Hello there, this is tradingpedia.com and this video deals with rising and falling wedges. These are classic technical analysis reversal patterns, as they form at the end of bullish, respectively bearish trends.
Rising and falling wedges
Rising and falling wedges are powerful patterns – a rising wedge is always falling, is a bearish pattern, and a falling wedge is always rising, is a bearish pattern.
A rising wedge looks like this – the market is in a bullish trend, and then suddenly it begins forming a series of marginal highs only, before eventually reversing. This is called a rising wedge, and to interpret it correctly you must connect the marginal highs and the higher lows, and it looks like this. The opposite is true in the case of a falling wedge.
To trade them, the ideal way is to wait for the lower edge to break. This is also called the 2-4 trendline if you are to label them as 1,2,3,4,5. Very often the price action in the 5th segment pierces the 1-3 trendline – that is something you want to see in such a pattern. Then the market breaks lower and it often retests the 2-4 trendline.
It usually reverses 50% of the entire wedge, and often 100% of the entire wedge. How to trade it? Well, this is the entry price, you must put a stop loss at the highs, let’s make it of a different color, this would be the entry – this is the risk, and this is the reward. If you go for the 50% retracement, that would be more than 1:2 or 1:3 risk-reward ratio, more than enough and if you go for the 100% retracement, then money management would be even better.
Why it is mandatory to have a stop loss at the highs in a rising wedge or at the lows in a falling wedge? The answer comes from the fact that these patterns sometimes do not work. They do not work in the sense that sometimes the market forms a so-called running triangle, that looks like a wedge, but in reality, after breaking the 2-4 trendline, the market fully reverses and continues aggressively in the opposite direction. So a stop-loss is mandatory.
This is an example of a rising wedge, but on this chart, we see an example of a falling wedge. If we apply the same principles as discussed here, we see that the market, when dropping from 1.24 to 1.19, it formed a series of marginal lows and lower highs. If we connect these one – imagine five points here – we see that the fifth segment pierces the 1-3 trendline is a good sign that you want to see. The entry on the long side comes by the time that the price breaks the upper edge of the falling wedge and the stop-loss is mandatory to be at the lows.
This is the risk and you can define the reward in many ways. The 50% retracement provides for more than 1:4 or 1:5 risk-reward ratio. The 100% retracement of the wedge it exceeds the wildest expectations as the market climbed higher in a bullish trend and made a new high. On the two wedges, this is the trade on the long side, this is the trade on the short side. In this case it also retested a bit the trendline, which is something that happens often.
One more thing on wedges – typically when the market forms such a pattern, either at the bottom or the top of a trend, the series of lower lows or higher highs forms in a divergence with an oscillator. If you use an oscillator, like the Relative Strength Index (RSI), and so on, it is very likely that the price will diverge from the oscillator.
If we apply the RSI, like this, we see that the RSI is on the rise, but the price keeps falling. This is a bearish divergence. It is risky trading bearish divergences because the market may keep forming lower lows and the RSI may keep showing a divergence. But if you use the divergence as only a confirmation to trade the falling wedge, then you simply wait for the price to break the 2-4 trendline before going long, because it means two things. First of all, the divergence ended, and second of all, the falling wedge ended as well.
To sum up, look for a series of lower lows and higher highs in a falling wedge or a rising wedge, wait for the price to break the so-called 2-4 trendline, there are five segments in a wedge, and the price typically pierces the 2-4 trendline.
Go short after a rising wedge and long after a falling wedge by the time that the price breaks the 2-4 trendline, place a stop-loss order at the top of a rising wedge or at the bottom of a falling edge, and target 50% of the entire wedge or 100% for magnificent risk-reward ratios.
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