3.11 Trading with Wedge Chart Patterns

 

Wedge Pattern.
 
 
A wedge pattern consists of a band of prices that are enclosed within two lines that are sloping towards each other and gradually reach an intersection point. 
 
Did you know that a wedge formation was used by the ancient Romans to break up an enemy formation into two, and then deal with them separately? Well, who says our markets are any less violent, and hey! Why not use some of our pattern weapons in this battle? So don your combat gear (we mean read on!) and prepare for the battle.
 
A wedge shows that prices are taking a pause, a temporary halt, during the primary and present trend. The upper sloping line is a resistance or supply line. The lower sloping line is a support or demand line. It signals a period of indecision in the market, with neither bears nor bulls being able to make turn the market decisively in their favor. After this period of indecision there are only two possible outcomes - yes, you got that right, the trend may continue or it reverses. The wedge patterns are either continuation patterns or reversal patterns, depending on the market situation. You will see "how" and "when".
 
Wedges are of two kinds – rising and falling.
 

Rising Wedge

 
If the two sloping lines both have an upward trend, the pattern is known as a rising wedge. 
 
The rising wedge pattern shows that the market is making successively higher highs and higher lows.  The lower line of the pattern is sloping up much faster than the upper line – hence the contraction of the pattern towards its apex. 
 
If the rising wedge appears during a downtrend, it functions as a continuation pattern. If it appears during an up trend, it works as a reversal pattern. The narrowing of the pattern indicates, in an up trend, that the buyers are gradually losing their power. In a downtrend, the wedge functions as a correction, and its narrowing indicates that the buyers are unable to sustain the correction.
 
Regardless of where it appears, the rising wedge is almost always bearish.
 
When you manage to spot this pattern, keep sell orders ready.
 

Rising Wedge After an Uptrend - Reversal Pattern

 
Chart with rising wedge pattern after an uptrend.
 
The above Forex chart is a monthly chart where the price action went for a bearish month after 4 months of bullish price action. That was your clue that a wedge pattern may emerge, and it did. The lows and the highs both were getting higher but the steepness of the highs getting higher was less. And that was an indication that the bullishness was under check. The price action took a nose dive and the trend reversed. A rising wedge after an uptrend is a "Reversal Pattern".
 

Rising Wedge after a Downtrend - Continuation Pattern

 
Forex chart with rising wedge pattern after a downtrend.
 
 
The chart above is again a monthly Forex chart where price action had first monthly red candle after five months of bullish moves. Again your clue for the possibilities of a wedge formation. The less steepness of the highs was countering the bullishness of the market and the bears won again. The price fell and the bearish trend continued. Rising wedge during a downtrend is a "Continuation" chart pattern.
 

Falling Wedge

 
On the other hand if the two sloping lines both have a downward trend, the pattern is known as a falling wedge.
 
The falling wedge pattern shows that the market is making successively lower highs and lower lows.  The upper line of the pattern is sloping down much faster than the lower line – hence the contraction of the pattern towards its apex. 
 
If the falling wedge appears during a downtrend, it functions as a reversal pattern. If it appears during an up trend, it works as a continuation pattern. 
 
In an uptrend the pattern shows up as a correction and the narrowing of the pattern indicates that the sellers are gradually losing their power and unable to sustain the correction any further.  In a downtrend, the narrowing wedge indicates that the selling momentum is losing steam, and the bulls are likely to force a reversal.
 
Regardless of where it appears, the falling wedge is almost always bullish.
 
When you manage to spot this pattern, keep buy orders ready.
 

Falling Wedge after an Uptrend - A Continuation Pattern

 
Forex chart with falling wedge after an uptrend.
 
The above chart shows that though the price action faced some bearish mood after an uptrend but the lows were not getting lower so much as the highs were. The slowdown in the price action was getting support faster. And the result was? Well, the price action broke out of the wedge on the upside and the uptrend continued.
 
A falling wedge during an uptrend is a "Continuation" pattern. 
 

Falling Wedge after a Downtrend - A Reversal Pattern

 
Chart with a falling wedge after downtrend.

 

In the chart above a wedge pattern emerged when the downtrend started slowing down. However the lows were getting support faster than the highs were getting resistances. The support from the bulls won the battle and the price action broke above the wedge. A we had mentioned earlier that a falling wedge is almost always a bullish pattern and coming out of a downtrend, falling wedges are a reversal pattern.

 

How to Trade Wedge Patterns?

 

Like any trade position the what you need to know are the following points:

 

  • When to enter?

 

  • Where to put your stop-loss order?

 

  • What should be the profit target?

 

When to enter?

 

You should target the entry when a break out from the wedge pattern takes place. It is always better to wait for some time to see it the break out is decisive or was just a false alarm.

 

Deciding Stop-loss Levels

 

Put your stop-loss order at the low of the previous candle.

 

Profit Targets

 

It is always better to close half of your position when the price moves to a distance which is equal to the widest part of the wedge from the breakout point. While doing so, move your stop-loss for the remaining half position to the breakout level. As a wedge is either a trend reversal or continuation pattern, the price movement generally continues in that direction and hence you may have an opportunity to get some much larger profits on your remaining half position. Even if the price-action reverses, your losses will be zero as you had moved your stop-loss order to the entry point.

 

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