The wedge pattern is a chart pattern in technical analysis that can be identified by two converging trend lines. Its presence in chart patterns is considered one of the most unique, as it can exist in any part of a trend on a chart and can be viewed as either a trend reversal or continuation pattern, depending on market dynamics.
A price breakout from wedge patterns often leads to significant price movements either upward or downward, making them favored by many experienced traders. In this article, we will explore techniques for identifying and trading wedges pattern through multiple forex trading examples.
Wedge Pattern in Trading
The Wedge Pattern is a chart pattern that formed by two converging trend lines in a candlestick chart, where price of an asset may fluctuate within the range formed by these two lines. These trend lines can be either in ascending or descending slope, and by justify through how the both lines converge, it can be characterized into two types of wedge pattern:
Rising Wedge (Ascending Wedge)
Formed by two converging line sloping upward. Considered as a bearish reversal pattern.
Falling Wedge (Descending Wedge)
Formed by two converging line sloping downward. Considered as a bullish reversal pattern.
As the two lines gradually converge to form the wedge, the converging price action normally indicates a period of decreasing in market volatility and signals an impending breakout.
The breakout can be either downward in a rising wedge or upward in a falling wedge, leading to a significant rise or fall in price after the breakout. This makes the wedge pattern one of the most closely watched chart patterns in technical analysis.
Although wedge patterns are generally considered reversal patterns, they do not necessarily need to appear at the end of a trend like double top or double bottom patterns do. In some cases, they can be considered trend continuation patterns.
To better understand wedge patterns, in the following section, we will explore in depth how different types of wedge patterns actually work and how they can be applied to trading.
Rising Wedge Pattern
The Rising Wedge Pattern (Ascending Wedge Pattern) is formed by two converging trendlines that slope upwards. As the price moves higher, price volatility and range decrease within the wedge, with the upper trendline serving as resistance and the lower trendline serving as support.
1. Rising Wedge in Downtrend
The ascending wedge is generally considered a bearish reversal pattern, particularly when it appears in an uptrend. In the most ideal scenario, the price will eventually break below the lower support line, leading to a significant decline in price.
Here’s why: when we look at it from the perspective of market sentiment and interpret it from its forming process:
- In an uptrend, bears make multiple attempts to short the price, leading to the new high being barely higher than the previous high, indicating weakening upside momentum.
- With every new high formed, there is a significant pullback, but the lows of these pullbacks are still higher than the previous lows.
- After multiple attempts, the bulls eventually wane, the price breaks below the support line, and this leads to a significant decline in price.
2. Rising Wedge in Downtrend
Despite being known as a bearish reversal pattern, a rising wedge that appears in a downtrend may indicate a potential continuation of the downtrend rather than a reversal.
In such cases, a rising wedge can be interpreted as a temporary rebound or consolidation within the larger downtrend. This can indicate a lack of strong buying strength supporting the upside momentum in a downtrend.
Therefore, a rising wedge can generally be considered a bearish signal in most cases, whether it appears in a downtrend or an uptrend.
Trading Rising Wedge Breakout
Considering the ascending wedge pattern in an uptrend as a bearish reversal, the primary trading opportunity lies in short-selling when the price breakout below the support line.
Below is an example of a rising wedge pattern in forex, specifically in the hourly chart of AUD/USD, where we will explain the trading opportunities in detail.
In the rising wedge chart below, the highs marked with letters (A), (B), (C), and (D) form the upper resistance trendline, and the lows marked with lowercase letters (a), (b), and (c) form the lower support trendline.
1. Rising Wedge Breakout
The rising wedge pattern breakout would essentially be the main trading opportunity in the pattern. In the AUD/USD above, at the point that marked with the number 1 is the most typical entry for a short-selling trade in a rising wedge pattern.
Although there is a certain amount of decline shortly after the downward breakout, the substantial drop only occurs a day later when the price breaks below the previous low at point (c). In the segment of price movement between point C and the number 3, a small head and shoulders pattern is actually formed, which further confirms the validity of the ascending wedge pattern.
Comparing the prices at the number 1 and point D, it is evident that point D provides a better entry price for a short trade. However, entering a short trade at point D carries a higher risk of being stopped out because the ascending wedge pattern could also break out to the upside, which we will explain in detail in the next chapter.
2. Rising Wedge in Consolidated Range
In this pattern, the points (C) would present a first entry point for some experienced traders. By connecting the point (AB) and the point (ab), traders may immediately identify the rising wedge pattern formed at this stage. Point (C) would simply present the opportunity for short-selling the resistance trend line formed in the rising wedge.
When the price pulls back to point (c), we may find that it is the support level of the ascending trendline connecting the lows at points (a) and (b), and also the support level of the previous high at point (B). Price finding support at point (c) presents a short-term buying opportunity with the target being the upper resistance trendline.
At this point, the formation of the ascending wedge pattern is largely clear. Subsequently, when the price rises again to the upper resistance line at point (D) and encounters resistance, it presents another clear short-selling opportunity, given that a rising wedge is considered a bearish pattern.
In fact, the trading opportunities at this stage of ascending wedge pattern essentially involve the simply theory of support and resistance line. When the price rises and touches the resistance line, it presents a short-selling opportunity, while a price drop that holds steady at the support line presents a buying opportunity.
Rising Wedge Bullish Breakout
Despite being known as a bearish pattern, a bullish breakout in a rising wedge is not uncommon. Essentially, the wedge pattern is derived from the ascending channel pattern, meaning that a rising wedge still poses the possibility of either a bullish breakout or a bearish breakout.
Below is an example from the S&P 500 Index daily chart, where the rising wedge pattern ultimately formed a bullish breakout.
For experienced traders, identifying a rising wedge pattern does not necessarily mean that they will trade the pattern with a bearish expectation. Instead, they will trade based on the breakout direction.
In the rising wedge pattern in the S&P 500 Index example above, the bullish breakout above the upper resistance line provided two buying opportunities. As mentioned, trading the wedge pattern is essentially based on the support and resistance concept. Breaking above the upper resistance suggests that the upper resistance line is now turning into support, presenting a buying opportunity on the support line retest.
Falling Wedge Pattern
The Falling Wedge Pattern (Descending Wedge) is formed by two converging trend lines sloping downwards, with the upper line acting as resistance and the lower line as support. As the market continues to decline, the price movement within the descending wedge becomes smaller. In the most ideal case, the price eventually breaks upward, leading to a significant rise in price.
Similar to its counterpart, the falling wedge pattern can be identified as a continuation or reversal pattern depending on where it appear. If falling wedge appears in a extended downtrends, this may suggests the potential of bullish reversal; while falling wedge appears in an major uptrend may suggests a potential continuation in the uptrend.
We may interpret the market dynamics of the falling wedge pattern meaning as follows:
- In a bearish market, the bulls repeatedly support the buying strength, so each new low is not much lower than the previous low.
- After each new low, there is a significant rebound, but the rebound fails to surpass the previous high.
- Eventually, after a few attempts by the bulls, the bearish forces wane, leading to a price breakout above the resistance, causing the price to rise rapidly.
It is also worth noting that similar to the bullish rising wedge breakout, the falling wedge, despite being generally considered a bullish pattern, can sometimes result in a bearish breakout. Therefore, when trading the descending wedge, traders should also remain flexible and consider on the possibility of both breakout directions.
Trading Falling Wedge Breakout
Below is a two-hour chart of the EUR/USD pair, illustrating a falling wedge pattern. In fact, this wedge pattern can only be identified in the later stages of the pattern. We are using this case to explain a specific key point: Wedge pattern does not necessarily require an upper or lower line to serve as a support or resistance.