The Wolfe wave pattern refers to harmonic wave configuration seen in all markets and depicts a struggle for equilibrium between the forces of demand for a commodity and its supply, and predicts the reversal of trends. The Wolfe Waves are five (5) waves that indicate either bullish or bearish trends and help a trader forecast where price is headed and the expected time it will attain such price.
The Wolfe Wave was elucidated by Bill Wolfe, an S&P 500 index trader, and helps identify channels that provide a trader with a reliable metric for defining their points of entry and exit in a trade setup.
This pattern can be found on any timeframe but are quite specific in terms of scope. That is, depending on the channel, the waves are visible on the minute, hourly, daily, or monthly timeframes but they can predict scope with remarkable accuracy. Therefore, if judiciously applied, they are quite useful.
How to identify the Wolfe Wave pattern?
To correctly identify as a Wolfe Wave, a series of criteria must be met. However, the underlying principle of the pattern lies in the symmetry. Below are a set of rules guiding the identification of Wolfe Waves:
- The Wolfe Waves must form in an equidistant channel. An equidistant channel refers to parallel trend (bullish or bearish) lines that delineate the boundaries of an ongoing trend. It is formed by pinpointing the support and resistance levels in a trending or consolidating chart. The more parallel the trend lines, the better the accuracy.
- Waves 1 & 2 must form a price channel that will contain waves 3 & 4.
- The time between waves 1 & 2 and waves 3 & 4 should be approximately equal
- Wave 5 (the final wave) should break the channel representing a false or pseudo breakout that later ends within the channel.
- Fibonacci extension levels 127% and 162% of the preceding channel point usually coincides with waves 3 and 5 respectively.
Where can the Wolfe wave be found?
The Wolfe Wave can be seen in the following:
—Uptrends in rising channels
—Downtrends in falling channels
—Consolidations in level or horizontal channels
Bullish Wolfe wave
The bullish pattern is seen in a descending channel forming 4 waves of the Wolfe pattern. Here, price will progressively make lower lows and lower highs that depict a downward trend. Following the channel breakout, the 5th wave will form.
Bearish Wolfe wave
The bearish Wolfe Wave pattern forms in a rising channel forming 4 waves of the pattern. Price progressively makes higher highs and higher lows that depict an uptrend. Following the breakout, the 5th wave will form starting a bearish trend.
Note: whenever the Wolfe Waves pattern is seen in a consolidating market, price can break out in either direction.
What does it tell a trader?
The Wolfe Wave pattern can make traders profitable by helping them identify when a trend reversal is about to happen after 3 attempts and a false breakout.
Measuring the take profit level of the Wolfe wave
To do this, connect the starting on wave 1 to the starting point of wave 4 and project this line until it meets with the price at a point (wave 6). This is applicable to both bullish and bearish patterns. It is vital to note that there is no precise point for exiting a trade in the Wolfe pattern.
Trading the Wolfe Wave pattern: strategy
Both Wolfe waves can be traded in the same way. Below is an example of a trading strategy using the Wolfe Wave setup:
- The first step to taking a trade using this pattern is to recognize the trend in a higher time frame of a trending market. This can be done by locating and marking out the higher highs and lower lows.
- Identify the Wolfe Wave pattern on the chart (Bullish or Bearish) by applying the rules stated above.
- When price breaks, patiently wait for the price to retrace and close within the channel (wave 5). Open a buy or sell trade when this happens.
- Measure the target level as stated above and place your buy or sell stops below or above the last low or high made by price respectively (that is, above or below wave 5)
If properly learned, it is a very easy to use strategy in trading a trending market.
The Wolfe Wave pattern is a strategy that is based on a false price breakout reversal signal that offers traders a high reward-to-risk ratio if price rightly moves in the opposite trend of the channel. The key to profitable use of the pattern relies on the strict observance of the symmetry of the waves and slope of the equidistant channel. Deep slopes allow for a greater chance of a complete reversal of the trend.