Source: MT4 GBP/JPY chart
Wolfe Waves are a naturally occurring trading pattern present in all financial markets. Originally discovered by an S&P500 trader named Bill Wolfe, Wolfe Waves work a bit like Elliot Waves, albeit there are some differences in charting techniques.
Patterns identified as Wolfe Waves are natural and reliable reversal patterns, present in all markets and timeframes. We already discussed Harmonic Patterns in currency markets and Wolfe's way of charting is indirectly connected to them. Wolfe Waves are used in breakout trading and things may get a little subjective when it comes down to their identification.
A Five Wave Pattern
As the name suggests, this pattern is composed of five waves showing supply and demand towards an equilibrium price. Wolfe Waves usually develop on all time frames and are used to predict where the price is heading to and when it will might get there.
If identified correctly, Wolfe Waves can be used to accurately predict the scope (equilibrium price) of the underlying security and to anticipate price reversals which are likely to cause big price movements.
The most important thing is to identify the prevailing trendline and ensuring that it has at least four touch points. The next thing is to see a clear break of this trendline. Remembering that reversals in the market only happen 20% of the time, the last high/low should be challenged.
The Wolfe Secret is to use this point for your trigger on the price pattern. The idea is that the prevailing trendline becomes a diagonal support/resistance line that you use to identify this entry point.
Identification of the Wolfe Wave
The Wolfe Wave consists of a 1-2-3-4-5 wave formation, with 2 and 4 being the retracement waves seen in the Wolfe Wave formation. Wolfe Wave traders distinguish two different types of Wolfe Waves—strict waves and modified waves.
Strict Wolfe Waves are charted by using these rules:
- waves 3-4 must stay within the channel created by 1-2
- wave 1-2 equals waves 3-4
- wave 4 is between waves 1 and 2
- there is regular time between all waves
- wave 5 exceeds the trendline created by waves 1 and 3.
Example: A strict Wolfe Wave MT4 GBP/JPY H1 chart
The main difference between strict and modified waves is that in a modified Wolfe Wave, point 4 is found within the channel created by waves 1-2.
Example: A modified bearish Wolfe Wave MT4 GBP/JPY H1 chart
Example: Modified bullish Wolfe Wave MT4 GBP/JPY H1 chart
Trigger: After the perceived Wolfe Wave pattern has been identified, place the limit order trigger entry near the diagonal line resistance area of the price pattern. Usually the trade is taken when when the price closes above the trendline created by waves 1 and 3.
Stop: The last high/low of the pattern.
Profit Target: Point 5 is the trade entry point, and is expected to hit the EPA (the take profit point) by meeting a line drawn from point 1 which also intersects point 4.
In the example below we can clearly see that the EPA (expected price at arrival) has been met and overshot.
Example: MT4 GBP/JPY H1 chart EPA line has been hit
Have Faith in Your Time Frame
Trading Wolfe Waves is a mental challenge just as much as it is a skill. It's very important that you keep things in a certain degree of perspective when you are in, or about to enter a trade. Wolfe waves appear in any available time frame, so it's important to stick to one time frame.
A sure fire way to make bad trading decisions is to change time frames in the middle of your trading. For example, you are watching a 15 minute chart and finally decide that now is the correct time to enter. Things go wrong, so you turn to a one minute chart, close your 15 min trade and open a new trade on one minute. It's like petting a small kitten that soon turns into a tiger.
Always respect your stop loss and your strategy. If you are afraid of volatility, you can't do anything beneficial to your trading by switching over to different time frames. My advice is to use the VPS tool in conjunction with MT4 Supreme Edition indicators, this combo should keep you calm minded when trading.
An Easier Way to Identify Wolfe Waves
There are some MT4 indicators that traders can use to spot Wolfe Waves. A free version of the Wolfe Wave MT4 Indicator is also available, but I advise you to always check the above mentioned rules and see if the indicator plots lines and waves as it should.
If you have any questions or comments, please don't hesitate to share them in the comments section below.
Cheers and safe trading,