Technical Analysis – Wedges

Like flags, wedges are either bullish or bearish, only they are not called that. A bullish wedge is called a falling one, while a bearish wedge is a rising one. It is said that a rising wedge always forms at the top of a bullish trend, or towards its end, and a falling wedge appears at the bottom of a bearish trend. This is true most of the time, but consider that in some cases the market forms a wedge-like formation that has nothing to do with the previous trend. An example of such appears in complex Elliott Waves formations, and we’re going to cover them all here on the Trading Academy project. The following are some generalities of rising and falling wedges:

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How to Treat a Wedge

Elliott Waves theory allows for a wedge to be treated as a terminal pattern. This makes for plenty of rules to be watched during the wedge formation, and allows traders to position for the correct side of the market. Unfortunately, this is a painful process. Wedges take a lot of time to consolidate, and depending on the timeframe they are forming on, this may mean weeks, or even years. Because the inner moves within the wedge are corrective in nature, they are difficult to correctly label and interpret. The right way to treat a wedge on the longer timeframes is therefore to simply ignore it and trade something else, such as a different currency pair, until the wedge is broken.

Wait for the Break.

A perfect wedge happened on the EUR/USD weekly chart some time ago and, if what has been said above is a good piece of advice, the whole period of consolidation should be avoided until the wedge breaks. The chart below shows the rising wedge on this long timeframe, and a quick count reveals that the wedge took 94 weeks until completion.
wedges - 1
Of course, it is not possible to know right from the start that the market is forming a wedge. However, after a while, considering the rising trendlines, the wedge formation is obvious. To wait for the break means to look for the lower trendline to be broken. If we label the wedge, the result should be like the one in the picture below.
wedges - 2
A break implies that the price is moving below the 2–4 trendline, and this is what conservative traders are looking for. As in the case of bullish or bearish flags, which we treated in the previous article, it is not enough for the trendline to be broken, but we should also look for the higher-lows series to be broken too. A nice set-up is to place a pending sell stop order for the 2–4 trendline break in such a way that the higher-lows series is broken by the time the pending order is filled. A proper stop loss should be at the top of the wedge, and the take profit this time should be bigger, as in the case of flags. The reason for this comes from the fact that wedges are almost always reversal patterns when compared with flags. This means that by the time the wedge is broken a new trend has started, whereas in the case of flags, the previous trend resumes. Consequently, the risk/reward ratio should be bigger, starting from 1:2 and moving all the way until 1:4 or even more. This is how powerful wedges are! In this way we have confirmation that the pattern is completed and a new trend has started. If this is what conservative traders do, though,  how about aggressive ones?

The Aggressive Approach to Trading Wedges

Aggressive traders will always try to position themselves ahead of the 2–4 trendline break: that is, during the wedge formation. It is not a rule of thumb, but the 1–3 trendline is almost always pierced by the fifth wave. This gives a great entry point, even though the market may still consolidate around that area for a while to come. This approach is a riskier one, but extremely rewarding for the disciplined and well-prepared trader. Elliott waves theory offers concrete rules for trading a rising or falling wedge like a terminal pattern, and this means that traders can set a proper stop loss for any trade, as the length of the waves can be calculated exactly. In this case, the risk/reward ratio is even more appealing, and aggressive traders will use the 2–4 trendline break as an opportunity to add to the old position. In this way, profits are multiplied by trading the same pattern. Wedges are patterns that are part of the classical technical analysis area, and they have a big advantage when compared with others: They are extremely visible, especially if they form on the longer timeframes, like the wedge used as an example in this article. In this way, it is impossible for traders not to identify them and to position correctly for the new trend.

The next article will deal with pennants as continuation patterns, as these small consolidation areas are powerful tools that confirm a trend. They look a bit like the flag patterns, so a quick review of the article related to flags is recommended at this point.

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