Beware A Wedge Pattern

There are dozens, perhaps even hundreds, of technical chart patterns. Most of them don't make much sense. The majority are nothing more than subjective lines drawn on a chart. Their track record at forecasting future price movements is no better than flipping a coin.

There is, however, one chart pattern We place a great deal of faith in. It's a terrific signal for when a trend is about to come to an end and reverse. The pattern is called a "wedge," and it is my favorite technical formation.

A wedge forms when a stock makes an extended move higher or lower, and when the distance between the highs and lows gets compressed. Whenever a stock or an index breaks out of these patterns, the ensuing move is often quick and large.

The psychology driving the wedge has something to do with the anxiety created as a trend gets extended. Folks who were early to catch the trend are nervously trying to protect profits. Latecomers - who need to jump on board or risk being left out of all the cocktail-party conversations - are worried about being the "greater fool." So, when the wedge breaks, and it looks like the trend has shifted, everyone rushes to get out. The recent action in the dollar is a perfect example...

This is an example of a falling-wedge pattern. The chart is in an extended decline. And you can see how the distance between the high and low points since May has continued to narrow. The wedge eventually comes to a point, and the chart has to break out of the pattern one way or another.

The best indicator to use to determine the direction of the break is the moving average convergence divergence (MACD) indicator – which is displayed on the bottom chart.

The MACD helps determine the strength of a trend. If a stock is falling and the MACD is falling as well, the downtrend is strong and likely to continue. In the above dollar index chart, however, the MACD is actually moving higher while the dollar is falling. This "positive divergence" suggests the momentum behind the downtrend is weakening and the chart is likely to break out to the upside.

And that is exactly what happened...

Now, let's take a look at a recent chart of the S&P 500...

This is an example of a rising-wedge pattern, where the chart is in an extended uptrend. Notice how the index is moving up while the MACD is declining. This "negative divergence" is a warning sign the momentum behind the trend is weakening and traders should be on the lookout for a reversal.

There is still some room inside the wedge pattern for the S&P to continue higher. But the chart is nearing an apex. And if the negative divergence continues, the next big move will likely be to the downside.