The Wedge Pattern Trading Strategy Guide

What is a wedge pattern?

The pattern formed by the price of a security when the support trendline, and, the resistance trendline converge is known as the wedge pattern.

Support trendline can be constructed by drawing a straight line connecting the price lows.

Resistance trendline can be constructed by drawing a straight line connecting the price highs.

An example of a wedge pattern is shown below:

Wedge Pattern 1

The wedge pattern is a commonly found pattern in the price charts of financial securities. The securities could be anything – equities, bonds, indices, currency, commodities, derivatives, etc.  

 

The most important feature of a wedge pattern is that the price must contract.  Take a look at the picture below to see where the contraction of price occurs in the wedge:

Wedge Pattern 2

Types of wedge pattern:

Based on the construction of the straight lines to form the support trendline, and, the resistance trendline, wedge pattern could be of two types:

  1. Falling wedge pattern
  2. Rising wedge pattern

1- Falling wedge pattern

The falling wedge pattern is formed when the price of the security contracts due to the lower lows, and, lower highs made by the price.  For example:

Wedge Pattern 3

2- Rising wedge pattern

The rising wedge pattern is formed when the price of the security contracts due to the higher lows, and, higher highs made by the price.  For example:

Wedge Pattern 4

How to trade the falling wedge pattern?

The falling wedge pattern is generally (not always) considered as a bullish pattern. Bullish in the sense that the price will break the resistance trendline, and, form an uptrend.

Wedge Pattern

As already mentioned, it is generally considered as a bullish pattern. It could be that the support trendline is broken, and, a downtrend is formed.

Now that we know that either of the trend lines could be broken, let’s devise a strategy to trade falling wedge pattern.

Track the total number of buyers, and, the total number of sellers, when the price is close to the resistance trendline. If the total number of buyers is greater than the total number of sellers at, or around, the resistance level, generally, the resistance level would be broken, and, the price would form an uptrend.  

Falling Wedge Pattern Example:

Below is the chart of Copper Futures on September 28, 2017.

Wedge Pattern

                         Copper Futures – September 28, 2017

So, it would be a promising idea to initiate a buy position when the price is above the resistance trendline. Remember to place a stop loss order somewhere below the resistance trendline.

                             Copper Futures – September 28, 2017

 

How to trade the rising wedge pattern?

A rising wedge pattern is, generally, considered a bearish pattern. Bearish in the sense that, generally, the support trendline would be broken; and, a downtrend would begin.

As already mentioned, it is generally considered as a bearish pattern. It could be that the resistance trendline is broken, and, an uptrend is formed.

Remember nothing in the market is certain. Any strategy can fail. Smart traders use stop loss order to protect themselves from adverse move.

Now that we know that either of the trend lines could be broken, let’s devise a strategy to trade rising wedge pattern.

Track the total number of buyers, and, the total number of sellers, when the price is close to the support trendline. If the total number of sellers is greater than the total number of buyers at, or around, the support trendline, generally, the support trend line would be broken, and, a downtrend would begin.  

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Rising Wedge Example:

Below is the chart of Crude Oil Futures from May 22, 2017 to June 1, 2017.

                  Crude Oil Futures – May 22, 2017 to June 1, 2017

So, it would be rewarding to initiate a sell position when the price is below the support trendline. Remember to place a stop loss order somewhere above the support trendline.

                Crude Oil Futures – May 22, 2017 to June 1, 2017

Example

Let’s see how wedge pattern can be utilized to earn a decent profit.

Below is a chart of Copper Futures from September 21, 2017 to September 26, 2017.

                   Copper Futures – September 21, 2017 to September 26, 2017

 

Step 1

Wait for the points A, B, C, and D to appear; as only then a wedge pattern can be formed.

Step 2

Connect Point A with Point B to get a straight line. This gives us the support trendline (say line AB).

Connect Point C with Point D to get a straight line. This gives us the resistance trendline (say line CD.

Step 3

Produce the line AB and the line CD; as shown in the picture above. If the two lines meet, we can be assured that the price is contracting. Hence, this is a wedge pattern. Now determine if it is a rising wedge or a falling wedge.

As the price has made higher lows and higher highs, it is a rising wedge. Hence, most probably the price will break the support trendline.

Step 4

At point E in the picture below, if the total number of sellers is more than the total number of buyers, the support trend-line will break and price would move below the support trend-line to form a downtrend.

If the price moves below the support trend line, we should initiate a sell position; as shown below:

 

The amount of decrease in the price is considerable; from the point E. Hence, the strategy would have generated a decent profit.

Points to Remember:

  • Be careful while choosing the highs and the lows to form the wedge pattern. Trading is not an exact science. Slight deviations can be ignored.
  • Many experienced traders are of the view that wedge pattern takes three to six months to develop. On the other hand, there are many experienced traders who use this strategy for day trading
  • Always use stop loss.

 

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