Trading models based on channels: Wolfe Waves

Price channels are a clear example of resources that can be used to define both entry points and exit points. In addition they allow to analyze the current situation in the market in such a way that they allow the trader to make better decisions. Once the channel is formed, we can obtain a lot of information related to the price movement inside the same channel, however the problem occurs when the market does not move in a defined channel, a situation in which it can be difficult to detect breakout points and therefore the reaction of the market can take us by surprise.

For these cases the investor can use the so-called “advanced channel models“, among which we can highlight the Wolfe Waves, which can help us to identify potential entry and exit points of the market based on channels, even when in appearance there is no clearly defined channel.

Identification of Wolfe Waves

The Wolfe wave analysis, as well as any other pattern analysis is based on the axiom “history repeats itself.” Specifically, the Wolfe wave model seeks to identify the future breakpoint in channels so that the trader can enter the market in advance and determine a specific profit target. The channel models of Wolfe waves belong to the reversal patterns type and their objective is to predict the upward breakout of a bearish channel or the downward breakout of a bullish channel.

According to the author of this trading technique, the Wolfe wave is produced by natural market need to find a balance between supply and demand. As a model of natural rhythm, Wolfe waves can be applied to any market, not just Forex. The author’s research of this model allow to analyze the Elliott Waves from another perspective and even have a better understanding of this tool. For example, Wolfe waves in a bearish channel could be identified with the 1-2-3-4-5  structure of the correction wave 2 of  Elliott Waves. Combining both theories, Wolfe wave formations of an amazing accuracy could be found inside correction Elliott waves. The following image shows two examples of Wolfe Waves:

Bullish and bearish Wolfe Waves
Bullish and Bearish Wolfe Waves

In the picture above we have two situations in which we find Wolfe waves represented in its ideal form. In the same image you can see the main characteristics to identify a Wolf wave pattern:

  • Waves 3-4 remains inside the channel formed by waves 1-2.
  • Waves 1-2 are the same and show symmetry with waves 3-4.
  • Wave 5 exceeds the line formed by the union of points 1 and 3.
  • Point 5 corresponds to the best entry point and the estimated target profit corresponds to the point where the price intersects the extended line formed by points 1 and 4 (the blue line).
  • A trick that can be useful i to draw Fibonacci retracements in the movement between points 2 and 3 as shown in the image below.

In the next picture we can see an example of Wolfe waves in a EUR/USD chart of 1 hour for August 2008. Notice that the conditions described above are met almost perfectly:

Example of Wolfe Waves
Real example of waves in a H1 price chart of EUR/USD

Metatrader 4 does not have Wolfe waves among its built-in technical indicators. You can download a modified indicator for MT4 that shows Wolfe waves in any time frame using the following article:

-Wolfe waves indicator for Metatrader 4


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