As those of you who have attended one of my courses will know I always prefer to use live current market examples to illustrate the lesson. What is the point of using a chart from 1972 as a Case Study. It of course worked out perfectly. But in real life we work on the hard right of the screen. There is considerable danger in doing this. I sometimes am humiliated by the market not doing what it should according to our library of patterns. However, people who attend my course know I am not a god and know we are discussing probability. We say, what will happen next is often…. or usually…. but never always….The point is you do have an edge and if you follow the rules you will, over time, get it right.
Understanding that, we will look at the Falling Wedge in the South African Rand (ZAR). If what follows is according to the pattern or not, it means little statistically. What I will describe is what usually happens next. We need a Stop because it does not always happen and may not happen in this instance. But if we keep doing this when a market forms this pattern we will make money overall.
We are very used to buying dips in the dollar and this has been a very successful strategy for literally years. This gives us a Recency Bias. It has always worked recently and so it always works. In fact it becomes close to a Law. At the start of the year we saw a climactic day. The dollar soared and then, as traders were scrambling to buy the dollar in a state of near bullish panic, a wave of selling halted the advance and there was a scramble to exit. Takuri, as we would say in Candlestick language. Massive rejection. This was a candlestick top and has remained the high since.
In recent weeks the Dollar has drifted against the Rand. It is drifting and narrowing. We FX traders also notice it has got quieter. The hysteria has gone to bed for the moment. A Falling Wedge is a chart pattern, formed by price action contained by converging and descending trend lines. They are the pressure areas in a chart where some bulls (in this case dollar bulls) are pessimistic and wants to sell to book some profits. Where as most bulls are optimistic about the market and keep buying slowly on every fall. In the beginning of the pattern there is more bearish activity. As the price falls further there is more bullish activity. This results in lower low swing lows and lower low swing highs with diminishing range. Both the support and resistance lines are sloping downwards and converging. It is normally a continuation pattern and is resolved by a move in the direction of the trend -i.e higher for the Dollar.
A Classical Falling Wedge Defined
This pattern is formed because of a battle between demand and supply. These are pressure areas where bulls are weaker than bears in the beginning but become stronger than bears at the end of the pattern. These are target areas where some traders book profit while most bulls are buying. As the target area is approached there is increased selling due to profit booking. This brings down the price. As the price falls substantially it becomes an opportunity for the bulls to buy the stock. This creates a swing bottom and the price goes up. As the price climbs up those who wanted to book profit early but failed to do, think that now is the opportunity to sell their shares. This creates a swing top and the price falls down. This drama continues to create lower and lower swing highs and lower and lower swing lows which appear to be bearish. This is an apparent but minor trend reversal. But the strong bullish under current is expressed in the fact that each subsequent range diminishes in size indicating decrease in the momentum of fall. These contracting ranges with reduced volume gives us the clue that the apparent down trend is loosing steam. So it is not a classical down trend. But a corrective reaction in an up trend. So be prepared for the upward break out in the direction of the previous trend. The slope of the lower support trend line is less steeper than the slope of the upper resistance trend line. This also indicates that the bearish force is less stronger than underlying bullish force. After all the selling is exhausted the bullish activity becomes apparent. When the last range becomes smaller than all the ranges, the price breaks out of the falling wedge pattern towards the up side. Thus the up trend resumes and continues.
How Far Will it Go?
As is usual in charting we measure the hight of the pattern to estimate is Minimum Price Objective (MPO). The MPO is not the target. Target infers and end to the move. They can often go further, much further. It is the minimum we would expect normally from this particular consolidation….from this pause in its journey.
To estimate the MPO I have measured the hight of the Falling Wedge. My colleague chartists do not agree how to do this. Some take the widest point and some other points. What we are trying to measure is the volatility inside the pattern at its greatest. Some would arge that we saw that at the spike top. I prefer to ignore the spike and sat the real volatility maximum was the next largest gap. This is obviously subjective but experience has shown me that taking the widest point can overstate the worth of the pattern. (We will not discuss this here but its a very interesting and contentious subject.) Measured my way, if the break is successful, we should get to 17 quickly and easily. 17.00 is also a resistance point for other reasons (reversal in the Wedge and a round number.) I am happy with that.
We look now for a good break out (long bar, close near the high, gap, high volume – as many of these as possible make it a good break.) We can place the Stop below the current low for the Falling Wedge pattern and still have a risk:reward ratio of more than 3:1.
So there its is: The Falling Wedge. It would be very nice but remember not required that this works out perfectly on this occasion. If it does, do not be seduced into thinking it always works. It does not, just mostly. If it does not work, you will be stopped out and lose but you will lose a manageable amount and be ready to do it again whenever you see this pattern next. If you do, over time, you will rewarded for your skill, patience and discipline.