How do you trade a falling wedge?
A falling wedge is a bullish reversal pattern that forms when prices are trending downward and the trading range narrows. The pattern is created by two converging trendlines, one drawn along the highs and the other along the lows, that form a wedge shape on the chart.
Trading a falling wedge requires a bit of skill and patience, but the rewards can be significant. Here are some steps to help you trade a falling wedge effectively:
- Identify the pattern: The first step in trading a falling wedge is to identify the pattern on your chart. Look for a downward trend that is narrowing, with the lows getting closer to the highs. The pattern should also have at least two or three reaction highs and lows that can be connected to form the trendlines.
- Confirm the pattern: Once you have identified a falling wedge, it’s important to confirm that it is a valid pattern. This can be done by looking for a volume spike on the breakout, as well as a strong move in the opposite direction.
- Set a stop-loss: As with any trade, it’s important to set a stop-loss in case the trade goes against you. A stop-loss can be placed just below the lower trendline of the wedge, as this is the point at which the pattern would be invalidated.
- Look for a breakout: The key to trading a falling wedge is to wait for a breakout. This occurs when the price action moves above the upper trendline of the pattern, indicating a reversal of the trend.
- Enter the trade: Once the breakout occurs, it’s time to enter the trade. You can do this by buying a call option or by buying the underlying asset.
- Take profit: Take profit when price reaches the previous swing high or use a profit target of 1.5 – 2.5 times the height of the wedge, measured from the base of the wedge to the highest point.
Now let’s take an example of how to trade a falling wedge.
Example: The stock XYZ is trading at $50 per share and forms a falling wedge pattern. The stock breaks out above the upper trendline of the wedge and closes above it. With this, we can enter a long position at $52 and set a stop-loss at $48, just below the lower trendline of the wedge. The profit target can be set at $60, which is 1.5 times the height of the wedge measured from the base of the wedge to the highest point.
In conclusion, trading a falling wedge requires a bit of skill and patience, but the rewards can be significant. By following the steps outlined above, you can identify and confirm the pattern, set a stop-loss, and enter the trade at the right time. Remember to always use a proper risk management strategy, and never risk more than you can afford to lose.