We're wrapping up our holiday review of technical analysis
methods today by looking at two key patterns.
The wedge pattern signals a reversal in the current trend. The
wedge is similar to the triangle, but tends to take much longer to
develop. The wedge term could also be as long as several
It demonstrates a convergence of resistance and support over
this period, while overall price levels trend upward or downward.
So the wedge contains a narrowing trading range while signaling
price direction change. In a falling wedge, the sentiment is
bullish because you would anticipate a price reversal to the upside
at the end of the wedge.
The slope of the top, or resistance, is probably going to be
sharper than the slope of the descending support line, which may
even be flat. Within the wedge, expect to see at least two tests of
both resistance and support. These double tops and bottoms are part
of the wedge development.
A buy signal occurs when the price finally breaks through
resistance and begins moving upward. This normally is also
accompanied by heavier than normal volume. The rising wedge is
exactly the opposite. It demonstrates an ascending and narrowing
price range. It is bearish, and you should expect price tests on
the top and the bottom, culminating in a breakout below support.
This is a sell signal at the conclusion of the wedge.
Any time a space is found between one period's closing price and
the next period's opening price, a gap has been formed. A "period"
is normally a single trading day, but some traders (notably day
traders and micro traders) also track 15-minute or 5-minute charts,
looking for important signals.
One important attribute of chart patterns is that all of the
generally observed significance to patterns applies whether in very
short periods or over extended periods of time. In the stock price
illustration below, note the narrowing trading range in the form of
a pennant, ending with an important combination of an upward price
gap and a following strong breakout to the upside.
Gaps in a Stock Chart, Source: Yahoo! Inc.
There are many different kinds of gaps. A common gap is found in
any stock with even moderate volatility and does not really signal
any change in the current trend. But runaway and breakout gaps are
very meaningful. A runaway gap involves a series of gaps, one after
the other and in the same price direction. A breakaway gap occurs
when the gap itself moves price through resistance or support.
These gaps generally are the start of a major price movement. As
the short-term trend begins to end, an exhaustion gap is likely to
occur, which is either accompanied by or shortly followed by high
volume. This normally signals that prices are going to stop moving
in the current direction and move in the opposite direction. These
are generalizations, but they can be useful for confirming trends
noticed by other signals, such as double tops or bottoms,
head-and-shoulders patterns, and changes in volume.
The chart below shows three the types of gaps, which often will
be seen as part of a short-term trend within a short period of
Three Types of Gaps, Source: Yahoo! Inc.
The Bottom Line on Technical Analysis
Technical analysis can compliment fundamental research,
helping determine the timing of trades to maximize profits.
Institutional investors can use technical analysis for
program trading based on the technical movements of stocks.
Stocks trade within ranges, and when those ranges are
violated, share prices are likely to move either higher or
lower, depending on the direction of the movement.
Breakouts on heavy volume are a better indication of the
direction than those that occur on low share volume.
Technical analysis can be effectively used to determine the
short-term direction of a stock.
Long-term, stocks move based on the fundamentals, not based
on the technicals.
Just like most things, understanding technical stock price
movement takes practice. But to a trained eye, a stock chart can
give the astute investor an idea where the stock price may go.
Practice before you act, and gain confidence. You'll be glad you
did when you start to make profitable trades.