When you learn to trade CFDs, stocks or forex and you study stock charts and other analytical tools, one of the more challenging patterns to analyze properly – even though you’ll find them often – are rising and falling wedges. “What goes up must come down” is certainly the conventional wisdom when it comes to the stock trading playbook. As a result, it is often said that a rising wedge is falling, and a falling one is climbing up – in the same way that an ascending wedge is an exception to the rule that wedges normally give no clear indication as to which way the share price will break out. However, when you scrutinize them properly, are wedges always truly reversal patterns? If so, what is it when looking at a wedge that confirms the reversal pattern?
Elliot Waves Theory and wedges
If you take into consideration the Elliott Waves Theory, wedges usually form between the first and the third, and the second and the fourth trend lines. When they are making an ending diagonal, each of the five waves that form a wedge should be corrective – or, in other words, they should present themselves in a corrective shape. You should therefore be able to see a zig-zag, flat, triangle and so on.
The theory goes further than that, however. It also says that the third wave in such a wedge diagonal should not be the shortest one. This allows you to speculate fairly accurately where the wedge will possibly end. The maximum value for the fifth wave to come can be gleaned by calculating how long the third wave is, and then applying this above the fourth wave.
If a price extends beyond this, it stands to reason that the third wave is not the shortest one any longer. This is a critical advantage to have in your trading strategy weaponry because it means that what you are looking at is no longer a wedge.
How to measure how long it took a wedge to for
Failing to take into account how long it has taken a wedge to form is one of the biggest mistakes you can make. To see what time frame a wedge has formed over, measure how long it has taken the whole wedge to form. Now project this measure of time on the right of your chart, starting from the time the wedge ends.
Now, after the lower trend line in your wedge is interrupted – that is the second to fourth line – look out for the price to go back to the 50% level from the whole wedge in a shorter period of time than the time it took for the wedge to form in the first place.
How can you tell if you’re still looking at a wedge? It’s likely not a wedge if, after you project the time on the right location, the 50% level isn’t retraced and the time element is running out.
What is the lesson?
As far as CFD trading tips go, this is a good one: wedges are deceptive. Traditionally, most market traders are expecting them to be reversal patterns and therefore looking at them with a reversal bias. However, as we’ve seen, this is not always the case.
The best time to take out a climbing or falling wedge is to look for the 50% retracing to show up after the second or fourth trend line is broken. This should happen in a shorter period of time than it does for the entire wedge to shape up. The highs that present themselves at the fifth wave should then normally stay true for the duration of this period.