A pattern that is similar in shape to the triangle, but with some special differences, is the wedge. Like the triangle, the wedge is characterised by converging price lines and falling volume. But where it differs is how the wedge can often signal an impending reversal of the price trend in effect. Wedge patterns occur in two varieties, the rising wedge and the falling wedge.
Wedge Or Triangle: What's The Difference?
In terms of formation on the chart, the wedge will be formed by two diagonal lines representing support and resistance that converge in the same direction, whereas the triangle will be formed by one diagonal line and one horizontal line, or by two diagonal lines that converge at a midpoint vertically. While the wedge normally foreshadows a reversal in trend line direction, the triangle will signal a breakout in the direction of one of the diagonal lines.
The rising wedge is characterised by two upward diagonal price trend lines with increasing levels of support and resistance that move in a converging pattern. The formation is normally considered to be a bearish signal, because it is usually immediately followed by a downward price trend.
A falling wedge pattern is characterised by diagonal downward lines showing diminishing levels of support and resistance that move in a converging pattern. The falling wedge is normally considered to be a bullish pattern that is usually immediately followed by an uptrend.
Continuation Or Reversal?
Some analysts view the wedge as potentially a continuation pattern in addition to a reversal pattern. Much of the discussion regarding its function is centered on timing. Early in the formation of the pattern, while support and resistance remain distant from one another, the wedge could be interpreted as signaling the continuation of a trend for some time. However, analysts anticipate that the formation of the wedge pattern will eventually lead to a reversal in the trend as the distance between support and resistance narrows at the apex of the formation.
At this point, the trader will expect to see either a downward or upward price breakout, depending on the initial direction of the wedge. One way to discern whether the wedge represents a continuation or a reversal is by examining what has occurred before it forms. If a rising wedge forms following the end of a long downtrend, then there is a good chance it could extend for a longer time as a trend continuation. However, if it forms as part of a longer upwards trend, traders should be on the lookout for a downward reversal.
Pay Attention To Timing
Wedges are considered to be more difficult to trade than some other patterns like triangles because using them successfully to predict a reversal depends much on timing. While triangles can show more predictability at the conclusion of their formation, wedges have been noted at times to give off a false signal, where price moves outside of support or resistance levels momentarily in a "whipsaw effect."
To avoid being caught out with a mistaken prediction of an upward or downward breakout, traders should place stops judiciously before betting on a lengthy reversal. Many traders also complement the analysis of wedge pattern formations with other technical tools such as Elliot Waves and Stochastic indicators to confirm the signals given by the formation.
Setting Price Targets
Once a breakout from the wedge pattern has been determined, traders can use the size of the wedge as a guide for setting profit targets. Generally, traders can expect the ensuing uptrend or downtrend to mirror the length of the one that has ended, unless the new trend is broken by some other unforeseen change in market fundamentals.
As with analysis of other chart patterns, keeping an eye on trading volume can be an important aid in detecting a possible reversal ahead. During the finalisation of an uptrend or downtrend, volumes tend to decrease as market participants lose conviction over the strength of a tendency and as the likelihood of a reversal increases. A subsequent increase in volume following a breakout will then serve to confirm that a reversal has occurred.
The formation of wedge patterns on price charts has been considered a useful sign that a trend reversal will eventually occur. However, unlike some other patterns that may be easier to interpret, wedges can show some ambiguous behaviour that make them tricky to read.
To successfully use wedges to predict upcoming price movements, traders will want to carefully consider the context and the length of the formations in which they occur; and use complementary technical indicators and volume changes to verify the movements that they appear to be signaling. Additionally, they are advised to use stops to guard against the effects of any "false signals" and be prepared to adjust their strategies swiftly for changing conditions should these occur.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…