Wedges are popular patterns among traders but the way to interpret a wedge and to trade it is very tricky as it has multiple interpretations.
There is a strong believe that wedges are reversal patterns, namely they are forming at the end of a trend. While this is a valid statement most of the times, one cannot say that wedges are ALWAYS reversal patterns as there are situations when price simply continues in the same direction after a wedge is completed.
Before going into more details regarding the above statement, it should be known that wedges can be falling or rising. As a rule of thumb, a falling wedge it is said that is always rising, and a rising wedge is always falling.
It should be mentioned here that wedges are so-called five wave structures and therefore they should be labeled with numbers. This is essential as by labeling them there will be two resulting trend lines that are key in trading such patterns.
As it can be seen in the picture below, the resulting 1-3 and 2-4 trend lines are defining the shape of the wedge and between the two, the 2-4 trend line is by far the most important one. The reason for that comes from the fact that by the time it is broken, the pattern is considered to be completed and the new move should start.
After the 2-4 trend line of a falling wedge is broken, a bullish move should be expected, while the opposite is true when it comes to the 2-4 trend line of a rising wedge.
The 1-3 trend line is most of the times pierced by the last swing lower/higher (depending on the type of the wedge) but that is not mandatory. While the 1-3 trend line is likely to be pierced multiple times, the 2-4 one should be clean and easy to identify.
As it can be seen above, the key stays with the break of the 2-4 trend line as at that moment a long or short position should be traded. But how do you identify the moment that a wedge is forming?
One way is to use an oscillator and look for divergences between price and oscillator as this is the very first sign a counter move is expected. The favorite oscillator for spotting divergences is the RSI (Relative Strength Index) but others can be used as well.
Another way is to use Elliott Waves Theory as by counting the waves with this theory it means the wedge can form either at the end of a complex correction, or it is a 4th wave or a B wave.
In both situations, there is only one way to trade these patterns: trade the break of the 2-4 trend line with a stop loss at the lowest point (in the case of a falling wedge) or the highest point (in the case of a rising wedge). Aggressive traders should stay in the trade until the whole wedge is completely retraced (after all, it should be a reversal pattern, right?) but conservative ones will always exit at 50% retracement.
The reason for exiting at 50% retracement of the whole wedge comes from what we said at the beginning of this article: they are not always reversal patterns, and this is why a stop loss is mandatory.
There is one situation with Elliott Waves Theory when a wedge is forming as a 4th wave or a wave b, and that is bullish as a continuation move should be expected. However, this is rare and this is why wedges are almost always concluding the way it is shown above.
In order to overcome this small likelihood that price moves beyond your stop loss, the thing to do is to reverse the trade by the time the stop loss is hit. This means effectively going short after a falling wedge is stopped or long after a rising wedge is stopped with a 1:1 rr ratio, namely setting a take profit equal with the amount of pips that were stopped.
It should be a safer trade as it means that the move to follow is either a 5th wave in an impulsive move or a c wave, in both cases a powerful move in the opposite direction. Aggressive trades can trade a double size if the wedge is stopped and this way a profit can be made while conservative traders just reverse the trade in order to recover the previous loss.
To summarize, wedges should be traded for the 50% retracement level after the 2-4 trend line is broken, and if price returns and exceeds the end of the 5th wave, a trade in the opposite direction should be taken with the purpose of recovering the previous loss.
The bigger the time frame, the stronger the pattern is, so identifying one on the daily or even higher time frames offers great opportunities.