A falling wedge is a pattern denoted on the charts by a downward slope with two converging trendlines. It is typically a bullish chart formation, indicating the potential for trend reversal. However, it can be a continuation pattern of the primary trend. A falling wedge starts with the two trendlines wide at the beginning and narrows toward the end, creating a cone-like shape.
Falling wedge patterns are frequently found in financial markets and individual securities. They are as common as the head and shoulders tops and bottoms and double tops and double bottoms. Traders, especially future traders, tend to look for falling wedges to help identify trend reversals and forecast price targets. The patterns are reliable and can provide actionable entry and exit levels. It offers favorable risk-reward potential when executed correctly. Falling wedges may confuse novice traders since the two converging lines are not parallel. Also, it often requires additional confirmation signals. Typically in conjunction with other technical indicators and oscillators to confirm a trend reversal or the continuation of the primary trend.
Experienced traders favor rising and falling wedge patterns as they offer well-defined entry and exit points. A rising wedge is often a topping pattern. A falling wedge is typically a bottoming pattern. Because wedges are directional and terminal patterns, they will end, resulting in either a bullish or bearish outcome.
While wedge patterns can develop over days, weeks, months, or years, the general rule is the longer it takes to form, the more explosive in speed and magnitude after the ensuing breakout or breakdown. Similar to any trendline analysis, the more successful tests of the trendline, the stronger the trend. Both converging trendlines of a falling wedge should show at least two to three touches that successfully tested support and resistance levels before a breakout or breakdown.
The actual signal occurs when it closes below support for a rising wedge pattern and above resistance for a falling wedge. However, a convincing move above resistance in a rising wedge and below support for a falling wedge signals the continuation of the primary trend. The height of the wedge pattern at the start of the formation and the lowest/highest level are added or subtracted from the breakout or breakdown level to forecast price targets.
A falling wedge pattern has developed over the past 8-months in the S&P 500 Index (SPX – 3,991.24). The top of the trendline is 4,554, and the bottom of the trendline is 4,034. Typically, a falling wedge signals the potential for a bullish reversal leading to a rally. However, a breakdown below the bottom of the trendline can signal the resumption of the prevailing downtrend.
Since the height of the falling wedge pattern for SPX is 784.62 points, the recent violation of the bottom of the trendline at 4,034 warns of a 784.62 point decline to 3,249. The 61.8% retracement from Mar 2020 to Jan 2022 rally also resides at 3,195. The Sept and Oct 2020 lows are also at 3,209.5 and 3,234, respectively. SPX must quickly trade above the bottom of the trendline (4,034) and then surge above 4,308-4,362 (5/4/22 high and the 50-day ma) to negate the breakdown.