Wolfe Wave - look for them

A while back I received an email from a reader (Michael) who stated that he uses wolf waves as one of his tools, and with some success. I have done some reading on wolfe waves and understand them to some extent, and I've even noticed the pattern a few times while trading. They are, like most patterns, obvious after the fact to the extent that you know if they were profitable or not.

The way I interpret the pattern is that it is a counter reaction to an over reaction. In other words, when price moves to fast in one direction, it often moves back quickly in the opposite direction. The catch is the entry in the wolfe wave. It gives you a relatively low risk entry to reward ratio. I see the pattern quick often in the volatile forex market. Take a look back on your charts and see if you can spot some of these. Better yet, slowly scroll forward and draw the lines as the pattern emerges, see if you get faked out or if you profit. And the same goes for any pattern, understand why it works and what the emotions are that are behind it and you will see it better.

I asked the reader if he would like to have a post here on wolf waves so we could better understand the pattern. Michael recommends a book called "Streetsmart" as it explains the pattern very well.

Here is Michael email (edited slightly):

There are two types of wolfe: one for going up, one for going down. so long and short. The key of the analysis is to discover 5 points and the last point 6th is the target

For Long:

Point 1 and 3 are the downside points, the 3rd must be lower tha 1st

Point 2 and 4 are the upperside points, the 4th must be lower than 2nd and higher than 1st.

When the trend goes to form the 5th point, which is lower the all the previous 4 points, and then begins to move up, you trace a line from 1st to 4th point, which gives you a projection to another point, the 6th point, which is the target.

So if the movement is right, price should go up and you make a huge gain. The stop can be placed below the lowest low, and now you can see the profit potential.

For Short, it is just contrary of this. I have enclose several pictures so you can see what I mean, one picture is worth a thousand words.