Wedges are reversal patterns that form at the end of trends. During a wedge formation, the price action hesitates, finding it difficult to continue making higher highs or lower lows. Investors love wedges because they provide a great risk-reward approach. Because the reversal is aggressive, the potential reward can be attractive.
Wedges resemble triangular formations, as they also have five segments and appear in two forms:
For a rising wedge, the market makes three marginal higher highs and two higher lows. Conversely, a falling wedge has three lower lows and two lower highs. In investors’ jargon, it is said that a rising wedge is falling, and a falling wedge is rising, indicating the price expectations after the wedge breaks.
Investors use two trendlines to connect the series of lower lows and lower highs in a falling wedge, or the series of higher highs and higher lows in a rising wedge. Moreover, they also label the wedge’s swings with numbers. Hence, a wedge is labeled 1-2-3-4-5, with the price action being contained between the 1-3 and 2-4 trendlines.
Of the two the 2-4 trendline is the most relevant. When price breaks it, it signifies the end of the reversal pattern and the move to follow is usually a strong one, in the opposite direction of the previous trend.
Trading a wedge is reasonably simple. As mentioned earlier, the break of the 2-4 trendline signifies that the reversal pattern is in place. However, the pattern does not always work; often the break of the 2-4 trendline is fake, and the market will keep following its previous trend without reversing. To avoid this, an entry should only be made when the price exceeds the 4th segment, high or low.
The rising wedge presented above clearly shows the price hesitation as it makes only marginal highs. By the time the lows in the 4th wave are broken, investors will have targeted the full retracement of the entire pattern.
Trading a falling wedge is similar, with the only difference being that investors go long after the price exceeds the highest value in the 4th wave. Aggressive investors choose to trade a break in the 2-4 trendline, but this is a risky approach as the 4th wave is not in place yet.
Two things typically happen during and after a wedge’s formation:
- The price usually pierces the 1-3 trendline just before the main reversal; and
- The price tends to retest the 2-4 trendline once broken.
However, the two aren’t necessary conditions while a wedge is forming. Instead, they simply confirm the presence of a wedge.
Wedges appear in trading theories like the Elliott Waves theory. Elliott documented wedges in a slightly different way; as terminal impulsive moves at the end of bullish or bearish trends. However, the concept behind the pattern is similar to the one described here.
- Wedges resemble triangular formations.
- Wedges are powerful reversal patterns.
- The price usually pierces the 1-3 trendline.
- The safest way to trade a wedge is to wait for the price to exceed the high/low of the 4th segment.