There are many different ways technical traders grow their investments. They spend their time looking at market data and charts, trying to tease out patterns, like the Wolfe wave. By doing so, technical traders hope to predict rises and falls in the equity markets that interest them.
What is a Wolfe wave?
The Wolfe wave is a technical chart pattern first identified by Bill and Brian Wolfe. According to the pair, these patterns naturally occur in all markets but are not always easy to identify. In a Wolfe wave, you have five total symmetric and consistent "waves" that indicate rises and falls in prices. According to the theory behind the Wolfe wave:
- A line drawn between the points of the first and third waves will predict one set of bounds for the channel.
- A line drawn between the points of the second and fourth waves indicates the second set of bounds for the channel.
- Where a line drawn through points 1 and 4 in the Wolfe wave intersects a theoretical sixth point is the target price for the end of the fifth wave.
- The fifth wave is the end of the Wolfe wave and the point where a trader takes their profit.
Identifying a Wolfe wave
Wolfe waves can be difficult to identify in real life because they rarely go as smoothly as they do in models. But there are several things to look for in a Wolfe wave.
- Waves 1 and 2 establish the boundaries of the pricing channel, within which waves 3 and 4 must fall.
- The interval from wave 1 to wave 2 should be roughly equal to the interval between waves 3 and 4. Consistency and symmetry are key here.
- Wave 5 should break out of the channel.
- A line drawn from wave 1 to wave 4 should intersect wave 5 (this is crucial for determining the target price point).
Keep in mind that Wolfe waves can be bearish or bullish. So, the first wave may be above or below the fifth, depending on the pattern.
Wolfe waves versus Gartley patterns
Although Gartleys look similar to Wolfe waves, they operate on a very different set of principles. Instead of seeking symmetry in all things, Gartley patterns are based on the idea that Fibonacci sequences and ratios can be used to predict future stock prices.
Generally speaking, Gartley patterns are used to get a bigger-picture idea of long-term stock trends from a technical perspective. They can be used in conjunction with other charts and indicators to help establish shorter-term patterns, though.
How to use a Wolfe wave
When using a Wolfe wave, you're really looking for pricing to move outside of the channel established by your model. These breakouts are where the profit lies, both for bulls and bears. What you're looking for depends on whether it's a bullish or bearish pattern and whether you're long or short on the position.
But, in general, the goal is for the line running from wave 1 to wave 4 to set your breakout point, the point at which you make your move. The Wolfe wave tells you that a reversal is about to occur (following five waves that terminate in the breakout), so you should take your position at the beginning of the fifth wave and take your profit at the breakout point.
Related investing topics
Let's say you're long ABC, Inc., and detect a Wolfe wave. The breakout point is at $34, but you've just left wave 4 and are headed toward wave 5. Once you reach wave 5, you will need to make your first move, which should be to buy more ABC, Inc., at a theoretical price representing the bottom of wave 5 of $25.
Hold until your breakout point of $34 is reached, and then sell your $25 shares. That's all there is to it -- the hardest part is detecting the wave in the first place.
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