Introduction to Wolfe Waves
Discovered by Bill Wolfe and made popular by Linda Rashke, Wolfe Wave is nothing but a natural rhythm in the markets. We know that price moves due to supply and demand which form an equilibrium. Surely a trading technique as powerful as this, yet so simple must have a catch right?
Well, there is. The key to riding the wave comes by accurately identifying the 5 waves that make up the Wolfe Wave. Finding this pattern in the right time frame is also equally important.
However, as Bill Wolfe puts it… trading with Wolfe Waves is similar to riding the surf. You need to practice practice and practice before you can identify the perfect wave to surf/ride.
At the heart of the Wolfe Wave trading system lies the fact of natural physics. Newton’s 3rd law which states that every action has an equal and opposite reaction.
So, what is the Wolfe Wave all about?
By identifying the key five waves, you will be able to predict a future price point as well as the time when it is likely to reach that price point. One of the unique aspects of Wolfe Waves is that they can predict not just price but also time.
Figure 1: Example of Wolfe wave patterns
This is of great importance because while there are some indicators that can predict future price movements, having to predict that price movement at a future time is something which sounds too good to be true.
Indicators that come close to predicting such turning points are the Fibonacci time cycle indicators, but there is still a great amount of complexity and objectivity that comes with it.
How to plot the wolfe waves?
Below are two examples of a Bullish and Bearish Wolfe Wave, which is something you might have come across if you were trying to learn more about Wolfe Waves.
Wolfe Wave Patterns
There are basically two Wolfe wave patterns, the Bullish and Bearish Wolfe Wave patterns.
As you can see by the above illustration, by plotting the right Wolfe waves, you will be able to predict the estimated price and the estimated time. Sounds too simple to be true? If you closely observe, you will find that the wolfe wave patterns somewhat represents a triangle pattern with the exception of the 5th wave.
Obvious from the above patterns, it is easy to realize how critical it is to plotting the right pivots (1, 2, 3, 4, 5).
Here are the rules stated by Bill Wolfe when plotting the waves.
Rules for Wolfe Wave Structure
- Always start from Point 2. In a bullish wave, Point 2 will be a top, while in a bearish wave, Point 2 forms a bottom
- The previous bottom (in case of a bullish wave) or the previous top (in case of a bearish wave) forms Point 1
- Point 3 forms the top, above Point 2 in a bearish wave, or forms the bottom, below Point 2 in a bullish wave
- Point 4 is the bottom of the decline from Point 3 in a bearish wave, or it can be the top of the rally from Point 3 in a bullish wave
- Point 5 will be the top from Point 4 in a bearish wave or Point 5 forms the bottom from Point 4 in a bullish wave.
While it might seem a bit confusing to read, those who have some basic experience in waves should be able to identify the 5 points. Wolfe further went on to set out some rules to ensure that the correct Wolfe Wave is formed. They are as follows:
In a Bearish Wave:
- Point 3 and 5 must make higher highs than Point 1
- Point 4 must form a higher lows than Point 2
In Figure 2, you can see how the bearish wolve wave pattern is drawn. We first identify a period of consolidation. Following this, a reference point 2 is taken. From here on, look for subsequent lower high which forms point 3 and the next higher low which forms point 4.
Once the triangle looking pattern is formed, extend the lines until they converge to a point. Near this convergence point, plot a horizontal line. Now using a trend line, connect points 1 and 4. This forms the EPA line.
On the break out from the Wolfe wave, you can set your trade to target the EPA line. Alternately, you can also extend the lines 1 and 3 and 2 and 4 and from the point of convergence of these two lines, you can then set the horizontal line and a vertical line to identify the potential price and time.
In a Bullish Wave:
- Point 3 and 5 must make lower lows than Point 1
- Point 4 must make lower lows than Point 2
Trading the Wolfe Wave pattern
Once you plot the above 5 points, the next step is to draw a trend line. There are 3 trend lines that will guide us. Irrespective of whether it is a bullish or a bearish wave, the following three trend lines will make price action more clearer to us.
- Trend line #1 must connect pivots 1, 3, 5
- Trend line #2 must connect pivots 2 and 4
- Trend line #3 must connect pivots 1 and 4
The convergence of Trend line #1 and Trend line #2 forms the estimated time of arrival (ETA)
Trend line #3 is projected into the future and shows us the estimated price at arrival (EPA)
When you have completed drawing the trend lines, you can then either go short or long from wave 5 and according to the Wolfe Wave theory, price should reach the projected EPA at the specified convergence of Trend lines 1 and 2, which form the ETA.
There basically two ways to trade with the wolfe wave pattern.
The first is to trade the break out and target the EPA line based on the price and time convergence. However, this is not the most efficient way to trade as such trades are rare to come by.
A second and more efficient way to trade is to look at the breakout from the wolfe wave pattern. Following, this you can then target the EPA line as price is most likely to test this level.
The stops can be placed a few pips above the swing high or low prior to the breakout level. Traders can also look at individual candlestick patterns that form near the breakout level to ascertain whether price action will move in the direction of the breakout.
Common misconceptions of Wolfe Waves
- Wolfe Waves work differently to that of Elliot Waves and are in fact plotted differently
- Using the ZigZag indicator doesn’t yield accurate readings
- There are perfect and imperfect Wolfe waves, therefore not all Wolfe Waves will reach the projected price
- Wolfe Waves works perfectly on both shorter time frames as well as longer time frames
In the next section, we take a look at the wolfe wave pattern and the guidelines that traders should bear in mind.
You can alternately simply download the wolfe wave indicator and let the indicator automatically plot the wolfe waves for you.
The wolfe wave indicator is very simple and does not have too many configuration patterns.
Figure 4: Wolfe wave pattern indicator
Figure 4 shows the wolfe wave indicator’s settings. As you can see the configurations are very simple. The length setting basically determines the minimum number of bars to look into for forming the wolfe wave pattern.
You can adjust this setting to your preference. However, if you use larger values, you will get very few wolfe wave patterns. At the same time, using smaller values can lead to many and confusing wolfe wave patterns.
Guidelines for drawing the Wolfe Waves
Although the wolfe wave indicator can be used, it is also beneficial that readers should understand the guidelines for plotting wolfe waves. This will help you to automatically eliminate any fake wolfe wave patterns that might fail.
There are some simple rules you can follow to ascertain if you have plotted the Wolfe Waves correctly.
Rule #1: Relation between Pivot 3 and 1
The trend line connecting pivot 3 and 1 (and subsequently, pivot 5) should be an almost straight line. In fact, Bill Wolfe goes on to say that in order to find the pivot 1, look to the left of the chart and plot a horizontal line from Pivot 3. The first pivot that satisfies this criterion should be seen as pivot 1.
Rule #2: Convergence of trend lines
Trend lines drawn from Pivot 1 to 3 and Pivot 2 to 4 must converge. If the trend lines do not converge or are wide apart, then you need to re-draw the Wolfe Wave.
Rule #3: Pivot 5
Pivot 5 can either be in-line with the trend line connecting Pivots 1 and 3 or it can also exceed the trend line.
Rule #4: Creating the sweet zone
The sweet zone is created in order to identify the strength of the wave from Pivot 5. To do this, Wolfe simply draws a parallel line from the trend line connecting Pivots 2 and 4 from Pivot 1 (or 3, it doesn’t matter)
Wolfe states that pivot 5 should not exceed the sweet zone drawn by this parallel line. If this trend line doesn’t support price, then you should switch to a different time frame.
Rule #5: Formation of a contrary wave
This is an important element to check if you have drawn the right Wolfe wave. Bill Wolfe states that in order for a Wave to be perfect, there should be a contrary wave coming up within the bigger wave. Below is a screen shot of the same price chart as above, but with contrary waves plotted.
You can however skip this step if you want to simply trade based off the bounce to the EPA line.
Volumes are an important aspect of Wolfe Waves because we basically trading on reversals. Reversals are often associated with an increased volume followed by decline.
Bill Wolfe states that Pivot 5 would usually see high volume followed by a decline. This is important because the volume determines the strength of the ride from Pivot 5.
The trading concepts of Wolfe Wave trading is a closely guarded secret. Bill Wolfe teaches his method for $3000 which includes a 35 page manual (which he claims wasn’t updated in 15 years) and 10 fax sheets sent via email to help you perfect the Wolfe Wave trading concept.
Bill Wolfe also requires his students to sign an NDA. If you consider just the cost, its easy to see why anyone who takes the course (irrespective of whether they respect the NDA or not) would be philanthropic enough to share their knowledge.
Another point that I should mention is that Bill Wolfe states that half the articles on the Internet about Wolfe Waves is in fact crap and that a lot has changed since he first discovered Wolfe Waves.
While this might seem disappointing, I think it is a great opportunity for traders to learn about Wolfe waves by practicing along and manually plotting the pivots.
Conclusion – When to plot Wolfe Waves
Bill Wolfe states that the best time to plot Wolfe Waves is when markets are closed. While this seems plausible for the equity markets, it is quite difficult in the forex markets, unless you are awake during the one hour time frame when markets are closed.
The ideal time is to plot Wolfe Waves over the weekend. While this might limit your number of trades, if you get the Wolfe waves right on at least 5 – 10 forex pairs per week the rewards should be quite substantial. Wolfe Wave also teaches traders the concept of discipline and keeps you away from over trading.
The wolfe wave patterns can be plotted on any security and works in any time frame of your choice.