• August 30, 2010

Updating Bulkowski: The Falling Wedge Pattern

by Donald Harder

Our research on how stock patterns have fared since Thomas Bulkowski provided his wonderful research continues with the bullish falling wedge chart pattern.

As we mentioned in related articles, we decided to do our own research in order to see just how much things have changed since Bulkowski last updated his own research. It was our feeling that typical technical analysis has been losing its edge due to wide knowledge and usage of the subject. Our research has strengthened this suspicion. The interesting news is that our research has also uncovered hidden edges and opportunities that are as yet underexploited. So let’s get started.

A falling wedge can either be a continuation pattern or a reversal pattern. Bulkowski considered this a low probability trade despite the relatively high success rate due to a low break even rate (number of times the price moved at least 5% past the breakout).

Unlike other chart patterns we studied, our findings with the falling wedge pattern was a bit more positive.

We researched the success rate of this pattern over the past two years and we made the following assumptions:

• A successful move is one that extended at least 10% after the breakout
• A failed move is one that broke through the bottom support of the pattern without first climbing 10%.

In addition to the chart pattern, we made the assumption that the success or failure rate would be tied to the performance over the overall market and the volume on the breakout, so we measured each individual stock’s volume and we juxtaposed each stock against the following S&P 500 factors:

• Investor sentiment level (overly bullish +75, overly bearish +30)
• Strength of market trend (ADX +30 = strong trend)

Results:

Overall Success Rate: 62%

Volume:

• 26% of successful moves saw a significant volume increase on the breakout
• 44% of the failed moves broke out on increased volume

Sentiment:

• 19% of all successful breakouts occurred when investor sentiment was overly bullish (75 or above) and 35% occurred when sentiment was overly bearish (below 30)
• a negligible number of all failed breakouts occurred when investor sentiment was at a bullish extreme (75 or above), but 56% occurred when sentiment was overly bearish

Trend Strength:

• 42% of all successful breakouts occurred when the “downtrend” was strong (ADX 30+)
• 56% of all failed breakouts occurred when the “downtrend” was strong (ADX 30+)

Conclusion:

Buying falling wedge pattern breakout appears to have an edge with 62% of all falling wedge breakouts over the past two years resulted in 10% gains or more.

There doesn’t appear to be any correlation with volume, investor sentiment or the strength of the trend.

One thing we did observe, which is harder to quantify, is that the sharper the angle of the wedge the higher the percentage of success. That is, when stock prices are in a steep, tight decline, the subsequent rebound on a break higher appears to be a profitable trade. Moreover, rebounds from sharp moves lower appeared to have a much larger percent gain potential as well.

Bottom line, we believe there is a tradeable edge with the falling wedge pattern if one focuses primarily on sharp-angled wedges.

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