Whenever traders put money into crypto, they often seek a dramatic price spike to boost their portfolios and grow their wealth. However, when the digital asset’s price trends downward, these traders immediately search for signs of a reversal, aiming for the asset’s price to surge to new heights. This anticipation of a turnaround allows them to capitalize on potential profits.
Enter the falling wedge pattern, a technical analysis tool that signifies a potential bullish reversal following a downtrend, distinguished by converging trend lines that depict diminishing selling pressure.
In this guide, we’ll review this bullish pattern, including what it is, how it works, and how to identify it. We’ll also discuss how to trade wedge patterns in stocks and crypto markets.
What is a falling wedge pattern?
A falling wedge pattern is a wedge formation that follows an asset’s deep dip in price. The formation signifies one of two things:
- A rally is about to occur, and an asset will become bullish in the coming days or weeks.
- The asset could continue an uptrend it experienced earlier.
For a falling wedge pattern to take place, a descending wedge pattern must form following bullish activity for an asset. The price undergoes a massive correction, and the security moves swiftly downward. From there, two converging lines regarding the security form on the technical charts. The wedge pattern is complete when the two lines meet, meaning the asset's price has broken beyond the present resistance level and again ascends.
What are the characteristics of a falling wedge?
The falling wedge pattern stands out for its distinctive shape and insights into market sentiment, especially during downtrends. This pattern is particularly valued for its predictive capabilities, allowing traders to anticipate changes in momentum and prepare for potential upward movements. It comes with specific characteristics, helping traders seek opportunities in a declining market.
Prior trend
A falling wedge pattern often takes between 90 and 180 days to form. To take shape, it requires a prior reversal trend. This initial downward movement is crucial as it sets the stage for the potential bullish reversal that the pattern suggests.
Upper resistance line
Two (and sometimes three) highs form during a falling wedge pattern, with the second or latter reaching a slightly lower number than the first. These two highs create the upper resistance line (the monetary figure the price has trouble passing).
Lower support line
Similar to the upper resistance line, this is also a downward-sloping line but connects the lower lows. It reflects the decreasing selling pressure, showing that sellers are becoming less aggressive as the pattern matures.
Contraction
Both the upper resistance and lower support lines create a cone shape on the technical charts as the pattern ages. Eventually, the low points converge, suggesting the bears are losing market control, and selling pressure is beginning to lighten.
Resistance break
Resistance break is when the asset's price moves beyond the previously established resistance point. This is a bullish sign the asset may travel north from here, although a minor correction could still occur before a rapid and solid jump is recorded.
Volume
Volume plays a significant role in confirming the falling wedge pattern. Typically, the volume should decrease as the pattern develops, indicating waning selling pressure. A spike in volume on the breakout above the resistance line confirms the pattern and the potential for a bullish reversal.
How does a falling wedge pattern work?
A falling wedge pattern suggests when a specific asset has reached its final low. All assets endure periods of descent in their lives. Sometimes assets fall in price and hover for a period of time before falling again. This indicates that the previous low was not the asset’s final resting point.
The falling wedge begins when an asset shows two sporadic highs occurring almost randomly. For the wedge pattern to continue, two similar lows in isolated incidents must also be observed.
The second high and second low must lie under the previous high and low—suggesting that the bears' grip on the market is slipping, and the asset’s resistance level is weakening.
From here, the resistance level will likely cross if there’s a spike in daily trading volume for the asset. There, the previously recorded downtrend is reversed, and the asset spikes again, ending the process behind the falling wedge pattern.
How to identify a falling wedge pattern
Identifying a falling wedge pattern is a crucial skill for traders aiming to harness the potential of bullish reversals. By signaling that a trend reversal is on the horizon, the pattern offers an opportunity for traders to position themselves advantageously before a potential uptick.
Here's how to spot a falling wedge pattern:
Look for an upward or downward trend
If the asset is in an uptrend, the wedge pattern forms to help the uptrend continue. Otherwise, if the asset is in a downward trend, this is a sign that the wedge pattern will form in a reversal.
Use a trend line to connect lower highs and lower lows
Draw two converging trend lines; the upper line connects the lower highs, and the lower line connects the lower lows. These lines should be converging, creating a narrowing, wedge-like shape.
Watch out for divergence between price and an oscillator
Divergence occurs when the price action in the chart isn’t reflected by the oscillator, such as the relative strength index (RSI) or the moving average convergence divergence (MACD).
For example, if the price makes new lows but the oscillator doesn’t, it could indicate a weakening downward momentum, suggesting a potential reversal.
Leverage other oscillators and technical instruments to confirm an oversold signal
Oscillators can be used to find signs that an asset is oversold. An oversold condition, particularly within a falling wedge, may hint at an upcoming reversal as selling pressure starts to exhaust.
Check for a break above resistance for a long entry
Should the asset move beyond the present resistance level, this is a vital sign that the downtrend is over, and the asset is beginning another heavy ascent set to last. This is a prime scenario for a trader looking to garner higher profits.
How to trade a falling wedge
The falling wedge pattern indicates diminishing selling pressure and a forthcoming shift in market sentiment. Successfully trading the pattern involves a systematic process from identification to execution and exit. Here are seven steps to get started:
1. Find and identify the falling wedge pattern on a graph
The first step is to locate a falling wedge pattern within the context of a prevailing downtrend. This involves spotting converging trend lines that connect a series of lower highs and lower lows, forming a wedge.
2. Check for a breakout
The key to trading the falling wedge is to wait for a price breakout above the wedge’s upper resistance line. This breakout indicates a potential reversal of the downtrend and the start of an upward price movement.
3. Review the breakout
Before entering a trade, assess the breakout for confirmation. This includes checking for increased volume during the breakout, which can validate the reversal signal’s strength.
4. Enter the market
Once the breakout is confirmed, consider entering the market with a long position. The entry point can be immediately after the breakout or upon a retest of the breakout level, where the price retraces to the resistance line, which now acts as support.
5. Place a stop-loss order
To manage risk effectively, place a stop-loss order just below the recent low within the wedge or below the breakout point. This limits potential losses if the market doesn’t move as anticipated.
6. Determine your profit target
Set a profit target based on the height of the wedge at its widest point, projecting this distance upward from the breakout point. Alternatively, use key resistance levels or moving averages as targets.
7. Choose an exit strategy
Decide on how to exit a profitable trade, whether reaching a set price target or using trailing stops to maximize gains while protecting profits.
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