Unbiased Forex Broker Experts

Part IV. Wedge pattern

Wedge pattern - Forex School
Commander in Pips: Today we will talk about Wedge pattern. I think it will make you happy that this pattern is much simpler than previous ones – both to trade, and to understand.

Pipruit: Oh, thank you, Sir, because I just don’t know where I can totally figure out with previous ones.​

 a Wedge pattern could be viewed in a couple of shapes – as a rising and as a falling one - Forex School
Commander in Pips: You’re welcome. So, a Wedge pattern could be viewed in a couple of shapes – as a rising and as a falling one. The form of the pattern itself is the same, but it could have different direction – upward or downward.

In the classical approach to technical analysis, wedges are usually treated as a reversal pattern, or at least as pattern that could lead to significant retracement in the opposite direction. When we will discuss the market mechanics of the wedge – you will understand why this works in that way. If a wedge forms on long-term charts, such as monthly, it even could warn us about a long-term reversal possibility.

But currently it is better to treat wedges mostly as indecision patterns, although it more gravitates toward reversal nature than to continuation nature. In fact a wedge would remain as a reversal pattern but this indecisiveness quality comes from the current tricky market environment and the wishes of market makers to punish the public. Market makers know that the public knows the classical explanation of wedge patterns, and that the public treats wedges as reversal patterns. So, the public will enter the market accordingly with predictable placement of stops. Market makers very often force wedges to fail at least temporally to grab public stops and then release them, so that wedges then show their natural price action. In the modern trading environment, pattern failure or fake breakouts are as common as normal price action itself. Keep this in mind this, and be as cunning as a fox.

a wedge is a market consolidation between sloping support and resistance lines - Forex School
 In general, a wedge is a market consolidation between sloping support and resistance lines. Price forms highs and lows in the same direction but pace of highs and lows forming is different. That’s why this kind of price action gets the form of a wedge:

Chart #1 | GBP/USD Weekly
Price forms highs and lows in the same direction - Forex School
Here you can see a perfect example of a falling wedge. See – although the market is forming lower lows and lower highs – they have a different pace and the highs move lower faster than the lows. The second important moment is that this is typical for perfect examples of wedges – the market shows precisely 5 swings inside the pattern. This is not absolutely necessary, but when it happens, the pattern becomes more reliable. After 5th swing the market should decide where it intends to go. Sometimes it gives us an early clue – see, the market has not quite reached the lower border of the wedge and turns up again. This is a bullish sign and happens very often in different triangle formations – such as wedges and triangles. Now let’s discuss the market mechanics of wedge pattern.

Market mechanics

Although a wedge could indicate as reversal or a pause in a long term move (such as on chart #1) – the mechanics will be the same, except the question of who will be the winner at the end. Wedge indicates the different strength of Sellers and Buyers. On chart #1, since the wedge has started to form, it means that a significant amount of sellers have stepped in and hold the market from any further upside move (initial swing down of the wedge pattern).

Once new sellers have opened their positions and the market has shown retracement – new buyers step in, i.e. those who want add to their positions and those who want to buy initially. This leads to a second swing in the wedge body. Then, those sellers, who were not in time to enter during first move down or decided to wait for some retracement will attempt entering short at this second possibility. That leads to the third move inside the wedge pattern, and this move is downward. This kind of price action appears again and again while the wedge is forming, but it has an important tendency – despite the fact, that the market moves down as the wedge pattern forming, sellers are not so strong, because they do not have sufficient power to force the market to establish new lower lows at the same pace as lower highs. It gives to any wedge pattern the quality of exhausting a market move, when the direction of wedge shows who in particular is exhausting while it is forming.

If the wedge direction is downward – then sellers are exhausting gradually, if upward – then buyers. In our case it is sellers who are growing exhausted.

Almost the same is happening when we see an upward wedge. In this case it looks like everything is OK – the market continues its move up, forms higher highs and higher lows. But the low-to-low pace is greater than the high-to-high and this tells, that although buyers still have charge to buy up all the sellers positions, they have less and less power to move the market higher. Their strength is exhausting gradually. When buyer’s power is not enough even to absorb positions of new sellers – then the market shows a downward breakout of the wedge. If new buyers will appear – the market could show only some retracement, if not, it could even be a turnover to the downside.

Description and Trading the Wedge

There is a simple rule to estimate – will a wedge be reversal or continuation.

If wedge direction coincides with the previous move – the more probable that it will be reversal. If wedge direction is opposite to the previous trend – more probable that it will be continuation.

This is very simple to understand from the mechanics of a wedge. For instance, we know that the wedge is a model of exhausting. Since, its direction is opposite to the previous trend, that, say, upward (like on chart #2), hence this wedge is exhausting of sellers, hence – sellers should exhaust some time, and upward move will continue. In this case the wedge will have a continuation bias, relative to the previous move.

If this is too hard for you – here is another simple rule. During wedge forming time exhaust those participants that direction of wedge is. So, if wedge is down – hence sellers will exhaust and buyers will win, the same is true for up wedge.

Any wedge assumes breakout in opposite direction to it own direction. Although as usual, there could be wedge failings and different exceptions.

Target of the wedge could be estimated with different methods. For example, some traders use as a target the distance of pattern’s first swing – so called height of pattern. They assume, that the market should move at least for the same distance after breakout – look at chart #2. But you may use any other tools for target estimation – for instance Fibonacci extensions, like those as the same chart. Market has hit 1.618 extension and then turns to retracement. As you can see, it works nicely here.

Falling wedge

A falling wedge forms when the market consolidates between two downward support and resistance lines. The slope of resistance line is steeper, than support one and as we discussed lower highs are formed faster than lower lows. The shape of such kind price action looks like wedge, so that’s why this pattern is called like that.

Any wedge is a consolidating type of price action, so the market is building energy during the time of wedge holds. Sometime this energy should be released, so we have to expect breakout of the wedge pattern in one or the other direction, according the rules that we’ve pointed.

Chart #2 | GBP/USD Weekly
Description and Trading the Wedge - Forex School
Describe me what you see on Chart #2?

Pipruit: Ok, previous move was up, but wedge is sloped down. Hence, according to our rules, sellers should exhaust during the wedge and buyers will win – the up move should continue. Consequently, this wedge should be a continuation pattern – so that has happened.
Commander in Pips: Right. Now let’s take a look at reversal falling wedge:

Chart #3 | NZD/USD Weekly
NZD/USD Weekly reversal falling wedge - Forex School
Pipruit: Yes, I see that our rule holds – direction of the wedge coincides with the previous move and – Tada! It has become a reversal one. Commander and is it always like that?
Commander in Pips: Well, mostly yes. But there is no such word in the market as “always”. The market is probability substance. If something “always” appears – then everybody has become a millionaire already, because all that they have needed to do is just find out what this “always” is.

Rising wedge

A rising wedge is formed when price stands between the upward sloping support and resistance lines. But now the support line is steeper than resistance, and hence higher lows are being formed faster than higher highs. Appearance of a rising wedge after an move up could become an early notification about reversal. Alternately, if rising wedge appears during move down – very probable that it will become a continuation pattern.

Let’s add another chart that shows rising reversal wedge – just to show what it looks like. I will not show you rising continuation wedge, because it very similar to falling.

Pipruit: Sure, no problem.​

Chart #4 | AUD/USD Weekly
AUD/USD Weekly Rising wedge - Forex School
Pipruit: I see, and why have you added MACD indicator?
Commander in Pips: Because now we will turn to discussion how to trade a wedge and we will need it. Take a look at the same chart #1 but with tools that we will need to discussion of trading process.

Some observations that may be will be useful to deal with wedges:

1. Wedges with greater slope usually lead to stronger moves after breakout;

2. A wedge is more reliable if the market shows true breakout after the 5th swing in the wedge body;

3. If the market shows too long consolidation in wedge pattern – more than 5 swings, then the market could show a flat exit from the wedge – just sideways breakout;

4. If the market during the 5th swing couldn’t reach an opposite border of the wedge and turns right back (look at chart #1) – this tells us about the direction of the breakout and that the breakout is near;

5. MACD very often shows trend shifting in direction of a breakout ahead of breakout itself. This could be an early caution that a breakout is near;

6. We have not yet studied such term as “Divergence”, but it very often appears when a wedge is forming.

Now let’s discuss the wedge trading process on an example of a falling continuation wedge on GBP/USD. Total approach and its basics to trading is the same as with other patterns – combine all tools that you know to get as clear context for trading as possible.

Chart #5 | GBP/USD Weekly
GBP/USD Weekly wedge trading example - Forex School
The major idea is to catch early signs of possible breakout and possess ourselves with as tight of a reasonable stop loss as possible. Also – to confirm the theoretical direction of a breakout with some clues. This is the task.

For instance, we start to watch for this wedge at “A” point at the end of 2005. Then we see a move up and the market has hit the upper border of the wedge – we do not see anything special. Only single detail has attracted our attention – long white candle (we remember that it is called a Marubozu, right?). This looked like shift in momentum, but we didn’t have much confidence with that yet. Anyway this was insufficient to call this “context” at all. Also we know that this is just the 4th swing.

But a bit later in March 2006 we have seen something. First, the market has shown bullish engulfing and it’s low almost coincided with the low of the Marubozu and we know that the low of a white Marubozu itself is a support area. Second, the trend has turned bullish and held bullish during whole 5th swing to the downside. The market has formed an engulfing pattern precisely near the area of 0.618-0.786 Fib support from the recent swing high. And the last one - appearing of an engulfing near Fib support and Marubozu support tells that there is a strong possibly that the market will not reach the low border of the wedge, and this is the 5th swing…

That’s quite enough to make an attempt with a long position. It does not matter how you’ve entered on the top of engulfing or waited for some retracement to enter. More important is that we use this pattern for stop placement. Our logic here is as follows: if the market will break this pattern, then the trend turns bearish again and it could reach the lower border of the wedge. Currently the 5th swing is forming. If the market will not show any exit from the wedge, we may see a sideways consolidation, or even a wedge failure. So, placing your stop order here looks reasonable, although is better to place it closer to “A” point – low of previous swing, just to let market breath.

If, for instance, the market will erase engulfing, reach the lower border and only after that will show breakout, then you may enter again with the same logic and algorithm. The market should show you some signs, that bulls have taken the control.

Pipruit: And why we can’t just jump in after confirmation of breakout?
Commander in Pips: Well, in fact you can do that, but you have to answer on couple of questions – where do you intend to enter and where do you place your stop loss?

Pipruit: Hm, well, I jump in right on the next bar, after breakout one… Stop… it’s much harder. I will just place money stop, say, 2% of my assets.
Commander in Pips: Well, in this case we both see that you have made profit, because there was no retracement after breakout. But, if you trade a wedge, say on hourly chart, and market breaks the wedge – it could run fast, so you will enter at a worse price, because the market does not show any retracement lower.

Second, your stop has to be protected and logical. In other words, it has to be placed at such area, which tells you that your position is wrong, if market will reach it. For example, in our case – if market will move below 0.786 support, then trend turns bearish and bullish engulfing will fail – hence we have no reason to hold long positions.

In your case, if the market even will show some pullback and your stop will be triggered, this absolutely does not tell you that market has changed direction.

Pipruit: Looks like you’re right.
Commander in Pips: You can see that in all charts that we use as examples, MACD shows trend shifting before breakout and holds it during the last swing inside the wedge. This happens very often.

So, use all tools in your trading arsenal to estimate early prompts of a possible breakout. It’s better to have a position before the breakout moment. Even if you will miss some wedges and will not see clues in the necessary moment – it’s normal, it’s better to skip some trades, than to loose money. Try to apply strict rules, at least in the beginning – you will definitely miss some good wedges to trade, but you will miss even more wedges that are better not to trade at all.

Comments

Grindin4pips
3 years ago,
Registered user
Commander in Pips! Our mission may be compromised!

The images associated with this part won't load.

I have tried Opera, Firefox and Internet Explorer and they do not load.

Pips are at risk!!

Admins/Mods/CIP, To whom should I address future instances, if found to?

Thanks!
Hamza Samiullah
2 years ago,
Registered user
Good work..
One-fm
11 months ago,
Registered user
Kudos.

Table of Contents