We talked about triangle patterns in our last pattern article. If you’ve started to apply the strategy in your trading and investing, you’ll notice that some patterns that ostensibly look like triangles don’t quite fit with the usual ascending, symmetrical, or descending arrangements because of how their trendlines converge. If that’s the case, you’re probably right; you might be looking at something else entirely. You might be looking at a reversal pattern known as the wedge.
Understanding Wedge Patterns
Wedge patterns are recurring formations that appear on financial market charts. It is characterized by a triangular shape formed when prices gradually converge and become a narrowing range between a security’s higher and lower prices. The pattern indicates that a continuation or a reversal of the current trend is coming. The wedge pattern can come in two types:
Rising Wedge
The rising wedge is characterized by a price movement generating higher highs and lows, creating an upward channel. During the price move, the channel narrows as the stock tracks higher prices while the lows get closer to the highs. The rising wedge signals that the price may be overextended, and buying pressure is starting to get exhausted. Most traders and investors see this as an early sign of a potential bearish reversal.
Falling Wedge
On the other hand, the falling wedge exhibits a series of descending highs and lows wherein the lows decline at a shallower angle compared to the highs. This series of price actions infer that the selling pressure is weakening and suggests that a possible bullish reversal may likely occur.
Differentiating wedges from triangles
One common question traders and investors ask is how wedge patterns differ from triangles, which share visual similarities with the triangle pattern. However, each pattern possesses a distinct characteristic that makes it unique.
- Formation – The critical visual difference between a wedge and a triangle pattern is how they exhibit their converging trendlines. In a wedge, the trendlines are slanted upward or downward. On the other hand, the triangle’s trendlines converge horizontally.
- Volume – During both patterns’ formation, a declining trading volume and continuous decrease are general signs for wedges as the pattern progresses. Conversely, when a triangle is formed, the volume varies, which is not a part of the triangle pattern’s reliability.
- Breakout: Wedge pattern breakouts are generally against the prevailing trend, as it is often a signal for a potential reversal. Triangles, conversely, have breakouts that can work both ways, as a continuation or a reversal.
How do you trade wedge patterns?
Wedge patterns have a straightforward approach when applied to trading. It all boils down to the breakout and how aggressive you are regarding entry. The most common entry option is to buy during the pattern’s breakout. This allows you to take full advantage of the reversal. The second option is to wait for the price to retest the breakout area to limit entry into false signals.
Rising Wedge
Falling Wedge
Like triangle patterns, you can measure the height of the widest part of the wedge and then set it on the breakout point to find your exit price.
Both the entry and exit approach have their limitations and strengths. Always remember to backtest each approach to better understand the expectations and performance of the wedge pattern and match the strategies with your trading goals.
The pros and cons of wedge patterns
Like all chart patterns, wedge patterns have distinct advantages and disadvantages. Understanding them and their limitations is essential to know if the pattern is still in play or if it’s time to cut your losses.
Let’s start with the pros:
Clear Visual Representation
Wedge patterns are easily identified using clear visual cues. This makes it a pattern to spot for novice and experienced traders.
Versatility
Wedges appear across different timeframes. This makes them applicable to traders of various types.
Defined Entry and Exit Points
Wedge pattern breakouts have clear rules for entry and exit points, making them easy for traders to execute.
Works well with other indicators
Patterns can increase performance when combined with other indicators. This helps provide context on the move, like volume data, long-term trends, etc.
Moving on to the cons:
False Breakouts
One of the most common pitfalls of many technical patterns, wedges are also susceptible to false breakouts.
Subjectivity
Identifying where to connect your trendlines is sometimes an issue for some traders as the subjectivity of these can vary the interpretation of the pattern.
Overlapping Patterns
Patterns can sometimes overlap with other technical patterns. This makes the interpretation more complex, as this will generally ask you to prioritize the more prominent pattern in most cases.
Final thoughts
Wedge patterns are another evidence of the complexities of the financial market. Traders can sometimes interpret these patterns differently, leading to different trading strategies and preferences. However, if you stick to the general rules of trading wedges and test their limits, you lower your chances of encountering problems while trading with them. Always remember to prioritize risk management and capital preservation above all else.
