Rising and Falling Wedge Patterns: How to Trade Them?

In this article, we will discuss

Of the many candlestick and price chart patterns recognised by experts today, most either signal a trend reversal or a trend continuation. Very few patterns can be used to predict both trend reversals and continuations. Among these rare indicators are the wedge patterns, which can warn you about potential trend reversals or confirm the strengthening of the prevailing trend.

In this article, let us take a closer look at what wedge-shaped patterns are, the different types of these patterns and how you can develop trading strategies when these signals appear.

What is a Wedge Pattern?

A wedge pattern is a signal formed on a price chart when two distinct trend lines appear to converge with each successive trading session. The trend lines include an upper line that connects the high points and a lower line that connects the low price points. The upper line is typically the resistance level, while the lower trend line represents the support level

Depending on the overall direction of the price movement during the phase, these patterns are categorised as one of two types — rising wedge patterns and falling wedge patterns.

Both these patterns can point to a potential trend reversal or trend continuation, depending on where they occur. Let us take a deep dive into each of these wedge-shaped patterns.

A Closer Look at the Rising Wedge

The rising wedge, also known as the upward or ascending wedge, has the overall effect of moving the price upward. During this phase, the resistance level and the support level are both rising, but the increase in the support level is steeper. This means the lower trend line rises faster than the upper trend line, giving the impression that the two lines may be converging.

Such a convergence occurs when the price of a stock, security or index records higher tops but even higher bottoms. So, the difference between the highs and lows narrows with each trading session. Eventually, this consolidation comes to an end when the price breaks down past the lower trend line or the support level. If you spot an ascending wedge, you need to plan and trade this potential price breakdown.

How to Interpret an Upward Wedge?

The rising wedge pattern is most often interpreted as a sign of a bearish reversal. However, context matters greatly here. Depending on where this pattern occurs, it may be a sign of a bearish reversal or a bearish continuation. Let's explore each of these scenarios in detail.

  • The Upward Wedge as a Reversal Indicator

If the ascending wedge occurs at the end of a prevailing uptrend, it may be a sign of a possible downward reversal. Initially, when the wedge begins to form, sellers try to gain control and push the price downward, while buyers simultaneously try to retain control, thus driving the price upward. This results in strong support and resistance levels.

However, the selling pressure eventually dominates the buying pressure, leading to a price breakdown. When the price breaks down past the support level after the slightly upward consolidation, it indicates that the sellers have gained control of the market, leading to the formation of a new bearish trend after a prolonged uptrend.

  • The Upward Wedge as a Continuation Pattern

The ascending wedge pattern can also occur during an ongoing downtrend. In this case, it acts as a continuation pattern where the price temporarily rises before breaking downward again. When you notice the rising wedge-shaped pattern in the middle of a strong downtrend, it indicates that buyers temporarily try to gain control of the market, but are eventually overpowered by sellers (who already dominate the market).

A Closer Look at the Falling Wedge

The falling wedge is the exact opposite of the upward wedge. Also called the downward or descending wedge, this pattern results in an overall downward price movement. So, the resistance and support levels both decline in the downward wedge, but the decrease in the resistance level is steeper and faster. As a result, the upper trend line falls faster and appears to be converging with the lower trend line.

If you take a closer look at this type of wedge, you'll notice that the price is making lower bottoms but even lower tops. This reduces the difference between the highs and lows as each new trading session closes. Since the trend lines are not parallel, the pattern is terminal and comes to an end when the price breaks out past the upper trend line or the resistance level. When you notice the descending wedge, you need to have a strategy in place to profit from this potential upward price breakout.

How to Interpret a Downward Wedge?

The falling wedge pattern can also be interpreted as a sign of trend continuation or reversal, depending on the context in which it occurs. Since it involves the price breaking out of the resistance level, it can indicate a bullish reversal or continuation. Let us take a closer look at these two scenarios.

  • The Downward Wedge as a Reversal Indicator

When the descending wedge is seen at the end of an ongoing downtrend, it could be an indication that the price may reverse and start to move upward instead. This means that during the first few trading sessions, when the wedge is forming, buyers attempt to dominate the prevailing bearish market. At the same time, sellers also fight to retain control. So, the price simultaneously makes lower tops and lower bottoms.

Despite strong support and resistance levels, the price in a completed downward wedge manages to break out past the upper trend line. This is because the buyers end up gaining control of the market. A new bullish phase then begins after a prolonged bearish phase.

  • The Downward Wedge as a Continuation Pattern

If you spot the descending wedge-shaped pattern during an ongoing uptrend, this minor counter-trend may likely be a pause before the price shoots up again. This is because, in a market dominated by buyers, sellers try to gain control and temporarily drive the price down. However, the bullish trend prevails and the price breaks out of the resistance level.

How to Trade the Two Wedge-Shaped Patterns?

If you notice either of the two wedge-shaped patterns in the price chart, you need to know how to develop trading strategies to make the most of potential breakouts or breakdowns. Here are some tips that can help you enter a trade, set a stop-loss and take profit when you see these patterns.

  • Initiating a Trade

For any wedge-shaped pattern, the rule of thumb is to initiate a trade when the price breaches a trend line. You need to enter the trade in the direction of the price breakout. This means that in the case of an ascending wedge, you need to take a short position (or sell) at the price point just below the lower trend line (or support level). In the case of a descending wedge, you need to take a long position (or buy) at the price just above the upper trend line (or resistance level).

  • Setting a Stop-Loss

The ideal level for a stop loss is at the upper end of a rising (or bearish) wedge and the lower end of a falling (or bullish wedge). This way, you will be protected if the breakout is a false signal and the price reverses in the opposite direction.

  • Taking Profit

The take-profit level, also known as the target price, is the level at which you aim to exit the trade. Typically, the take-profit range for any trade initiated due to a wedge-shaped pattern must be equal to the size of the wedge at its widest or tallest region.

For instance, say you notice an upward wedge and the price breaks down at Rs. 161. This means you will take a short position at a point just below the breakdown level, say at Rs. 160. Now, if the wedge spans Rs. 20 at its tallest point, your take-profit level will be Rs. 20 less than the trade entry point, which is Rs. 140.

Similarly, if you notice a downward wedge in the above scenario, the take-profit level for your long position will be Rs. 180 (i.e. Rs. 160 + Rs. 20).

Limitations of the Wedge-Shaped Patterns

While the wedge-shaped patterns can be quite reliable most times, they do have some limitations that you should be aware of. Here is an overview of these risks.

  • False Breakouts:

Wedges can sometimes lead to false breakouts where the price appears to breach either of the trend lines but then reverses and moves in the opposite direction. You can minimise this risk by setting smart stop-loss limits for each trade.

  • Subjective Interpretation:

These patterns are also highly subjective, depending on where they occur and the overall context of the market and the security concerned. Different traders may interpret the signals differently, leading to varied trading decisions.

  • Volume Confirmation:

The interpretation of wedges is often closely linked to the trading volume. Generally, when a wedge occurs as a reversal pattern, the trading volume may increase. On the other hand, a decline in the trading volume during a wedge may be a sign that the trend may continue.

  • Sensitivity to Time Frames:

Wedges that form over shorter time frames may be less reliable. As a rule of thumb, the longer it takes for the price to consolidate during the wedge, the stronger the price breakout may be.

Conclusion

This concludes our discussion on wedges and how you can interpret and trade these patterns. If you notice either of the wedge-shaped patterns forming on the chart, you can look for additional confirmation using technical indicators like trading volume, moving averages, Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD) and Average True Range (ATR).

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING.
The asset classes and securities quoted in the film are exemplary and are not recommendatory.
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