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TECHNICAL ANALYSIS


Falling Wedge Signals NASDAQ Reversal

04/16/09 10:01:32 AM
by Alan R. Northam

The NASDAQ has been in a downward trend since October 2007, but now, this market has broken out of a falling wedge pattern. This breakout is signaling a reversal in trend from down to up.

Security:   $COMPQ
Position:   N/A

The NASDAQ has been trading in a downward trend since October 2007 but started to form a falling wedge pattern in November 2008. A falling wedge formation is formed when two trendlines are drawn, one off the descending market peaks and one of the descending market minimums, that tend to converge or come together. Such a pattern is shown in Figure 1.

Falling wedge patterns occur when the market hits resistance such as when all traders who want to sell have exhausted their resources. The market then starts to drift lower. According to Thomas Bulkowski's Encyclopedia Of Chart Patterns, falling wedge patterns can either be reversal patterns or continuation patterns and are split just about evenly between the two possibilities. Normally, when a breakout occurs in the direction opposite the prevailing trend, the pattern acts as a reversal pattern. However, when the breakout occurs in the same direction as the prevailing trend, the pattern acts as a continuation pattern.

In Figure 1, note that the NASDAQ has broken out above the falling wedge pattern, signaling a reversal in trend from down to up. Bulkowski warns that even though a falling wedge pattern has broken out either above or below the falling wedge pattern, signaling a reversal or continuation in trend, the breakout can turn out to be a false signal. Bulkowski suggests that if the breakout moves 5% or more in the direction of the breakout, the probability of the breakout signal being correct is greatly increased. Therefore, I have added a 5% target line to Figure 1. Note that the NASDAQ has traded through this 5% target, confirming the reversal in trend from down to up.

FIGURE 1: NASDAQ, DAILY. This figure shows the falling wedge pattern that started to develop in November 2008.
Graphic provided by: StockCharts.com.
 
Once the market breaks out of the falling wedge pattern to the upside, signaling a reversal in trend, we want to know how far the new upward trend can go. There is a minimum measurement rule that says that at a minimum, the market should retrace back up to the beginning or the falling wedge pattern. This rule suggests that as a minimum, the NASDAQ should move upward to the 1800 level or about 10% higher than its current price. Bulkowski's studies shows that on average the market rises 26% from the breakout price. Beyond that, if the falling wedge pattern is signaling a true reversal in trend from down to up, we will have to rely upon other price patterns yet to be developed, to help us identify higher price targets for the completion of the upward trend.

In conclusion, the NASDAQ has formed a falling wedge pattern that normally develops at the end of a trend. The NASDAQ has broken out above the falling wedge pattern, signaling a reversal in trend from down to up. The expected minimum rise in price is up to the 1800 price level, which is approximately a 10% rise from current price levels. Beyond that, the average price rise after a breakout of the falling wedge is 26%. Therefore, I would expect to see the NASDAQ move upward anywhere from 10% to 26% from the breakout price. However, I would also expect to see the NASDAQ move downward to retest the breakout from the falling wedge pattern before completing its upward move.



Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

Garland, Tx
Website: www.tradersclassroom.com
E-mail address: inquiry@tradersclassroom.com

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