On a price chart, a wedge is a price pattern formed by converging trend lines. Connecting the corresponding highs and lows of a price series across 10 to 50 periods, the two trend lines are constructed.
The lines indicate that the highs and lows are rising or falling at different rates, creating the impression of a wedge as they approach convergence. Technical analysts view wedge-shaped trend lines as important signs of a likely reversal in price action.
Knowledge of the Wedge Pattern
Both bullish and negative price reversals can be signaled by a wedge pattern. In any scenario, this pattern shares three characteristics: first, converging trend lines; second, a pattern of decreasing volume as the price advances through the pattern; and third, a breakout from one of the trend lines.
A rising wedge (which indicates a bearish reversal) and a falling wedge are the two variations of the wedge pattern (which signals a bullish reversal).
This typically occurs when the price of an asset has been rising over time, although it can also occur during a downward trend.
A trader or analyst can foresee a breakout reversal by converging trend lines drawn above and below the price chart pattern. Price may break either trend line, although wedge patterns tend to break in the opposite way.
Therefore, rising wedge patterns signal a greater likelihood of price declines falling a breach of the lower trend line.
Depending on the charting securities, traders can engage in bearish trades after the breakout by selling the security short or utilizing derivatives such as futures or options. These transactions would attempt to profit from the possibility that prices may decline.
When a security's price has been falling over time, a wedge pattern may appear immediately before the final leg of the decline.
As the price fall loses momentum and buyers intervene to limit the rate of decline, the trend lines formed above the highs and below the lows on the price chart pattern can converge. The price may break above the higher trend line prior to the lines converging.
When the price breaks the upper trend line, it is anticipated that the security's trend will reverse and move higher. Traders that recognize bullish reversal signals will seek out transactions that profit from the security's price increase.
Trading Benefits with Wedge Patterns
Despite this general rule, there are some patterns that seem to be useful in anticipating overall price changes. Price pattern methods for trading systems rarely yield returns that, over time, beat buy-and-hold strategies.
A wedge pattern has a larger than two-thirds chance of breaking out in the direction of a reversal, with a falling wedge being a more dependable indicator than a rising wedge (a bullish breakout in the case of rising wedges and a bearish breakout in the event of falling wedges).
The distance between the price at which a trade is initiated and the price at which it should be halted is often smaller than it was at the pattern's start since wedge formations have a tendency to converge to a narrower price channel.
This suggests that a stop loss order can be placed quite close to the time the trade is opened and that if the transaction is successful, the outcome may result in a return greater than the initial risk on the trade.