How to Use the Wolfe Wave to Improve your Daily ROI

Posted by On April 01, 2019 0 Comment

Over the past 90 years, the S&P 500—one of the most popular indexes on Wall Street—yielded an average rate of return has hovered around 10%. Because this particular index represents one of the most common forms of “passive investing”, anyone who hopes to be an active investor should use this ROI as a target.

Active traders are individuals who, instead of simply trying to create a diverse portfolio, will try to identify assets (stocks, bonds, currencies, etc.) that are currently undervalued or overvalued. Naturally, anyone who hopes to do this will need to have a select set of metrics indicating which positions are most likely to be winners.

There are many different chart patterns which, according to the theories of Bill Wolfe, are naturally occurring. The Wolfe Wave is a specific chart pattern that is derived from five recent movements in an asset’s price. When select conditions are observed in the market, an asset will be believed to be have escaped its channel and be on the verge of a major price swing. Wolfe Wave traders will consequently open a corresponding position in response.

In this article we will discuss everything you need to know about Wolfe Wave trading strategies. Though it is just one of many chart patterns that can be used as a technical indicator, it has been proven to be among the most effective. By making an active effort to understand Wolfe Wave trading, you may be able to improve your active ROI.

What is the Wolfe Wave?

The term “Wolfe Wave” is used to describe a series of price patterns that can be found in every speculative market. The price movements of most assets can be contained within a specific channel. Eventually, prices may escape these channels, which is an event traders refer to as a breakout. The purpose of looking for Wolfe Wave patterns is to determine when sustained breakouts are most likely to occur.

Wolfe Wave patterns exist due to the fact that all speculative assets will move up and down in an ongoing battle for equilibrium. In other words, if an asset is “actually” worth $10, its price may fluctuate between $8 and $12 in a typical trading period. The $8- $12 range represents an established channel. In the event that the price escapes this channel—perhaps trading at $5 or $15—then traders will have a reason to believe that the “actual” value of the asset has fundamentally changed.

In order to determine if a sustained channel breakout is likely to occur, it will be necessary to look at the asset’s five most recent high points and low points. The relative relationship between these points will help traders predict where the price is most likely to move.

Wolfe Waves are characterized by either rising channels in a bullish market or falling channels in a bearish market. The pattern will have materialized if the fifth point is outside of the channel itself (meaning a breakout has occurred). Once the channel has been broken, prices will likely “overreact” and volatility will increase. In the hypothetical channel mentioned above, a price breakout at $14 may lead investors to believe that the price might reverse and swing down to $5. Understanding Fibonacci trading patterns will make Wolfe Wave trading significantly easier.

What conditions are necessary for a Wolfe Wave to exist?

While Wolfe Wave patterns are naturally occurring, their existence cannot be “forced” by any individual trader. Instead, all traders will need to be patient and wait until a specific set of conditions have actually occurred.

  • The 3rd and 4th “waves” must exist within the specific channel created by waves 1 and 2
  • The waves themselves must be symmetrical—this means that the 1st and 2nd waves must equal the 3rd and 4th waves
  • The timing between the waves must remain consistent
  • The target price (occurring at a hypothetical 6th point) is created by connecting the 1st and 4th points

With most instances of Wolfe Waves, the 3rd and 5th points will have a geometric relationship indicative of Fibonacci trading patterns. Both 127% and 162% are Fibonacci numbers that are frequently observed by Wolfe Wave traders. If there is a significant amount of asymmetry or inconsistency between the waves, then traders will need to wait until the price movements have stabilized.

 

What are the pros and cons of using Wolfe Wave trading strategies?

As is the case with all trading patterns, Wolfe Waves have both pros and cons associated with them. Being aware of these pros and cons can help you trade with a greater sense of precision.

The pros of using Wolfe Wave trading strategies include:

  • Reliability: Wolfe Wave patterns are among the most reliable forms of channel trading. When the conditions are right, future price movements can be easily predicted.
  • Quick Analysis: Wolfe Waves do not require hours of analysis. Traders can quickly look at a price chart and determine if a breakout is likely to occur. They may also use advanced trading software to make the analysis even easier.
  • Dynamic: these patterns are naturally occurring and can be identified in almost any market. Both bullish and bearish markets can yield profitable positions. Additionally, Wolfe Wave trading strategies can be used by both short-term and long-term traders (though they are most commonly used by day traders).

The cons of using Wolfe Wave trading strategies include:

  • Occasionally Misleading: depending on the underlying cause of a breakout, these patterns may lead traders to assume the wrong position.
  • Need for patience: Wolfe Wave patterns only sometimes exist, meaning that there will not always be an opportunity for these strategies to be applied.

Overall, these trading strategies carry some degree of risk, but this risk is usually offset by a high daily ROI. If you hope to become a Wolfe Wave trader, it will be a good idea to have some practice. “Paper trading” will make it possible for you to gain the experience you need without needing to risk any actual capital.

You can also improve your trading strategy by issuing stop losses and pairing Wolfe Waves with additional technical indicators. For example, “The Gartley”—a trading pattern first described by H.M. Gartley in 1935—has been recognized to pair quite well with Wolfe Waves.

 

Conclusion

Though the values of all tradeable assets are largely shaped by (irrational) human forces, there are still many naturally occurring patterns that help make markets more predictable. One of these patterns is the Wolfe Wave, which can be recognized by looking at the five most recent reversal points on an ordinary price chart. With practice, patience, and careful application, looking for Wolfe Waves can help you effectively determine whether an asset is underpriced or overpriced in the status quo. As a result, your ROI may significantly improve.