The “wedge” chart pattern is one of the useful early warning signs of an impending reversal in the price action, and it is quite easy to spot.
It provides a good low risk, high reward trading opportunity as price gets squeezed as it nears the tip of the wedge.
What are the 3 strategies you can use to trade this pattern?
Enjoy the video! 😀
In this video tutorial, I will be covering the wedge chart pattern in depth (both the rising wedge and the falling wedge), including its shape, underlying psychology, and 3 effective trading strategies which you can use to trade it.
I will also be talking about the difference between the wedge pattern and trend channels, because many new traders have difficulty in distinguishing between these 2 types of patterns.
Based on the 2 main categories of chart patterns, I would classify the wedge pattern under the “Reversal Patterns” category, since it leads to a change in direction of price movements.
Do note, however, that a wedge can also be a “Continuation Pattern”, if it is part of a larger pattern. I will cover this more in depth later.
Contrary to our intuition, a rising wedge is actually bearish, whereas a falling wedge is bullish.
Observe the shape of the wedge, which is formed by 2 sloping lines which squeeze prices together at the tip.
When I teach the wedge pattern, I get quite a lot of new traders asking me, “isn’t the wedge similar to a trend channel?”
For clarity, a trend channel is usually comprised of 2 parallel sloping lines which contain prices within, and this is usually seen when prices are trending order in one direction.
In the slide above, we compare an uptrend channel (which is bullish), with a rising wedge (which is bearish).
At first glance, they both look bullish because both are sloping upwards, however the rising wedge is bearish because it actually shows a decline in buying power over time, as indicated by the less steep upper line.
The same reasoning applies to the downward price action as well, which is why a downtrend channel is bearish, whereas a falling wedge is bullish, because the latter shows a decline in selling power over time.
This is how a rising wedge looks like on the chart, and in this example, it lead to the end of the current trend, and resulted in a price reversal once price broke down from completion of the wedge pattern. The longer the pattern takes to form, and the larger the pattern, the larger the subsequent move will be.
This is an example of a falling wedge, which is bullish, and once price broke out from the pattern, it lead to a strong move upwards.
In this chart, we can see that the major trend is bullish (uptrend), and the wedge was a small bearish correction within this larger trend. So when the wedge pattern completed, the short-term bearish trend (which was the falling wedge) reversed, leading to a continuation of the major long-term bullish trend.
At this point of time, some of you might be wondering, why is the rising wedge (where price is moving upwards) bearish, whereas the falling wedge (where price is moving downwards) bullish?
The answer lies in the psychology and formation of the pattern.
In a rising wedge, although new higher highs and higher lows are made, each subsequent high is weaker (exceeds prior high by less), which means there are less and less buyers coming in, and perhaps more sellers stepping in, awaiting a reversal.
And in a falling wedge, although new lower highs and lower lows are made, each subsequent low is weaker (exceeds prior low by less), which means there are less and less sellers coming in, and perhaps more buyers stepping in, awaiting a reversal.
In both cases, it eventually leads to the opposite side taking control of the market, thus leading to a reversal in the price action.
So, how do you tackle this chart pattern?
There are 3 simple trading strategies you can use:
- Entering before the completion of the pattern (breakout for falling wedge and breakdown for rising wedge)
- Entering during the breakout (when the trendline is broken)
- Entering after the breakout (when the new trend has started)
The first strategy is to enter before the breakout/breakdown happens, because usually when the break happens, price moves very quickly and explosively, so you might miss it if you do not look at the charts every day.
So one way to avoid that is to enter near the tip of the wedge (yellow circle) when prices are being squeezed, and there is a good chance that the pattern is ripe for a break.
For this strategy, the risk is relatively low and the reward to risk ratio is good. For the EP, SL, TP levels, you can refer to the video.
The second strategy is to enter at the point of the break, which is when prices actually do break the trendline. In this example, I have indicated it with a blue circle.
Sometimes, the break is controlled, such as in this chart, but if you look at the previous chart, the break might be fast with long bars, making it hard to enter the trade during the break.
The third and final strategy is to look for opportunities to trade in the direction of the new trend once the wedge pattern has completed (including the break), such as entering on pullbacks. I have indicated a few potential entries using the yellow circles.
For the EP, SL, TP levels, you can refer to the video as well.
After entering a trade, the next big question is what profit target to use when trading the wedge pattern.
Thankfully, there is an easy measuring techinque for this chart pattern.
All you need to do is determine the height of the wedge (by measuring the longest point), and project that height from the point of the break. That will give you the profit target.
To conclude this blog post, I will share some additional tips on trading this pattern, some of which I might have mentioned in passing in earlier parts of the post.
One of the major tenets of trading is to trade with the trend, as the odds will be in your favour.
So when you are trying to trade a reversal of the trend, you need to make sure the pattern (in this case the wedge pattern) is large and powerful enough (relative to the size of the trend) to be able to reverse the trend.
If the wedge is small, then most likely it is only a small counter-trend move within the larger trend, such as a flag or pennant on a larger timeframe.
And lastly, having confluence increases your odds as well, so it helps if there is:
- Support below your entry price if you are buying into a falling wedge
- Moving averages below your entry price if you are buying into a falling wedge
- Resistance above your entry price if you are shorting into a rising wedge
- Moving average above your entry price if you are shorting into a rising wedge
Trade safe, and don’t forget to watch the video and subscribe to our Youtube channel if you have not done so! 😀