Inside the Recent Bearish Rising Wedge

Sep 5, 2008: 10:39 AM CST

Technicians should not be surprised with the recent downward price ejection out of the August consolidation pattern, known as a ‘rising wedge.’  Not only did the pattern follow classic definitions and expectations, we were treated with a prior example of the pattern just a few short months ago.  Let’s look at the Dow Jones index and step inside this pattern for a better educational foundation.

Dow Jones Daily Chart:

History repeats itself?  It sure seems likely, and many were aware of the possibility of the rising wedge seen from March to May repeating itself (almost exactly) into today’s environment.  The only major difference was that the current wedge endured two failure tests (failure tests take place after a breakout when price returns to test the lower trendline) instead of the one (red arrow) that occurred last time.

It’s very difficult to enter at the absolute breakout of the pattern, however the highest probability short-sell (or long liquidation) entry occurs at the failure test of the pattern (this is true on most patterns).  In fact, one could also call this a “throwback” rally before final expected capitulation.  Nevertheless, entry takes place as close to the trendline as possible, with a stop being placed on the opposite side of the upper trendline.  The target is often a “measured move” of the height of the pattern.

The initial target is always a test of the swing low, which in the Dow is near 10,800 from the July 15th low.  Odds look greater than ever that price will – at a minimum – test this price for a major battle at that level (the level is 1,200 on the S&P 500).

Notice the negative momentum divergences which set-up as price reached the ejection point (breakout zone) of the pattern – this adds to confirmation and confluence.

Let’s do something a little fun and go inside the bear wedge, sort of like entering the eye of a hurricane or core of a tornado… but safer.

Inside the Bearish Rising Wedge:

I’ve drawn this hourly chart on the Dow Jones index and drawn the trendline according to the “maximum touch” method, meaning you attempt to draw the line so as to maximize its significance in terms of times the trendline has been touched or tested.  You get better insight this way because it makes sense and captures the psychology (thinking process) of those who drew trendlines and experienced what they thought was a true break (such as what happened around August 12th).

This was a breakout as far as the pattern was concerned, but I felt that not enough time (cycle) had elapsed to be a true breakout – patterns need time to form, especially consolidation patterns.  One should also keep in mind that this entire move you’re seeing is an official “Bear Market Rally” or “Counter-Trend Retracement” so you have to keep that as the dominant structure – there was no reason to get excited and to believe a whole new bull market had emerged… or that the bottom was firmly set in place.

That being said, the false breakout took price back to the lower trend channel, back to the upper channel, and then to the breakout price around August 18th.  That level would be an “aggressive” short with a large stop placed above the upper trendline IF you believe that was a true breakout (you really don’t know until it’s been confirmed, but by the time it’s been confirmed, you often sacrifice initial trade location).

I prefer to enter on ‘failure tests’ or ‘throwback rallies’ such as what occurred on August 25th.  However, the flaw in this strategy is that there isn’t always a throwback to enter safely.  Interestingly enough, price came back to test the lower trendline two more times (giving heat to short-sellers and possibly causing them to take a stop-out if their stop was placed too close… ie. inside the channel).

Tuesday, September 2nd’s overnight strong gap likely got buyers excited, but they entered into a retest of a converging trendline and apex of the bearish wedge pattern, which proved to be the absolute top (or ‘perfect’ entry in hindsight).  From here, sellers dominated, the bearish wedge pattern was confirmed, and price has, and continues to plunge to meet its price objective (now around 200 points away).

Whenever you see a clear or distinct pattern, annotoate your charts, print them, and learn as many lessons you can so you can profit the next time the pattern possibly sets up.


2 Responses to “Inside the Recent Bearish Rising Wedge”

  1. Dominick Says:

    Corey, thanks for the analysis, as always it is very educational. But may I draw your attention to xlf and the two exceptionally long lower shadows toward the end of the day on 09/05/08. Can you explain this, did someone punch in a wrong number by mistake? It is almost a full $1.00 move.

  2. Anonymous Says:

    Top work, extreme good example of EW pattern trading & how powerfull all diagonals are.

    Good job!