damping effect.

Rising Wedges have been studied with climate time-series data (2)

References

(1) Bulkowski, T. N. (2021). Encyclopedia of chart patterns. John Wiley & Sons.

(2) Kaiser, J. (2017). Technical analysis of climate time series data.