When a falling wedge pattern appears in a forex chart it hints at bullish sentiment. Like the rising wedge, this pattern is quite common at all time scales. It comes in two forms:
- In an uptrend a falling wedge can form as a minor downward correction
- In a down trend a falling wedge can develop as the trend is about to reverse
The first case is signaling a continuation of the main trend. The second case is signaling a reversal could be on the cards. Traders use the context in which the wedge pattern appears to decide one case from the other.
Identifying the Falling Wedge Pattern
The falling wedge is very similar to other three-point chart patterns like pennants and triangles. It forms when the price is trapped between two converging lines; an upper resistance and a lower support line. The price is making lower highs and lower lows while at the same time volatility is falling.
To be a valid, both the resistance and the support line need to have a “steep” down slope. The price should be narrowing into a tight range.
The pattern ends often with a strong breakout. Be aware though that the support and resistance won’t always meet before the breakout takes place.
The continuation falling wedge is similar in shape to the pennant. Unlike a pennant, the wedge doesn’t need to exist on a flagpole. By convention shorter duration wedge patterns are usually classed pennants rather than wedges. The “falling” pennant and the falling wedge are traded the same – as buy signals.
Falling wedge as a continuation
To trade a falling wedge as a trend continuation (buy side) it should have certain features. Firstly the pattern has to appear inside a solid uptrend. You can confirm this with the simple moving average line. For example, if the pattern is 50 bars, use the slope of the simple moving average (SMA 100) as a guide.
The pattern should be a brief downward retracement of the main trend. If the wedge is retracing more than about one third of the trend, it’s probably not a good entry signal to trade on. You can use the Fibonacci retracement tool to judge the size with respect to the trend or just do it by sight.
Once established, the falling wedge is traded using a breakout strategy. This is done in much the same way as the pennant trade or the triangle trade.
When a falling wedge can indicate a reversal
With hindsight it’s fairly easy to spot a reversal wedge from a continuation wedge. However spotting them in live charts is tricky and prone to mistakes.
Firstly a reversal wedge should appear within a bearish trend. Additionally the configuration should be bigger and more prominent than a continuation wedge.
By that I mean the main area of the trend should start funneling downwards into a narrowing range. Volatility will be dropping off at the scale of the trend and below. When trading we check this with the ATR indicator using various different periods or just by sight.
How reliable is the Falling Wedge Pattern?
A chart pattern is only as good as its forecasting ability. To understand the reliability of the falling wedge specifically in forex, I looked at five currency pairs each over a ten year period. I checked for patterns of up to 50 bars in duration using a detection indicator.
On the four hour chart (H4), there were a total of 165 patterns over the entire period.
The ones that appeared in bearish trends or flat markets were ignored. The trend was measured as the slope of the simple moving average (SMA-100) using a simple 10 point box filter.
Of the remaining wedges that were in bull trends, the correction was measured just after the pattern completed. Where there was a bullish continuation, this was counted as a correct case. Where there was a bearish correction, this was counted as incorrect. The table below shows the results.
What this shows is that historically the falling wedge has had better than even chances of correctly predicating a bullish continuation on major forex pairs. However there is quite a bit of variation across pairs. Both GBP/USD and USD/CHF had the signal faring worse than random.
On the hourly chart (H1), there was less variation but the odds were slightly less favorable than on the four hour chart. The odds of a bullish continuation following a falling wedge were 51.7% on the hourly chart.
The falling wedge is similar to other three-point chart patterns such as triangles and pennants. Like the triangle, the falling wedge has proven useful as a continuation signal. We usually trade it in the same way, as a breakout. On major forex pairs the falling wedge has correctly predicted the resumption of a bullish trend with odds that are slightly better than chance alone.
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It’s a good idea but would you explain please what you mean by a brief retracement. How do you know when it is too far and what retracement tool? I have the indicator, but how do you get the lines to display like you have in the charts?
Usually you can do it just by looking at the chart to see how strong and how far the retracement wedge has already gone. I look for other factors too that could suggest it’s more than a brief correction and there could be stronger bearish sentiment building. Fibonacci retracement tool could be helpful but in most instances it shouldn’t be necessary.