The falling wedge is typically a bullish setup on a chart. It is one of of the most accurate patterns from which to trade, but it is also among the most difficult to identify early.
The Construct of a Bullish Falling Wedge
The falling wedge pattern can occur as a correction at the end of an uptrend or as the end of a downtrend prior to reversal. The standard wedge includes the conventional A-B-C corrective waves, plus a D-E extension (A-B-C-D-E). However, much of the difficulty in identify the wedge’s conclusion stems from the regularity that extensions occur within the C-Wave that result in an additional series of 3 or 5 waves (extensions of extensions that amplify the difficulty in projecting the pattern’s conclusion).
A long-term falling wedge pattern plays out over a 3 to 6 month period; though they can last even longer. Notice in the chart above that the falling wedge is often a component of a “flag pattern,” which means it has a “pole” caused by an upward price move (before correction) or downward price move (before the wedge conclusion and reversal). You cannot begin to accurately count waves in a falling wedge until you determine that a reversal on a corrective wave (A) does not reach a new high (B). Even then, it is safest to wait until a reversal of point C occurs and you have two clear support points (A and C) to connect. Connect Wave B to the initial swing high to establish your two points of trendline resistance that await a retest for validation.
Challenges of the Falling Wedge
To reap the rewards of the bullish falling wedge, you have to overcome its many obstacles. A key challenge is early entry. When you trade into the start of a falling wedge, you are likely to get trapped in a period of long consolidation that offers limited price swings for entry and exit. At this point, it is difficult for someone with an “investment” mindset or someone who believes that strong profits are coming to exit due to opportunity cost (missing other better opportunities while the pattern consolidates). However, detecting the developing consolidation allows you to exit with limited damage and await a better time for entry. Your cash is freed up for more timely trades.
Wedges often extend or contribute to other patterns. In many instances, you won’t determine that a wedge pattern is in place until after what appears to be a pennant or triangle support is broken. The break leads to the breach of channel lows and the E-wave extension. This breach of support can lead to further delays if the price does not bounce quickly, as the support becomes resistance and short traders lean into it to establish positions.
Remember from the Introduction to Elliott Wave Theory that every wave has sub-waves and every wave is a sub-wave of larger-scale waves. The same logic applies to patterns of waves being micro-and-macro patterns in relation to other pattern segments. Sometimes, as opposed to a reversal, a falling wedge break leads to an extended drop until bullish traders regain support at the next pattern level in the chart. You can dissect a long-term chart and identify falling wedges and other sub-patterns that contribute to the macro-level pattern that is broader in scope.
Entering and Exiting The Falling Wedge Pattern
There are two common points of entry traders look for when acting on a falling wedge pattern. One option is to enter when your A-C support line is touched by Wave E. This is often considered the more “aggressive” play, as there is downside risk if the support is breached. A safety precaution is to establish a tight stop-loss just below support at the time you enter. Determine your point of entry by projecting Wave E’s impact with the A-C support.
The other option, usually viewed as more conservative, is to wait until the resistance on the falling wedge is breached (as noted above). As the example shows, it is common that a wedge break returns to retest resistance-turned-support, as impatient traders stuck in the channel exit quickly. You enter at the point where the new support line has been established. If you prefer to use a stop-loss, place it below the resistance-turned-support line, or below the previous wedge support.
The example above is a falling wedge at the end of a downtrend where you can see the upper resistance line that failed to break, subsequently producing the falling wedge consolidation. This resistance is a great place to take profit. The reward of overcoming the hurdles of the falling wedge are that the pattern routinely returns to the point at which it started following reversal of the down-channel. Even if this level is broken, it is more likely to occur after an initial failure, unless it is approached with very strong volume and momentum. Otherwise, take profit and identify a point for re-entry.
As part of a flag pattern and consolidation after an upchannel, the falling wedge often breaks previous resistance, resulting in an extension move equal to the length of the flagpole. For instance, if the flag pole is $10 in length, and the wedge leads to a $3.80 drop to $6.20, a breach of the $10 resistance often produces a move to $20 (initial $10+$10). A more conservative target is the $10 break plus the $6.20 pivot point for $16.20.
Hopefully you now recognize the basic elements of the falling wedge pattern, the difficulty of identifying one early and the opportunities that come with a successful entry and exit. In penny stocks, where market makers using high-frequency algorithmic trading control much of the action, the final extension of a falling wedge is used to clear out stop-loss orders, allowing the MMs to scoop up cheap shares before a reversal.