Technical Analysis – Wedges
Like flags, wedges are bullish or bearish, only they are not being called like that. A bullish wedge is called a falling one, while a bearish wedge is a rising one. It is being said that a rising wedge is always forming 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 times, but consider that in some cases the market forms a wedge looking like formation that has nothing to do with the previous trend. Such an instance appears in complex Elliott Waves formations, and we’re going to cover them all here on the Trading Academy project. The following are generalities of rising and falling wedges:
- They are traveling between two well-defined trendlines. These trendlines point towards a common point in time, or they are converging. If the trendline is showing an expanding angle, the wedge looking like shape is not there anymore and the pattern should be scrapped, together with its interpretation.
- They have five segments. As a similarity with the Elliott waves theory, these segments are labeled with letters 1-2-3-4-5. They have nothing to do with impulsive waves the way we’re going to treat them here, but with corrective waves as all the segments are corrective in nature.
- They are reversal patterns. That is, most of the times, as there is one instance that calls for a rising wedge to have a bullish outcome and a falling one to have bearish follow-through price action. This is happening in running triangles.
- The most important trendline is the 2-4 trendline. A break here is key for the overall wedge interpretation.
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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 right side of the market. Unfortunately, this is a painful process. Wedges take a lot of time to consolidate and, depending on the time frame they are forming, this may mean weeks and even years. Because the inner moves within the wedge are corrective in nature, they are difficult to be correctly labeled and interpreted. Therefore, the right way to treat a wedge on the bigger timeframes is to simply ignore it and trade something else, a different currency pair until the wedge is broken.
Wait for the Break
A perfect wedge happened on the EURUSD 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 big timeframe and a quick count reveals the wedge took ninety-four weeks until completion.
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, it means to look at the lower trendline to be broken. If we label the wedge, the result should be like the one in the picture below.
A break implies price is moving below the 2-4 trendline and this is what conservative traders are looking for. Like in the case of bullish or bearish flags that we treated in the previous article, it is not enough for the trendline to be broken, but we should look for the higher-lows series to be broken too. A nice setup 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 like in the case of flags. The reason for this comes from the fact that, wedges are almost always reversal patterns when compared with flags. It means that by the time the wedge is broken, a new trend starts, while 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!This way we are having confirmation the pattern is completed and a new trend started. However, if this is what conservative traders are doing, how about aggressive ones?
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 almost always the 1-3 trendline is pierced by the fifth way. This gives a great entry place, even though the market may still consolidate around that area for a while. This approach is a riskier one but extremely rewarded for the disciplined and prepared trader. Elliott waves theory offers concrete rules for trading a rising or falling wedge like a terminal pattern and this means 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. This way, profits are multiplied trading the same pattern. Wedges are patterns part of the classical technical analysis area and they have a big advantage when compared with other: they are extremely visible, especially if they are forming on the bigger time frames, like this wedge used as an example in this article. This way, it is not possible 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 with the flag patterns, so a quick review of the flags related article is recommended at this point.
Recommended Further Readings
- Why Trading with a Regulated Forex Broker?
– What is regulation for a brokerage house, why it is important, things to look for, how to check if the broker is telling the truth, etc.
- Benefits of Mobile Forex Trading
– Pros and Cons of mobile trading, highlighting the net benefits of it.
- Explaining Commissions in Forex Trading
– What type of Forex trading accounts are subject to paying commissions, what does it means and is this a good or a bad thing?
- Opening a Live Trading Account
– Steps to open a live trading account with a Forex broker, starting with the time taken for the whole process, documentation to be sent, verification process, trading platforms to download, etc.
- What are “Lots” in Forex Trading
– Explaining the concept of a lot of Forex trading, and from that heading to micro-lots, different trading accounts, and broker’s limitations.
- Volume and Slippage – Value of a Pip and Execution Types
– Execution is important to every Forex trading and this article deals with the difficulties to trade big volumes with little or n- slippage.
- Basic Trading Styles – At Market or with Pending Orders
– Showing the possibilities a trader has, explaining the advantages and disadvantages of trading at the market or with pending orders.
Other Educational Materials
- A Forex trading system based on a genetic algorithm. Mendes, L., Godinho, P., & Dias, J. (2012). Journal of Heuristics, 18(4), 627-656.
- “Technical analysis.” Kritzer, Adam. In Forex for Beginners, pp. 135-164. Apress, 2012.