Wave theories are based on the idea of cyclic market development. The brightest representative of this direction is Elliott, who considers the wave price movement in the long term. His ideas are applied in fundamental analysis (4 stages of the market – growth, recession and extreme points), in technical analysis (8 types of waves in a rising and falling market). Wolfe Waves is another approach to identifying price waves that is confirmed by a pattern. Unlike Elliott waves, Wolfe waves are looked for on medium-term timeframes. These intervals are stable and at the same time there is a clear struggle between sellers and buyers.
Rules for the formation of Wolfe waves on the chart
The idea of Wolfe waves is that for every action there is a reaction. If there is a bullish move, then a bearish one will follow. The difference lies in the direction of the market and the strength of the trend. The essence of the tool is that the wave is formed from a series of segments, which ultimately create a diverging wedge or triangle. The deal is opened at the moment of the third touch of the extremum towards the opposite border. Or at the time of the breakdown of the triangle.
Example 1: Theoretical (wedge formation)
On an uptrend, tops are formed, at points 2 and 4 – corrections, often used in swing trading. But since the uptrend cannot grow forever, we wait for the third expansion and open a short position at the third top point (point 5).
Example 2. Practical (forming a triangle and a wedge)
Here you can see the formation of two patterns on a strong local movement in two directions. The numbers 1-5 indicate the tops of the figures, the red lines are the wave lines, the blue lines are the diverging wedge, the yellow lines are the converging triangle. A trade can be opened at point 5 at the moment of a rebound from the third lower extremum of the wedge. Or at point 6 – where the signal from the wedge is confirmed by the breakdown of the upper side of the triangle.
The rules for constructing Wolfe waves in accordance with the example above:
- 1 – the bottom of the wave, which becomes the basis for the entire figure.
- 2 is the first significant peak. Here on the chart, it is clearly visible, despite the flat section and the long downward shadow.
- 3 is the second low, which must be below point 1 to predict a bullish trend.
- 4 – the second maximum, which should be above point 1 (above the first minimum), but should be below point 2. This indicates a continuation of a strong downward movement.
- 5 is the third low below point 3.
- 6 – turn up.
Theoretically, a swing trader can catch each of these moves by reversing trades between highs and lows. This H4 interval allows you to earn on each wave. But until the formation of the figure is completed, it is impossible to accurately predict the depth of the correction and the direction of the trend. The formation of a 5-point formation and a clear reversal from the wedge to the inside of the figure with great confidence means a continuation of the upward movement.
An ideal pattern is formed relatively rarely, but its effectiveness is high. Less ideal patterns are the location of the bottom and subsequent lows for an uptrend at the same level. This will also indicate that sellers cannot push through a strong support level, the third bounce from which upwards is a signal to open a deal.
Conclusion. Wolfe Waves is a tool for H1-H4 timeframes that allows you to find areas of strong struggle between sellers and buyers and is based on the psychology of patterns. It can be used in combination with Elliott waves, which can be used to find global trend reversals. Simplify the search indicators ZigZag, WolfWave.