A wedge reversal pattern occurs when the market makes three pushes in either a rising or falling convergent triangular pattern. However, if you are a little flexible with how you define a wedge, you will discover that small wedges occur frequently and provide scalping opportunities almost every day.
“Two flags” (below) includes two traditional wedge reversal setups, each showing three legs. The pattern usually has five legs, but as with any triangle, it can sometimes have seven or even more minor reversals before the breakout occurs.
Although the final push often goes through the trend channel line, that is not always the case. For example, the third push in both wedges (Bars 5 and 12) failed to reach the trend channel line before the reversal and breakout occurred. Following the breakout, there are usually at least two countertrend legs. For example, after Bar 6 broke out of the wedge top, most traders were looking for a second leg down before the market would go above the top of the wedge (the Bar 5 high). This meant that any small rally to test the high likely would form a lower high and be followed by a second leg down. Aggressive traders could short on a limit or market order at or one or two ticks above the Bar 6 high with a stop above the Bar 5 high. More conservative traders would start looking to short at one tick below the low of any bar that rallied to test the high.
Once the bar after Bar 6 went above the Bar 6 high, traders would place an order to go short at one tick below the low of that bar once the bar closed. If filled, they would place a protective stop at one tick above the Bar 5 wedge high. If the market did not trigger the entry sell stop on the next bar, this would cue an order to go short at one tick below that bar, again with a protective stop at one tick above the Bar 5 high.
As long as the market stayed below the top of the wedge, traders would continue to place stop orders to go short. If a trader went short on the fourth bar after Bar 6, they would then place a protective stop above the high of Bar 5. Bar 7 attempted to rally, but it failed and became a lower high and it led to a major reversal.
On the down slope
As the market fell, it formed a potential wedge bottom with the three pushes down to the Bar 12 low (Bars 8, 10, and 12 were the three pushes down). The bear trend line above (using the Bars 9 and 11 highs) converged with the trend channel line below (using the Bars 8, 10, and 12 lows) and created a wedge shape. Bar 12 was a strong bull reversal bar with a bull body that was about half of the size of the bar, a low that was several ticks below the low of the prior bar, and only a one-tick tail at the top of the bar. It was also the second attempt to reverse the Bar 2 low of the day (Bar 11 was the first attempt).
Even though the momentum down from the Bar 7 lower high was strong, this is a good enough reversal for traders to look for at least two sideways to up legs. Traders would go long on a stop at one tick above the Bar 12 high and, if filled, place a protective sell stop at one tick below the low of the wedge (the Bar 12 low). If the wedge fails and the market falls below the low of the wedge, the selloff often will extend for a measured move down from the top to the bottom of the wedge. Traders could either exit any remaining longs or even go short below the Bar 12 low. Traders would expect the market to fall about 5.25 points below the Bar 12 low if the market were to fall below that low (the Bar 9 top of the wedge is 5.25 points above the Bar 12 low of the wedge). In fact, the market ultimately fell one tick more than that.
Once the long was triggered by the market going above the Bar 12 high, the market was likely to test the Bar 9 top of the wedge and then pull back and make at least one more attempt up, since the pattern was so strong. Instead, the market formed a double top bear flag (the highs of Bars 9 and 13) and a higher low entry never triggered.
Longs were looking for the market to fall but stay above the low of the wedge. As the market pulled back, they would place buy stops at one tick above the high of the prior bar, hoping for the market to reverse back up and make them long. Instead, the market sold off into the close and never triggered a higher low long. Even though a wedge with a good shape and a strong reversal bar might have about a 70% chance of trying to form a second leg up, there is still a 30% chance that it won’t. Nothing in trading is ever 100% certain and 70% odds are as good as you will ever find, even with the strongest setups.