Posted on: 16 Sep, 2019
The ‘falling wedge’ is a pattern that tends to show up quite regularly in markets with a low volatile and steady uptrend. One of the key advantages is that it will allow traders to reinstate long positions in line with an uptrend if they missed the initial move.
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In the domain of technical analysis, a pattern that without a doubt makes it into the stardom of the most popular ones is what’s referred to as ‘the wedge pattern’.
If you ask yourself, why is it called ‘wedge’? Well, the simple reason is that the price configuration that forms this pattern resembles the shape of a ‘wedge’ in an axe, knife or scissors to name a few.
The formation in a price chart looks like the example below. In this case, what’s illustrated is a 'falling wedge' as the dynamics involve a sequence of lower tops and lower bottoms. Note, one of the peculiarities of the wedge is a compressing range as the formation runs its normal course.
It is also important to note that the steepness of the upper trendline drawn through the lower tops tends to be much more pronounced as opposed to the shallower slope of the lower trendline, which makes a lot of sense from an order flow perspective as will be elaborated below.
The pattern is characterized as a ‘trend trading’ pattern as it provides an opportunity for traders to jump on board of the dominant trend, expecting to bank on a continuation of the main directional bias in a particular market, including stocks, bonds, futures, currencies, etc.
While not as recurrent, the ‘falling wedge’ pattern can also be found in the context of a downtrend to communicate a potential ‘trend reversal’ opportunity. Regardless of the context, its formation implies the anticipation of a technically-derived bullish outcome as the outcome the trader is after.
When it comes to the onset of a ‘falling wedge’ pattern, which is what this article focuses on, the pattern is initiated at the top of a bullish market, with its formation not validated until the technical trader is able to identify a rejection of the second lower low or falling top.
To illustrate the point above in an example, only when there is evidence that the area highlighted with a circle is being rejected, the trader will be in a position to assume the pattern is developing into a ‘falling wedge’. For that, I reiterate, we need to have sufficient proof that two lower bottoms and two lower tops are forming.
On average, it tends to take between 3 to 4 weeks for a 'falling wedge' to mature when trading off the daily chart or proportionally a shorter period of time the lower in timeframes one goes. If trading the 5-minute chart, it could easily develop within 3 to 4 hours of price action.
You will certainly be taking a riskier venue if you are looking to trade this pattern on the 1 or 5 minutes timeframes as the pattern can become much more erratic and noisy.
From an order flow perspective, a ‘falling wedge’ portrays the accumulation of long positions as the compressive nature of the lower bottoms implies that the market is absorbing whatever sell-side pressure comes through the books before the ultimate markup in price.
Put differently, every time the low gets taken out, buyers are stepping in sooner, which implies they are interested in the liquidity that becomes available from the moment the lows get taken out, which time and time again, will be caused by reversal traders’ stops being triggered.
Let’s now pause for a second to analyze the entry point in the ‘falling wedge’ pattern. Once the boundary-like descending trendline by connecting the lower tops is broken by price close outside of it, that’s when trading activity picks up as bids are flooding in to join the long trade.
At times, the breakout of lead to a temporary sideways action where the broken descending trendline is retested before the demand imbalance cause the resumption of the dominant trend. See below an example where the breakout point leads to a retest of the trendline first.
How about the area we will be targeting as part of a ‘falling wedge’ pattern? Well, you simply need to measure the maximum height of the wedge formation from the very first bottom-up until the vertical line intersects with the descending trendline as the picture below shows.
But wait, if you want to limit your downside risks when playing this pattern, you definitely need to count of the placement of a stop loss. The next question that you must ask yourself as a trader, therefore, is where will the stop loss be placed?
The most logical area where, if reached, it will invalidate the pattern is a few pips or points below the recent low. It’s always advisable to leave a few pips of buffer as there will be instances when the price revisits the area where your stop loss is, only to bounce back and get you out of a position that you could have saved if you left this extra room.
If you are aiming to potentially increase the rate of success trading this pattern, there are additional required steps you can take.
First, I would recommend analyzing the volume sequence as the pattern forms. If the sell-side volume candles (in red below) show a tapering of volume as the black trendline below illustrates, it communicates that the sellers are running out of gas.
Secondly, when it comes to the time frames most suitable to play this pattern, I’d personally recommend that the strategy may yield the best results for those looking to engage in swing trading positions as it gives the trader and the pattern itself some more time to play out.
Also remember, one of the key principles when trading any chart pattern, including the ‘falling wedge’, is the fact that the longer the time horizon analyzed, the more reliable it becomes given that for the pattern to develop, it involves a more mature construction.
If you are interested in following the current ‘falling wedges’ being formed in situ, a great website that offers a gold mine of information is www.tradingview.com , specifically the section of ‘falling wedge’ ideas, which is where thousands of users share this developing pattern in their favorite markets, which makes it a very useful resource to check out.
The ‘falling wedge’ is a pattern that tends to show up quite regularly in markets with a low volatile and steady uptrend. One of the key advantages is that it will allow traders to reinstate long positions in line with an uptrend if they missed the initial move. Besides, the placement of the stop loss, entry and profit level is quite mechanical with a rather attractive risk-reward scenario. The pattern is, therefore, an attractive way to look for a way to enter into a bullish market in anticipation of riding it into new highs.
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