Predicting market movements with chart patterns is one of the most effective tools for making trade decisions. Chart patterns are pure price-action and the basis of underlying buying and selling pressure.
They are formed by support and resistance levels, as well as by more complex versions of trend lines.
Patterns have a proven track record, and day traders rely on them to identify reversal or continuation signals, to open positions, and to identify price targets. Traders also look out for patterns to help them know if the odds are in their favour.
If you’ve studied harmonic patterns, then you are probably familiar with the more common types of patterns such as Butterfly, Gartley, Bat, Cypher, and Crab patterns. However, there is also a slightly less known, but the equally effective harmonic pattern called the Wolfe Wave pattern.
The Wolfe Wave is composed of five-wave patterns in price that imply an underlying equilibrium price.
Wolfe Waves work a bit like the Elliot waves.
For example, they get the 1-2-3-4-5 wave formations seen with Elliot waves and put them into a shape context that traders can trade as bullish or bearish. However, there are some differences in both waves.
Wolfe Wave patterns can develop over short- and long-term time frames such as minutes or weeks. They are used by traders to predict where a price is heading and when it will get there.
The Wolfe Wave is a natural pattern found in every market. Its basic shape shows a fight for balance, or equilibrium, between supply and demand. This naturally occurring pattern was not invented but rather discovered as a means of predicting levels of supply and demand.
These patterns are very versatile in terms of time, but they are specific in terms of scope. For instance, Wolfe Waves occur in a wide range of time frames, over minutes or even as long as weeks or months, depending on the channel. On the other hand, the scope can be predicted with amazing accuracy. For this reason, when correctly exploited, Wolfe Waves can be extremely effective.
The overriding factor in identifying the Wolfe Wave pattern is symmetry.
Here are some key points to remember for identifying Wolfe Waves:
Waves 3-4 must stay within the channel created by waves 1-2.
Waves 1-2 equal waves 3-4 (showing symmetry).
Wave 4 revisits the channel of points established by waves 1-2.
There should be regular timing intervals between waves.1
Waves 3 and 5 are usually 127% or 162% (Fibonacci) extensions of the previous channel point.
The first graph shows the formation of the bullish wolfe wave.
It is bullish because the final outcome/breakout occurs in a bullish direction. As we have stated above, traders expect a new breakout to occur after the formation of the first 4 waves. So, the pattern began by forming the first 4 waves. The movement of these waves have been marked using the numbers 1 to 5. What happened after that is a bullish breakout shown by the green arrow.
This makes it a bullish wolfe wave pattern.
The second graph shows the formation of a bearish wolf wave.
It is bearish because the final outcome/breakout occurs in a bearish direction. The price action first formed the first 4 waves. The movement of these waves have been marked using the numbers 1 to 5. After the 4 waves were formed, a breakout occurred in a bearish direction.
This makes it a bearish wolfe wave.
It is also important to note that Wolfe Waves, along with most pattern trading strategies, are highly subjective. The key to profiting is accurately identifying and exploiting these trends in real-time, which can be more difficult than it sounds. As a result, it is wise to paper trade this technique –as it is any new technique you are learning – before going live.
Identifying Complex Patterns Using Technical Analysis
In a Wolfe Wave pattern, the fifth wave breaks out of the channel. According to the theory behind the pattern, a line drawn from the point at the beginning of the first wave and passing through the beginning of the fourth wave predicts a target price for the end of the fifth wave.
If a trader properly identifies a Wolfe Wave as it forms, the beginning of the fifth wave represents an opportunity to take a long or short position. The target price predicts the end of the wave, and therefore the point at which the trader aims to profit off the position.
Technical analysis makes use of chart patterns such as Wolfe Waves to predict market movements and time trades for maximum profit. Traders who use technical analysis look at charts depicting price movements for securities over a period of time.
In general, technical analysis rests upon theories of supply and demand which imply certain price levels above or below which securities will struggle to trade. Levels of support correspond to prices low enough to attract enough demand to stabilize and raise share prices, while levels of resistance correspond to prices high enough to cause shareholders to sell shares and take profits, reducing demand levels and causing prices to level off or drop.
When technical analysts look for patterns such as Wolfe Waves, they attempt to profit off of a breakout, where share prices move outside of the channel formed by support and resistance levels.
The same laws of supply and demand that generate levels of support and resistance also suggest prices will regain their equilibrium after a breakout. Traders seeking maximum profit must be able to identify the correct points at which to buy or sell in real time.
While many techniques exist to do this, traders run significant risks if they misidentify patterns or trends. Those interested in using such techniques would generally do well to research patterns and the theories behind them carefully, engage in paper trading to test those theories without putting money on the line and make judicious use of hedges or stop loss positions to limit the potential down side of a mistimed trade.
Bottom Line
Like many other trading patterns, the Wolfe Wave can be extremely effective if correctly exploited. Just remember that the key to using this pattern for profitable trades is its correct and timely identification.
Generally, the Wolfe Wave can be seen when the price is contained within a channel and give you a good idea when the price is going to break-out of the channel and reverse.
Traders who use this pattern time their trades based upon the resistance and support lines indicated by the pattern.
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