Last Updated on 17 November, 2020 by Samuelsson
In technical analysis, there are many patterns that are used by traders to get a sense of where the price may be headed. One popular category of patterns is contracting patterns, where the market comes from rather volatile conditions, and then contract, forming what appears like a wedge or a triangle in the chart. One such pattern that’s used quite frequently by technical analysts, is the rising wedge pattern.
A rising wedge is a bearish pattern that signals that the market is going to continue downwards , or turn bearish, depending on the previous trend direction. However, some traders choose to regard the rising wedge as a bullish pattern, if the conditions are right.
This article is going to look closer at the rising wedge pattern, and the things you need to know in order to start trading it. Here are the things you’ll learn:
- The exact definition and meaning of the pattern
- The psychology behind the rising wedge pattern
- Exact rules outlining how many traders choose to trade the pattern. This includes where and how to place the stop loss and profit target
- Some techniques you can use to improve the performance of the pattern, and avoid false breakouts.
- How the rising wedge compares to triangles
- A short introduction to the falling wedge pattern
What Is a Rising Wedge? : Definition and meaning
As said the rising wedge is a bearish pattern that usually signals the end of the current bullish trend, or the continuation of the bearish price moves, depending on the direction of the preceding trend.
As to the definition of the pattern, it closely resembles a wedge that has both its lines rising, as you see in the image above. Below we have broken down the definition of the pattern, and the various conditions you need to take into consideration.
1.The support and resistance lines
As the wedge forms, you should be able to draw a resistance line that connects the highs, and a support line that connects the bottoms. As you might expect, both these lines should be sloping upwards, and converge so that the distance traveled by the market gets smaller and smaller the further it moves into the wedge.
According to the original definition of the pattern, you like to see that both lines converge with the same slope. However, if the resistance line (the upper line) isn’t rising as fast as the support line, it tells us that the bullish forces don’t have quite the strength it takes to push the market to make higher highs, which some choose to regard as a bearish sign.
According to the original definition, it’s preferred to see the volume decline as the pattern advances into the wedge. This simply shows that fewer and fewer market participants are ready to step in as the market gets higher. As such, it’s reasonable to expect that markets stand a higher chance of turning around soon.
3. The Breakout
The last part of the rising wedge pattern is the breakout that appears at the end. As you probably understand, we assume that the breakout will occur in the downward direction, as that would signal that the market is taking off and is headed down.
Most of those who use breakouts, choose to regard a breakout to the downside as the signal showing that the new bearish phase has begun, or will continue, depending on the preceding trend. However, one of the most challenging aspects of breakout trading, in general, is to not act on false breakouts, where the market just turns around right after having broken out!
In just a bit you’ll be introduced to a couple of techniques we and other traders use to mitigate this issue!
4. The preceding trend
Another thing to remember is that there must be a preceding bullish trend for the pattern to qualify as a reversal pattern. In general, a trend that has been ongoing for a long time will be harder to break than one that hasn’t been forming for so long. This is because market participants tend to grow accustomed to the direction of the trend, which makes them more eager to buy on dips. This, in turn, makes it harder for the market to truly reverse.
That’s not to say that long-lasting trends won’t turn around. It’s just that the market has picked up momentum that will be in favor of the current trend. In addition, as is the case in the stock market, there tend to be some factors that speak for that the current trend will continue, more often than not.
Psychology of Rising Wedges
Having covered the exact definition of the rising wedge, let’s now look at what might be going on as it forms. Although it’s impossible to tell exactly what leads to a certain pattern forming, it’s a good exercise to try to understand the psychological reasons behind it. Even though we might not get the exact right answer, the mere act of starting to contemplate why certain moves occur will lead to many new insights over time.
With that said, here is what a rising wedge might be telling us about the market.
When the market comes from a bullish scenario, most market participants are optimistic about the future, and expect prices to continue up. Nothing seems unusual, and as expected, prices continue to go up.
As the market heads deeper into what soon is going to become a rising wedge, the volatility naturally starts to fade, and so does volume. More and more market participants are now waiting for the price to break out to the upside or downside. However, since the market has been going up prior to, and throughout the rising wedge, a heavier emphasis is put on the possibility of there being a bearish breakout, to break the pattern. As a result, more people start to sell their positions to get out of the market before it turns down. Ironically, this action also causes prices to drop below the lower support line, which in turn marks the start of the bearish price swing.
How To Trade the Rising Wedge
With the definition and psychology out of the way, it’s now time to look closer at how many traders choose to trade the rising wedge.
Just remember that no pattern or trading strategy will work on all timeframes and markets. Therefore it’s critical that you learn how to validate trading strategies to make sure that they work with the very setup you’ve chosen to work with. Our article on backtesting is the perfect resource if you want to learn how to carry out tests like these yourself.
With that said, here are the three aspects of the rising wedge that traders take into account when trading the pattern.
As we covered earlier, the breakout is the signal that most traders use as their entry signal.
Now, while you might think the most appropriate course of action is to just short the market as the lower support line is broken, that’s not the case according to some traders. The reason is that the market is prone to false breakouts, which means that it soon reverts and turns to the upside.
The solution becomes to extend the lower resistance line and wait for the market to revisit that level. Then, only if the resistance line is respected, you may decide to take the trade!
In the image below we have provided an example of this very setup. The market first breaks down through the lower line, and continues down a bit before it reverses up again. Then as we see that the breakout level remains intact, we decide to take the trade.
Many traders choose to use a profit target in combination with a stop loss to exit the trade. Then they will be brought out of the trade either at a profit or a loss.
Usually, you should aim to aim to have a risk-reward ratio of 2 or more. This means that a potential profit should be at least twice the size of a potential loss, which then should be reflected in that the stop loss should be placed at a distance from the entry double that of the stop loss distance.
As to the exact placement, you could go about in several ways. However, rising wedges usually are said to have a price target that’s equal to the widest distance of the wedge. In the image below, we have marked the profit target according to this definition.
When it comes to the stop loss there aren’t as clear guidelines that remain specific to the rising wedge. However, a rule of thumb is to place the stop at a level which if hit signals that the setup has been disproven.
Generally, you should place the stop to give the market some room to move. As we’ve already mentioned, false breakouts are quite common, and by giving the market some extra room to play with, we may avoid some of these!
In the image below you see an example of where the stop loss can be placed relative to the wedge pattern. As you see, it’s placed slightly below the resistance level, to accommodate random price swings.
How to Improve the Rising Wedge Pattern: 3 Techniques!
When it comes to improving the performance of the wedge patterns you spot, there are nearly an endless amount of techniques you could make use
. However, in this part, we wanted to present three different techniques that we have found to work well in some of our trading strategies. Just remember that this by no means is a guarantee that they will work well with your market. Again, we recommend that you use backtesting to make sure that the techniques you use work as expected.
Gaps can give us a hint about how bullish or bearish a market is. For instance, if there are a lot of negative gaps, we could assume that bears are in control at the moment, and that there is a bigger chance of a downward-facing breakout.
Another thing to consider is the size of the gaps. As a general rule of thumb, the bigger the gap, the more significant it is.
2.Adding distance to the breakout level
One technique that some traders use to combat false breakouts, is to add a distance to the breakout level itself. That way they decrease the chance of the breakout level being crossed accidentally by random price swings.
The image below shows a setup where the breakout level has been placed slightly above the support line.
3. Volume patterns
As you might remember, the original definition of the rising wedge includes a type of volume pattern. Still, this doesn’t keep us from adding additional rules that could have a significant impact on performance!
One common volume condition often used in breakout trading, is to demand that the breakout occurs with significant volume. That way we get a hint that many market players acted on the move, which in theory should make it more significant.
Can Rising Wedges be Bullish?
Despite everything we’ve mentioned so far in this article, some traders will choose to regard the rising wedge as a bullish or neutral pattern.
The reason depends solely on the trader himself, and there are no clear reasons why they choose another definition. It could have to do with that their particular market reacts differently, or that they trade a timeframe where rising wedges usually have a positive outcome.
While there aren’t any clear rules to employ, this really brings to light the importance of always using some sort of validation of the patterns and strategies you intend to trade. Otherwise, you run a huge risk of trading strategies that are losing strategies.
Rising Wedge VS Triangle: What’s the Difference?
Many people get quite confused over the fact that the rising wedge in many cases seems completely similar to the triangle pattern. The truth is that both patterns are very similar to each other, and that there really is no big difference when it comes to their meaning.
The difference lies in that a triangle should have one of its support and resistance lines completely or nearly flat, whereas as a wedge has both its lines sloping.
Now, there are three types of triangles, meaning that the rising wedge won’t have the same meaning as every triangle pattern.
To be specific, it resembles a descending triangle. While the latter is categorized as a bearish continuation pattern, it also appears as a reversal pattern at the end of a downtrend.
Falling Wedge VS Rising Wedge
The inverse version of the rising wedge pattern is the falling wedge, and appears as a positive reversal formation at the end of a downtrend.
In our guide to the falling wedge, you may read more about the pattern!
In this guide to the rising wedge, we’ve had a closer look at the pattern, what it means, and how you can go about to improve the accuracy of the signal it provides.
We cannot end this article without one more time stressing the importance of testing and validating everything you’re going to trade, before putting real money on the line. Many people new to trading are never going to make it, simply because they don’t realize that the convictions they have about the market may not be true, and actually lead to losses rather than profits.
We, therefore, recommend that you take your time and learn an easy and fast coding language, to be able to start coding and testing your ideas in a quick and efficient manner. That will put you ahead of most of the competition, and ensure that only trade strategies that have worked well in the past.
If you want to read more about how to build and validate trading strategies, we recommend that you have a closer look at any of the following guides: