Another Tool For Your Trading Toolbox

| February 3, 2010 | 0 Comments

A couple of weeks ago we spoke about the hammer.  The hammer is a one day technical pattern producing low risk trades in certain situations.

Here’s another basic tool that works well in trading…

It’s called the wedge.  Many of you know that a wedge is a tool used by humans for many millennia.  It allows for the splitting or lifting of objects.  The wedge gives the user a mechanical advantage.

In trading, a wedge is a technical trading pattern that can give the user a statistical advantage.  By trading the wedges correctly, you can gain an edge over the market.

There are two types of wedges, rising and falling.  Wedges are a longer term pattern.  I’ve found the longer they build, the more profitable they can be.  In this article, let’s take a look at the rising wedge.  (These are also known as ascending wedges.)

The S&P 500 had been rising for quite a few months.  Looks good, right?  Well yes, you’re doing great if you bought down at the 1,000 level.  But, what if you’re on the sidelines and looking for a low risk trade?

Where is the lowest risk trade with the highest possible reward?

You could go long through the S&P 500 SPDR (SPY).  In this case, you would be looking for further upside in the S&P 500.

But the rising wedge pattern means something…

It means buyers are becoming increasingly exhausted as the market trades higher.  You can see this by comparing the green upper trend line with the red lower trend line.  Notice how they are converging.  The green trend line is rising at a flatter angle than the red trend line.

This gives the advantage to the bears in the short term.

Now, it’s been proven the best long term results come from trading with the trend of the market.  And in this case, the trend is still UP.

But in some scenarios, the reward to risk ratio of going with the trend just aren’t that good.  Once in a while, it pays to go against the grain when the risks are low and the potential reward is high.

And this is exactly what a wedge pattern represents…

It’s an opportunity to go against the trend of the market with low risk.  As long as you put a stop loss order above the recent highs, your risk is controlled.

As you can see, the S&P 500 has broken down out of the wedge pattern.  Just how far down the S&P will go remains to be seen.

But here’s a general rule of thumb…

Breakdowns from wedge patterns like the one above can retrace at least 75% of the wedge.  Meaning… we could test the 1,060 to 1,040 level on the S&P 500 in the next few weeks.

So be on the lookout for these high reward, low risk patterns.

Just remember, trading is about keeping the risks small and the rewards big.  The wedge pattern gives you the opportunity to do just that.

By the way, in my Technical Trading Alert service we made a very similar trade and subscribers are already showing a profit.  Setups like this can make savvy technical traders good money.

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Category: Technical Analysis

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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