Last Updated on 10 February, 2024 by Trading System
There indeed are many patterns in trading that are widely used by traders to get an idea of where prices are likely to head next. Often times they resemble geometrical figures of different kinds, such as triangles or rectangles. One common chart pattern is the falling wedge.
The falling wedge is a bullish price pattern that forms in a positive trend, marking a short pause that’s expected to result in a breakout to the upside. Still, some traders choose to regard the pattern as a bearish sign.
In this guide we’re going to look closer at the falling wedge trading pattern, and what you need to know in order to start trading it. We’re going to cover all the following things:
- The meaning and definition of the falling wedge
- The psychology of the pattern
- One common approach used by many traders to trade the falling wedge
- Falling wedges vs triangles
With all this to cover, let’s begin!
Definition and Meaning of Falling Wedges
Like we just mentioned, the falling wedge is a bullish price pattern that usually signals the end of the on-going bearish trend, or the continuation of the bearish market mode, depending on the prevailing trend direction.
The definition of the pattern isn’t that hard to remember. As its name suggests, it resembles a wedge where both lines are falling. The image below breaks down the pattern to make it easier to get an overview of all the criteria you need to consider.
1. The support and resistance lines
When the wedge starts to form you should be able to draw a line that connects the local highs, and another one that connects the local lows. Both these lines should be sloping downwards, and converge. This means that the distance the market can move gets smaller and smaller the further it moves into the wedge. In other words, market volatility decreases significantly.
The original definition of the pattern dictates that the slope of both lines should preferably be sloping with the same angle. Still, if the support line, which is the lower one, falls with a less steep angle than the upper line, it shows us that the bearish forces are falling short on the low. Some traders choose to interpret this as a bullish sign.
2. Volume
Many traders prefer that the volume is decreasing as the pattern forms and the market goes further and further into the wedge. This shows that fewer and fewer people are willing to bet on a continuation of the bearish price swing, and that the market might not have what it takes in terms of bearish sentiment to continue the bearish price swing for much longer.
3. The Breakout
The final part of a falling wedge is the breakout. Being a bullish pattern, most breakouts are expected to occur to the upside, which becomes the signal that the bullish phase will continue or begin, depending on the preceding trend.
One of the biggest challenges breakout traders face, is that of false breakouts. As you might have guessed, a false breakout is when the market breaks out past a breakout level, but then reverses and goes in the opposite direction of the initial breakout.
Being so ubiquitous, false breakouts can be incredibly expensive if not dealt with correctly. In just a bit we’re going to look closer at what you may do to prevent acting on false breakouts.
4. The preceding trend
One more thing you should keep in mind, is that there must be a bearish trend in place for the pattern to qualify as a reversal pattern
In general terms, trends that have been persisting for longer periods of time, will be more robust and harder to break than trends that haven’t been in play for so long. This has partly to do with the fact that many market players grow accustomed to the fact that the market is advancing in one particular direction, and therefore assume that prices will continue in that direction. In many cases, a long term trend is also a sign that there are underlying, fundamental reasons for the trend, which also makes it more probable that the trend will continue into the future.
The stock market is a perfect example of this, where the continuous improvements of the economy over time drives the bullish trend.
Psychology of Falling Wedges
With the exact definition of the pattern covered, we’ll now look at what might be going on as the pattern forms. Even if it’s impossible to ascertain one type of market structure that applies to every single occurrence of a price pattern, we can learn a lot from trying to understand the psychology behind a move.
Having said that, here is what a falling wedge might tell us about how market players act at the moment.
The initial phase
Coming from a bearish trend, most market participants have bearish outlooks, and expect the market to continue falling. This also holds true at first, when the market forms the first highs and lows of the pattern.
Now, as prices continue into the shape that is going to become the falling wedge, we also see how volatility levels become lower and lower. An increasing number of market players are now waiting for the market to perform a breakout, since they assume that extremely low volatility levels will give rise to a rapid volatility expansion, which tends to be the case.
As many people are expecting prices to break out to the upside, in accordance with the original definition of the pattern, some people will choose to go long, in hopes of catching the breakout before it occurs. This will help the bullish side along, and will help the bullish breakout take place.
The breakout
As soon as the market has broken out to the upside, many market participants notice that bulls have taken the lead, and choose to take part in what they assume is the start of a bullish price swing. As such, buying pressure increases even more, which helps to ensure the continuation of that positive price swing.
How to Trade the Falling Wedge
Now that we have had a closer look at the definition and psychology, it’s time to have a quick look at how many traders approach the rising wedge pattern.
However, before we do so, we want to make sure that you always remember that no pattern, regardless of its hypothetical performance, is going to work on all timeframes and markets. Due to this, it’s paramount that you learn the proper method of backtesting and validating a trading strategy, to ensure that it works well. This is something you may read more about in our article on backtesting.
With this out of the way, let’s now have a closer look at an approach many traders use to trade the falling wedge!
An Alternative Way to Act on the Breakout
While the most typical way of dealing with a breakout from a falling is to just follow it’s direction, some traders choose another approach.
Instead of going long as the market breaks out to the upside, they wait for the market to revisit the breakout level, ensure that it holds, and then decide to enter the trade. This way you reduce the risk of falling victim for as many false breakouts, as you first check if the market really respects the breakout level.
The image below showcases a setup where the market breaks out from a wedge and recedes to the breakout level, where it then turns up again.
BILD
Profit Target
One common way to exit trades, is to use a stop loss. Many times they’re combined with stop losses, which means that you have an exit mechanism that will get you out at a loss or a profit.
Most of the time you should aim to have a risk-reward ratio of at least 2, in order to stay profitable. This means that every profitable trade should be twice the size of any losing trades. This ensures that you stay profitable, even if 50% or more of your trades results in losses.
When it comes to the exact placement, there are some guidelines that pertain specifically to the falling wedge. To be speificic, some traders choose to place te profit target at a distance equal to the widest part of the wedge, away from the breakout level.
In the image below, you see how we placed a profit target using this approach!
BILD
Stop Loss
For stop losses, there aren’t quite as clear guidelines. However, a good rule of thumb often is to place the stop at a level that signals that the you were wrong, if it.
In the case of the falling wedge, this usually is a small distance below the wedge. The most important aspect is to place the stop at a level where the market is given room to have its random price swings bounce around, without it impacting hitting the stop too often. The concept of false breakouts isn’t only a concern when it comes to entry triggers, but stop losses placed too close could easily be hit for no apparent reason.
The image below shows an example of the stop loss placement in relation to the falling wedge. As should be clear, it’s placed slightly below the support level, to give the market enough room for its random swings.
Improving the Falling Wedge Pattern For Live Trading
Most trading patterns and formations cannot be used on their own, since they simply aren’t profitable enough. Still, they can provide a great foundation, on which you may add various filters and conditions to improve the accuracy of the signal provided. In other words, you try to rule out those patterns that don’t work so well.
In this part of the article, we’ll be sharing three techniques that have worked well for us in the past. Just remember to always use backtesting to validate that they methods discussed work well with your particular market and timeframe!
1.Gaps
By watching the size and direction of the gaps in the market, we may get a better sense of the prevailing market sentiment. For instance, if the market performs a lot of bullish gaps, we can be a little more certain that bulls are in control, and that the chances of seeing an upward-facing breakout is bigger.
A gap is generally given more significance the bigger it is.
2.Adding distance to the breakout level
As we mentioned earlier, false breakouts is one of the biggest challenges breakout traders face. One common techniques that attempts to make them fewer, is to add some distance to the breakout level itself. This ensures that the breakout level is hit fewer times by accident, which in theory makes those few times it’s actually crosses more reliable.
In the image below you see how we have added some distance to the breakout level.
IMAGE
3. Volume patterns
The original definition of the falling wedge includes a recommendation with regards to volume, and dictates that it’s preferable if it falls as the pattern is forming.
Now, in addition to this condition, you could choose to include one of your own.
For instance, you could look at the volume with which the breakout is made. High volume generally indicates that a price move is worth following, while weak volume suggests that it lacks in strength.
Can the Falling Wedge Be a Bullish Pattern?
The short answer to this question is that it can.
It all depends on the timeframe and market you trade, and how it resonates with the pattern.
This, once again, is why it’s really important that you always make sure to backtest the patters you’re going to trade, before putting real money on the line.
Falling Wedge Vs Triangle
One question that is usually asked by many, is how the falling wedge differs from the triangle pattern.
As you might know, there are three different types of triangle patterns, which means that the falling wedge will differ in different regards.
Here are the three types of triangles:
Let’s now look at the difference between the two major groups of triangles, namely ascending and descending triangles, and the wedge pattern
Ascending and descending triangle
The difference between wedges and ascending/descinding triangles, simply is that the latter has one line which is parallel. In contrast, the wedge pattern has both it’s line either falling or rising.
Symmetrical Triangle
The symmetrical pattern is completely horizontal, meaning that the lower line is rising, while the upper line is falling.
This isn’t the case with a wedge, where both lines should be falling or rising, depending on if it’s a falling or rising wedge.
Hopefully this makes the difference between the two patterns more clear!
Falling Wedge VS Rising Wedge
As you might have expected, the rising wedge is very similar to the falling wedge. It’s simply the inverse version of the latter, both in meaning and apperance.
Those who want to read more about the rising wedge may do so in our article on the topic!
Ending Words
Falling wedges are some of the most popular trading pattern around, and when used in the right manner, they can pinpoint great trading opportunities in the markets.
By right approach, we simply mean that you have made sure to validate your methods and approach on historical data, to make sure that they actually have worked in the past. Otherwise you run a huge risk of trading patterns that stand no chance whatsoever.
Here are some good resources you might want to have look at in order to validate your own trading strategies before going live:
Guide to building a trading strategy
Definitive guide to backtesting
FAQ
How is the falling wedge defined?
A falling wedge is a bullish price pattern that forms during a positive trend, signaling a short pause before a potential breakout to the upside. The falling wedge is characterized by two sloping lines, connecting local highs and lows, converging towards each other. It represents a decrease in market volatility.
How is the breakout from a falling wedge identified?
While the original definition suggests both lines have the same slope, some traders interpret a less steep angle on the support line as a bullish sign. The final part of a falling wedge is the breakout, typically expected to occur to the upside. Traders need to be cautious of false breakouts, where the market reverses direction after breaking out.
How do traders approach trading the falling wedge?
Unlike triangles, both lines in a falling wedge are either falling or rising. Triangles have one parallel line, and their patterns differ based on whether they are ascending, descending, or symmetrical. While some traders follow the direction of the breakout, others prefer waiting for the market to revisit the breakout level before entering the trade to reduce the risk of false breakouts.
