Learning

Key Concepts of Wolfe Waves

Finally yielding to huge public demand I share my notes on #WolfeWave:

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The Perfect Wave.

There was a movie several years ago about a group of surf bums that traveled the globe looking for the perfect surfing wave. I sort of do that with my computer. Not as exciting I’m sure. In the realm of their experience, they had their criteria for what made up the perfect wave as do I. Anyway, the point here is that even on a perfect Wave, you must exit at the 1 to 4 line. You will have a euphoric feeling at this point and think that the trade will continue forever. Train yourself. Shoreline and 1 to 4 line rhyme and both mean the end to a perfect Wave.

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Waves are canceled by contrary Waves.

Example: If I were long on a 15 min. chart and the price had not yet reached the 1 to 4 line but a contrary bearish Wave developed on a 5 min. chart, I would get out. If the Bearish Wave were to develop on a 1 min. chart, I would be less concerned. Judge the consequences of ignoring the contrary Wave. Is the 1 to 4 line very steep? Do I want to give back any of my profit?

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How to anticipate contrary Waves.

Ideally speaking, you would like to see the move from point 4, to point 5, as clean (uninterrupted) as possible. In some cases it may even have a parabolic curve to it. The reason for wanting to see this is that every “bump” along the way creates another “bump” for the next move, which would be the move to the 1 to 4 line. These “bumps” create support/resistance or potential contrary Waves. For example. If you had a completed Wave with a 1 to 4 target line indicating a big move, and the previous move from 4 to 5 was “clean”, it would have a better chance of success than if the move from 4 to 5 had a lot of “bumps”.

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How to approximate Wave 4.

It is very important that you train yourself to see from one Wave to the next. Sometimes it is  difficult because news events cause many ripples on the chart. However, with practice you will begin to see likely areas for waves to end. Once we know points 1, 2 and 3, of a new Wave, point 4 should not be too difficult to find. First we draw a line from point 1 to 3. Then we parallel it to point 2. We now know that Wave 4 must terminate within that space or else it would be impossible for it to be a Wave as the lines 1 to 3 and 2 to 4 could not converge. Next we look at the move from point 2 to 3 and look for a “hole” (gap) or the fewest amount of vertical lines that we can find. We then draw a line from point 1 through the gap or the fewest lines that we can find. This is the approximate balance line of supply/demand. When the price hits this line, it will likely stop and form a smaller contrary Wave and then move to point 5.  With experience, you will be able to eyeball this without drawing lines. It is a very satisfying feeling.

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How to approximate Wave 5, the “Sweet Zone.”

Finding what I call the “sweet spot” is probably the most rewarding part of Wave analysis. The sweet spot, or zone, is the area of entry on Wave 5. It is safe to say that once you pass (or equal) point 3 you have a completed Wave and you can expect a move to the target line of 1 to 4. However, the throw over can be quite substantial on some Waves and quite expensive, particularly if you are trading longer period charts. What I do is draw parallel lines between points 2 and 4 to point 3 or in some cases from point 1 . Often you will notice that the parallel line coincides with other support/resistance areas on the chart. The area from the price of point 3, to the parallel of points 2 and 4, to point 3, is the sweet zone. Heavy volume is another sign that price is stopping. Be very careful not to wait too long. Price can reverse as soon as it touches the price of point 3.  Generally speaking, if you enter at any price in the “sweet zone” you will have a very good position.

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Signs that a Wave will make it to the 1 to 4 target line.

The most important thing is the structure of the Wave itself. A well formed Wave with few
“bumps” that will eventually cause interruptions in the next Wave has the best chance of
success. Next, you want to pay very close attention to the tic volume. Ideally, you would like to see very heavy stopping volume at the 5 point. Then, as the price reverses it should do so on declining volume. As the price approaches the 1 to 4 line, the volume should increase again and finally stop the price. It should have a saucer like pattern on the chart.

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Signs that a Wave will not make it to the 1 to 4 target line.

A poorly formed Wave has less of a chance than a well formed Wave. If volume is not relatively heavy at the 5 point, you should be suspicious. As the price reverses, the volume should decrease. If it does not, move to a shorter time frame and be on the look out for a contrary Wave forming. Get out at the first sign of trouble and wait for the next Wave to form. If you entered in the “sweet zone” you probably have a profit anyway.

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Identifying Spikes and tips for trading them.

Spikes are isolated vertical bars that stick out of Waves 1 and 3. When drawing your trend line from 1 to 3 they will sometimes cause it to be too high or low as the case may be and consequently Wave 5 will not get to the price of Wave 3 before reversing. A way to deal with this would be to enter prematurely at Wave 5. I do not recommend jumping the gun for beginners and most definitely do not do it if the trend line is at a steep angle. Spikes are usually associated with openings or round numbers or other areas where stops may have been triggered. When the stops are satisfied, the price quickly returns to the norm for that area.

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Profiting from gaps.

When the market gaps open,  and appears to be forming a Wave but a suitable 1 point can’t be found, use an imaginary 1 point just below 2 and level with 3. I do not recommend this for beginners. Trading somewhat ambiguous Waves should be practiced by advanced students only.

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The Dominant Wave.

Often I will refer to the dominant wave and I am quickly asked how I determine which Wave is dominant. The dominant Wave is relative. If I were trading off a daily chart, I would look to a weekly chart to see if there were any Waves that might influence the daily. If I were trading a 5 min. chart I would look to a 15 min. chart. Generally speaking, if the Waves that you are trading are not making it to the 1 to 4 line, you are not in the correct time frame.

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Further Points.

For ambush traders who are essentially playing 5 min charts, it is advisable to shift to 1 min chart periodically to check on formation of Wolfe Waves.  As the trade is fast paced, go with the eye estimate and do not be obsessed about the symmetry.

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Wolfe Wave on smaller time frame work even with 60:40 ratio of bars (either way) between 1-3 and 3-5 (Ideally the number of bars between 1-3 and 3-5 should be equal, which also means equal time). As with any pattern, Wolfe Wave fail occasionally – but very rarely. On smaller time frame, I have observed failure occurring on very sharp trending days when prices just blast through everything, Wolfe Wave included.

Symmetry and ratios have to be checked carefully when studying Wolfe Wave on larger time frame like the hourly or the daily chart. There we have time to analyze in detail the formation of Wolfe Waves as per textbook rules. But that is something which I leave for the individuals to study and pursue themselves – here we will only concentrate on smaller time frame Wolfe Waves. Please note that for day traders — on 5 min charts – keep 5-day chart always open. Sometimes Wolfe Wave form on higher time frame like 10, 15, 30 and 60 min time frame. Generally due to the nature of Wolfe Wave, such Waves will span over more than a day. So it is advisable to check on the formation of Wolfe Waves on higher time frames at EOD, Weekly also.

Now we have to encapsulate the Wolfe Waves in cast iron rules for higher time frames especially 15 min and above. These Wolfe Waves will span more than a day of trade, so we will have enough time to really examine and fit in the ratios and satisfy ourselves in all aspects before selling our house and betting on a Wolfe Wave which is perfect.

The rules are as below. These will become more and more inflexible in nature on higher time frames and especially if playing the daily then please follow these rules and check the ratios and no compromise on the same.

The rules are for a bullish Wolfe Waves and I am not drawing a diagram and hope by now all 5 points – 1,2,3,4 and 5 are in your mind and you can visualize the rules below. If not, then have a pencil and paper ready and draw the points and ratios as you read along:

→ 2 should be the highest point in this Wolfe Wave;
→ 3 should be lower than 1 and it should be between 1.27 to 1.618 of 1-2;
→ 4 should be lower than 2 and it should be between 0.618 to 0.886 of 2-3;
→ 5 should be lower than 3 and it should be between 1.27 to 1.886 of 3-4;
→ Time gap between 1-3 and 3-5 should be equal or nearly equal.
(the above figures are Fibonacci ratios and in actual practice they can be rounded off to 0.6, 0.9,1.2, 1.65 and 1.9 – please note the rounding off has been done to accommodate wider range)

The above ratios and positions of the points have to be strictly followed for all time frames above 15 min.

For ambush players who are playing 5 min time frames – checking Wolfe Waves on 1, 2, 3, and 5 min time frame is essential and here go with the eye estimate, as the trade is fast paced. Wolfe Wave can take lot of flexibility in these time frames upto 60:40 either way on time gaps. But position of points as explained above has to be adhered to. Wolfe Waves can be used as profit taking and exit strategy at 1-3-5 line and also for taking new position to ride it to hit the target.

But on higher time frames it is advisable to adhere to the above ratios strictly.

The above ratios are basically Fibonacci ratios as all price movements (waves) occur at Fibonacci levels. Wolfe Waves are naturally occurring waves.

One way to track and focus Wolfe Wave is to monitor every 1.27 Fibonacci level, most Wolfe Wave starts with a 1.27 Fibonacci level. A wolf wave is supposed to be formed when point 4 stops before reaching point 2 and then reversing to make a new 1.27 Fibonacci level in the other direction, if you reach this point with all the right calculations then you have a wolf wave. All you have to do at that point is to draw a line from point 1 to point 4 to draw the target line. Also line 1-3 can be drawn and extended and wait for the potential point 5 to form. One of the classic ways to track Wolfe Wave. Most of the time the height of the 1 – 4 line at point 5 determines, the most likely target of the pattern, and hence one should take partial profits when that happens

Lame Wolf:  it may make what I call a lame wolf where pt 5 is not hit on the 1-3-5 line but it still works fine.

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I would produce the examples as we move forward. Thank you.