Wedge Patterns

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What are the Wedge Chart Patterns

The wedge is constructed by a convergence of support & resistance levels over a period of time, usually over a period of a few months.  The support and resistance levels are defined as per The Support and Resistance Section in Module 1, but in essence prices should touch each level in 2 different places that are not too close together.  
The Wedge Pattern is not dissimilar to the triangle pattern that we study later. The difference is the wedge points up or down i.e 45 degrees while the triangle will point sideways.  The wedge is also a longer-term pattern lasting three to six months (but not always) and the wedge forms a trend where volatility is contracting, i.e the trend is running out of steam.  The triangle is a consolidation pattern as we'll find out later.

The Wedge Pattern can be seen as a reversal pattern of the trend that forms within the wedge and can either continue the trend that formed prior to the wedge or reverse it.  Confused?  Well. let's take it step-by-step.  If we take the wedge on it's own, with no prior trend, then the pattern is a reversal against the trend within the wedge.  However, the wedge can also be part of a larger trend.  If the wedge is sloping against the prevailing trend then the pattern can be said to be a continuation of the prevailing trend.  If the wedge is sloping with the prevailing trend, i.e. a down trend has started to form a falling wedge, then this can be said to be a reversal.  

There are two main wedges - a falling wedge and a rising wedge.  As the names suggest one slopes down and one slopes up.  If you find it hard to get your heard around the reversal/continuation paragraph above then just remember one thing for now - the falling wedge is a bullish pattern and the rising wedge a bearish pattern. This means that the falling wedge will eventually break-out on the up side where there's continuing demand and available supply at these prices.  The rising wedge will break to the down side with supply continually willing at ever lower prices, thus breaking the support trend line.  We'll look at the falling wedge first. 

The Falling Wedge (reversal) Chart Pattern

In the falling narrowing wedge pattern (as seen in our IBM example below) the Market makes lower lows and lower highs within a contracting falling range.  Let's take the wedge on it's own without a prior trend.  When you find the falling wedge forming a downtrend it’s considered to be a trend reversal pattern (bullish), as a contraction in the channel (range) indicates that traders are loosing confidence in the down trend. They now see weakness in the down trend, so begin to close positions anticipating a reversal.   

The falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. The falling wedge is designed to spot a decrease in downside momentum and alert technicians to a potential trend reversal. Traders spot this decrease in downside momentum because the falling wedge has a shallower support line than it's resistance line, as can be seen in our chart.  This indicates a decrease in selling pressure.  Even though selling pressure may be diminishing, demand does not win out until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis to confirm signals.  It's important to use other technical indicators to identify this pattern and to form your overall trading strategy.  Fibonacci retracement, volume and oscillator divergences will help identify the potential for reversal.  We'll talk about these in later modules.

When you find the falling wedge in a prior up trend it’s considered a good indicator that the up trend will continue at a later date. This is somewhat confusing as there is a reversal from the falling wedge into an up trend, but remember that this falling wedge is in the middle of a larger up trend. You can think of it as a long term trend correction. In our below example the wedge reversal occurs at $25.25 accompanied by increasing volume.  

falling Wedge
IBM - Falling Wedge (Reversal) Example

The main points to note are:
  • A trend must form within the wedge for there to be a reversal.  This pattern trend should last between 3 and 6 months, but not exclusively.
  • Resistance and support should form lower lows and lower highs.  Trend lines touch at least 2 peaks and troughs - see Module1. The Importance of Trend and Trend Lines.  
  • The contraction is caused by a shallower lower support line against a steeper resistance line. The Shallower lows indicate a slowing in selling pressure.
  • Ideally Volume should decline during the wedge, showing lack of appetite for the continuation of the down trend.
  • The resistance break-out should occur on higher volume. As per our IBM example.
If the IBM falling wedge had been part of a larger down trend instead of the prior up trend then the main points above still hold.  The prior trend would merge into the wedge where the low point of the wedge forms the low point of the trend.

Trading The Falling Wedge (Reversal)
Our Buying signal comes when there’s a break of the upper resistance line (The top wedge line) indicating a reversal, as seen in our IBM example. As with other chart patterns traders can enter on the break, after a close of a candle above the break, on seeing a full candle above the break, a percentage above the break, or a given number of days after the break. This all depends on your risk threshold.

Generally a profit target is calculated in one of two ways with more emphasis put on the second way.  
  • First by subtracting the lowest point on the wedge from the highest point then adding the difference to the break point of the pattern.  In our example the lowest point of the wedge is $24 and the highest is $29.4 making a difference of $5.4. The break happens at $25.25, so our profit target is $5.4 + $25.25 = $30.65.  
  • The second way of generating a profit target is to use the difference between the height from the highest part of the wedge to the support level directly below to form a profit target.  In our example this would be $29.4 minus $26.75=$2.65.  Adding $2.65 to the break-out at $25.25, gives us a profit target of $27.9.  This is an easier target to reach and may be more suitable to your trading style.
Our stop/loss is chosen at just below the lowest point of the wedge, say at $24. A higher stop/loss could mean our trade is stopped before the rebound takes momentum. We need room to see out our trade.
If the trade didn't pan out and we were wrong about the break then there would have been a loss of $25.25 minus $25 = $1.25.  We'll go on to talk about risk reward ratios, money management an position sizes in Module 7, but for now let's stick to the basics.  Risk reward ratios are important in deciding whether the reward is worth the risk and should be incorporated into your trading strategy. In fact risk/reward should be central to your trading strategy, again Module 7 goes into detail.

Remember to keep in mind other resistance levels, as the profit target may get stuck at some of these levels, i.e. a historical high may form the top of the falling wedge and provide strong resistance.  Other traders will use other technical analysis before determining their trading strategy.  For instance the falling wedge may be a Fibonacci retracement and oscillators may be used to determine trading points.  These will be studied in later modules.

The Rising Wedge (Reversal) Chart Pattern

The rising wedge pattern forms when the market is making higher highs and higher lows in a contracting range. 
When you find this rising wedge in an up trend it’s considered a reversal pattern as the narrowing of support & resistance levels indicates that the market is loosing confidence in the up trend.  When you see the narrowing rising wedge in a prior counter down trend it is considered to be a continuation of the prior down trend . It’s indicating that the correction is loosing steam, i.e. traders are losing confidence in this correction and the downtrend will thus continue it’s bearish pattern.  In both cases the rising wedge is a bearish break-out pattern, i.e. the price will break-out of it's support level and head south with increasing supply against demand at lower prices.

As with the falling wedge the rising wedge has two converging trend lines, but this time with buying pressure weakening as we reach the conclusion of the wedge.  In our example chart of Anne Taylor Corp. we can see this in action.  Eventually buyers weaken so much and selling pressure builds there is a beak-out of support.  This downside break-out confirms the pattern.  

Ann Taylor Corp.  Rising Wedge (Reversal) Example

The features of the rising wedge (reversal) are in line with the falling wedge.  They are:
  • A trend must form within the wedge for there to be a reversal.  This pattern trend should last between 3 and 6 months, but not exclusively.  Sometimes the wedge is an extension to the prior trend, sometimes it's a counter trend consolidation.
  • Resistance and support should form higher lows and higher highs.  Trend lines touch at least 2 peaks and troughs - see Module1. The Importance of Trend and Trend Lines.  
  • The contraction is caused by a shallower upper resistance line against a steeper support line. The Shallower highs indicate a decrease in buying pressure and create a lower resistance line with less negative slope.
  • Ideally Volume should decline during the rising wedge.
  • The support break-out should occur on higher volume. As per our Ann Taylor Corp. example.
As with the falling wedge other technical analysis should be used to identify and trade this pattern.

Trading The Rising Wedge (Reversal)
We trade this pattern as we did it's sister pattern.  Instead of buying shares though traders will either sell or short the stock.  Shorting the stock involves borrowing the stock from a broker, selling it, then buying it back at lower price to give back to the broker.  
  • Profit target 1. In our example chart support is broken at $49 and our profit target is $37.8, which is calculated by taking the difference between the lowest point of the wedge (32.9) and the point directly above this low point (44.1) away from the support break.  So we've made $11.2 per share shorting this stock (minus fees).
  • Profit target 2. A profit target of $29 can be calculated if we calculate profit target by taking the difference between the wedge top (52.9) and bottom (32.9) from the break.  So we've made $20 per share shorting this stock (minus fees).  This is more ambitious and may not suit some traders, but it is an option.
Remember to keep in mind other support levels, as the profit target may get stuck at some of these levels, i.e. a historical low may form the bottom of the rising wedge and provide strong support.  Other traders will use other technical analysis before determining their trading strategy.  For instance the rising wedge may be a Fibonacci retracement and oscillators may be used to determine trading points.  These will be studied in later modules.

To Sum Up

Just be aware that these wedge patterns need other technical analysis to figure them out.  They're hard to spot, so with other indicators and tools reversals can be anticipated.  Oscillators and volume may start to diverge during the formation of a wedge and Fibonacci retracements may indicate the end of a wedge and imminent reversal.  But as always technical analysis is not an exact science and although these indicators and patterns can increase the probability of making the correct trade, many will go against you and large losses can be incurred.  Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.


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What are the Wedge Chart Patterns

The wedge is constructed by a convergence of support & resistance levels over a period of time, usually over a period of a few months.  The support and resistance levels are defined as per The Support and Resistance Section in Module 1, but in essence prices should touch each level in 2 different places that are not too close together.  
The Wedge Pattern is not dissimilar to the triangle pattern that we study later. The difference is the wedge points up or down i.e 45 degrees while the triangle will point sideways.  The wedge is also a longer-term pattern lasting three to six months (but not always) and the wedge forms a trend where volatility is contracting, i.e the trend is running out of steam.  The triangle is a consolidation pattern as we'll find out later.

The Wedge Pattern can be seen as a reversal pattern of the trend that forms within the wedge and can either continue the trend that formed prior to the wedge or reverse it.  Confused?  Well. let's take it step-by-step.  If we take the wedge on it's own, with no prior trend, then the pattern is a reversal against the trend within the wedge.  However, the wedge can also be part of a larger trend.  If the wedge is sloping against the prevailing trend then the pattern can be said to be a continuation of the prevailing trend.  If the wedge is sloping with the prevailing trend, i.e. a down trend has started to form a falling wedge, then this can be said to be a reversal.  

There are two main wedges - a falling wedge and a rising wedge.  As the names suggest one slopes down and one slopes up.  If you find it hard to get your heard around the reversal/continuation paragraph above then just remember one thing for now - the falling wedge is a bullish pattern and the rising wedge a bearish pattern. This means that the falling wedge will eventually break-out on the up side where there's continuing demand and available supply at these prices.  The rising wedge will break to the down side with supply continually willing at ever lower prices, thus breaking the support trend line.  We'll look at the falling wedge first. 

The Falling Wedge (reversal) Chart Pattern

In the falling narrowing wedge pattern (as seen in our IBM example below) the Market makes lower lows and lower highs within a contracting falling range.  Let's take the wedge on it's own without a prior trend.  When you find the falling wedge forming a downtrend it’s considered to be a trend reversal pattern (bullish), as a contraction in the channel (range) indicates that traders are loosing confidence in the down trend. They now see weakness in the down trend, so begin to close positions anticipating a reversal.   

The falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. The falling wedge is designed to spot a decrease in downside momentum and alert technicians to a potential trend reversal. Traders spot this decrease in downside momentum because the falling wedge has a shallower support line than it's resistance line, as can be seen in our chart.  This indicates a decrease in selling pressure.  Even though selling pressure may be diminishing, demand does not win out until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis to confirm signals.  It's important to use other technical indicators to identify this pattern and to form your overall trading strategy.  Fibonacci retracement, volume and oscillator divergences will help identify the potential for reversal.  We'll talk about these in later modules.

When you find the falling wedge in a prior up trend it’s considered a good indicator that the up trend will continue at a later date. This is somewhat confusing as there is a reversal from the falling wedge into an up trend, but remember that this falling wedge is in the middle of a larger up trend. You can think of it as a long term trend correction. In our below example the wedge reversal occurs at $25.25 accompanied by increasing volume.  

falling Wedge
IBM - Falling Wedge (Reversal) Example

The main points to note are:
  • A trend must form within the wedge for there to be a reversal.  This pattern trend should last between 3 and 6 months, but not exclusively.
  • Resistance and support should form lower lows and lower highs.  Trend lines touch at least 2 peaks and troughs - see Module1. The Importance of Trend and Trend Lines.  
  • The contraction is caused by a shallower lower support line against a steeper resistance line. The Shallower lows indicate a slowing in selling pressure.
  • Ideally Volume should decline during the wedge, showing lack of appetite for the continuation of the down trend.
  • The resistance break-out should occur on higher volume. As per our IBM example.
If the IBM falling wedge had been part of a larger down trend instead of the prior up trend then the main points above still hold.  The prior trend would merge into the wedge where the low point of the wedge forms the low point of the trend.

Trading The Falling Wedge (Reversal)
Our Buying signal comes when there’s a break of the upper resistance line (The top wedge line) indicating a reversal, as seen in our IBM example. As with other chart patterns traders can enter on the break, after a close of a candle above the break, on seeing a full candle above the break, a percentage above the break, or a given number of days after the break. This all depends on your risk threshold.

Generally a profit target is calculated in one of two ways with more emphasis put on the second way.  
  • First by subtracting the lowest point on the wedge from the highest point then adding the difference to the break point of the pattern.  In our example the lowest point of the wedge is $24 and the highest is $29.4 making a difference of $5.4. The break happens at $25.25, so our profit target is $5.4 + $25.25 = $30.65.  
  • The second way of generating a profit target is to use the difference between the height from the highest part of the wedge to the support level directly below to form a profit target.  In our example this would be $29.4 minus $26.75=$2.65.  Adding $2.65 to the break-out at $25.25, gives us a profit target of $27.9.  This is an easier target to reach and may be more suitable to your trading style.
Our stop/loss is chosen at just below the lowest point of the wedge, say at $24. A higher stop/loss could mean our trade is stopped before the rebound takes momentum. We need room to see out our trade.
If the trade didn't pan out and we were wrong about the break then there would have been a loss of $25.25 minus $25 = $1.25.  We'll go on to talk about risk reward ratios, money management an position sizes in Module 7, but for now let's stick to the basics.  Risk reward ratios are important in deciding whether the reward is worth the risk and should be incorporated into your trading strategy. In fact risk/reward should be central to your trading strategy, again Module 7 goes into detail.

Remember to keep in mind other resistance levels, as the profit target may get stuck at some of these levels, i.e. a historical high may form the top of the falling wedge and provide strong resistance.  Other traders will use other technical analysis before determining their trading strategy.  For instance the falling wedge may be a Fibonacci retracement and oscillators may be used to determine trading points.  These will be studied in later modules.

The Rising Wedge (Reversal) Chart Pattern

The rising wedge pattern forms when the market is making higher highs and higher lows in a contracting range. 
When you find this rising wedge in an up trend it’s considered a reversal pattern as the narrowing of support & resistance levels indicates that the market is loosing confidence in the up trend.  When you see the narrowing rising wedge in a prior counter down trend it is considered to be a continuation of the prior down trend . It’s indicating that the correction is loosing steam, i.e. traders are losing confidence in this correction and the downtrend will thus continue it’s bearish pattern.  In both cases the rising wedge is a bearish break-out pattern, i.e. the price will break-out of it's support level and head south with increasing supply against demand at lower prices.

As with the falling wedge the rising wedge has two converging trend lines, but this time with buying pressure weakening as we reach the conclusion of the wedge.  In our example chart of Anne Taylor Corp. we can see this in action.  Eventually buyers weaken so much and selling pressure builds there is a beak-out of support.  This downside break-out confirms the pattern.  

Ann Taylor Corp.  Rising Wedge (Reversal) Example

The features of the rising wedge (reversal) are in line with the falling wedge.  They are:
  • A trend must form within the wedge for there to be a reversal.  This pattern trend should last between 3 and 6 months, but not exclusively.  Sometimes the wedge is an extension to the prior trend, sometimes it's a counter trend consolidation.
  • Resistance and support should form higher lows and higher highs.  Trend lines touch at least 2 peaks and troughs - see Module1. The Importance of Trend and Trend Lines.  
  • The contraction is caused by a shallower upper resistance line against a steeper support line. The Shallower highs indicate a decrease in buying pressure and create a lower resistance line with less negative slope.
  • Ideally Volume should decline during the rising wedge.
  • The support break-out should occur on higher volume. As per our Ann Taylor Corp. example.
As with the falling wedge other technical analysis should be used to identify and trade this pattern.

Trading The Rising Wedge (Reversal)
We trade this pattern as we did it's sister pattern.  Instead of buying shares though traders will either sell or short the stock.  Shorting the stock involves borrowing the stock from a broker, selling it, then buying it back at lower price to give back to the broker.  
  • Profit target 1. In our example chart support is broken at $49 and our profit target is $37.8, which is calculated by taking the difference between the lowest point of the wedge (32.9) and the point directly above this low point (44.1) away from the support break.  So we've made $11.2 per share shorting this stock (minus fees).
  • Profit target 2. A profit target of $29 can be calculated if we calculate profit target by taking the difference between the wedge top (52.9) and bottom (32.9) from the break.  So we've made $20 per share shorting this stock (minus fees).  This is more ambitious and may not suit some traders, but it is an option.
Remember to keep in mind other support levels, as the profit target may get stuck at some of these levels, i.e. a historical low may form the bottom of the rising wedge and provide strong support.  Other traders will use other technical analysis before determining their trading strategy.  For instance the rising wedge may be a Fibonacci retracement and oscillators may be used to determine trading points.  These will be studied in later modules.

To Sum Up

Just be aware that these wedge patterns need other technical analysis to figure them out.  They're hard to spot, so with other indicators and tools reversals can be anticipated.  Oscillators and volume may start to diverge during the formation of a wedge and Fibonacci retracements may indicate the end of a wedge and imminent reversal.  But as always technical analysis is not an exact science and although these indicators and patterns can increase the probability of making the correct trade, many will go against you and large losses can be incurred.  Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.


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