Channels provide a simple and reliable way for traders to define their entry and exit points within an equity. Although the basic channel-trading rules provide traders with a good idea of where the price is going within the channel, they leave little insight into where breakouts might occur. Identifying patterns known as Wolfe Waves and Gartleys, however, can help predict these breakouts in terms of both their timing and scope (their proportion to the established channel). This article will take an in-depth look at the channeling techniques centered on these patterns, and how they can be applied to help you profit.

Wolfe Waves
The Wolfe Wave is a natural pattern found in every market. Its basic shape shows a fight for balance, or equilibrium, between supply and demand. This naturally occurring pattern was not invented, but rather discovered as a means to predicting levels of supply and demand.

These patterns are very versatile in terms of time, but they are specific in terms of scope. For instance, Wolfe Waves occur in a wide range of time frames, over minutes or even as long as weeks or months, depending on the channel. On the other hand, the scope can be predicted with amazing accuracy. For this reason, when correctly exploited, Wolfe Waves can be extremely effective.

The overriding factor in identifying the Wolfe Wave pattern is symmetry. As shown below, the most accurate patterns exist where, between 1-3-5, there are equal timing intervals between wave cycles.

ATWChannels1.gifATWChannels2.gif
Figure 1: Bullish Wolfe Wave Pattern Figure 2: Bearish Wolfe Wave Pattern
Source: www.harmonictrader.com

Here are some key points to remember for identifying Wolfe Waves:

  • Waves 3-4 must stay within the channel created by waves 1-2.
  • Waves 1-2 equal waves 3-4 (showing symmetry).
  • Wave 4 revisits the channel of points established by waves 1-2.
  • There should be regular timing intervals between waves.
  • Waves 3 and 5 are usually 127% or 162% (Fibonacci) extensions of the previous channel point.

The pattern can be found in:

  • Rising channels in an uptrend.
  • Falling channels in a downtrend.
  • Level channels during consolidation periods.

Notice that the point at wave 5 shown on the diagrams above is a move slightly above or below the channel created by waves 1-2 and 3-4. This move is usually a false price breakout or channel breakdown, and is the best place to enter a stock long or short. The "false" action at wave 5 occurs most of the time in the pattern, but isn't an absolutely necessary criterion. The point at wave 6 is the target level following from point 5 and is the most profitable part of the Wolfe Wave channel pattern. The target price (point 6) is found by connecting points 1 and 4 (see the red lines in Figures 1 and 2).

Figure 3 is an example of the pattern at work. Remember, wave 5 is an opportunity to take action with a short or long position while the point at wave 6 is the target price.

ATWChannels3.gif
Figure 3: Chart provided by http://www.chart.nu

It is also important to note that Wolfe Waves, along with most pattern trading strategies, are highly subjective. (For further reading on this kind of subjectivity, see Launching Elliott Wave into the 20th Century.) The key to profiting is accurately identifying and exploiting these trends in real time, which can be more difficult than it sounds. As a result, it is wise to paper trade this technique - as it is any new technique you are learning - before going live. And, remember to use stop losses to limit your losses.

The Gartley
The Gartley trading pattern was created by H.M. Gartley, who first illustrated it in his book "Profits in the Stock Market" (1935). The setup consists of a single large impulse wave followed by two small pullback impulse waves. The diagrams below show examples of the ideal setup, both bullish and bearish. In the bullish example XA represents the first large impulse with a price reversal at A. In accordance with Fibonacci ratios, retracement AB should be 61.8% of the price segment A minus X. This percentage is shown by the segment XB.


ATWChannels4.gif
Figure 4: Bullish Pattern
ATWChannels5.gif
Figure 5: Bearish Pattern
Source: www.harmonictrader.com

At point B, the price again makes a smaller impulse opposite to that of A. Ideally, the retracement BC should be between 61.8% and 78.6% of the AB price range, regardless of the the length of the lines. This percentage is shown by segment AC. At C, the price again makes a reversal impulse opposite to that of B. In this pattern, again as stated by Fibonacci ratios, the retracement CD should be between 127% and 161.8% of the range BC, and this proportion is shown along the line BD.

Price D is the optimal point for buying or selling. At entry D the target retracement to a higher price is initially 61.8% of the range of segment CD. The movement from point D to its next point is extremely profitable. Moves from point D are very quick and powerful, and they follow this model accurately 60% or more of the time.

Here are the key points to remember for Gartleys:

  • Ideally, AB equals CD in time length.
  • Point D is a 62-72% pullback from XA.
  • XD should ideally be 78.6% of the segment range XA.
  • Ideally CD equals AB.
  • Take action at point D.

The condition in which these patterns can be found depends on whether they are bullish or bearish:

  • Bullish Gartleys occur in uptrends.
  • Bearish Gartleys occur in downtrends.

Figure 6 demonstrates the bullish Gartley at work. And Figure 7 shows the bearish Gartley:

ATWChannels6.gif
Figure 6: Chart provided by http://www.chart.nu
ATWChannels7.gif
Figure 7: Chart provided by http://www.chart.nu

Conclusion Both of these channeling techniques provide traders with a reliable way to locate breakout points and determine their scope. When using these patterns in conjunction with basic channeling rules, traders have access to a reliable and extremely versatile trading system to use in any market conditions.

Resources
Wolfe Wave (http://www.wolfewave.com) - The original discoverer of the Wolfe Wave channel pattern. Voodoo Trader (http://www.chart.nu) - Channels and chart signal identification for many stocks. ChartSetups LLC (http://www.chartsetups.com) - A stock signals provider utilizing advanced channeling patterns.

Related Articles
  1. Chart Advisor

    Big Double Top Patterns On the Verge of Breaking

    These stocks have created big double top chart patterns, and are on the verge of breaking the patterns to the downside--a bearish signal.
  2. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  3. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  4. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  5. Trading Strategies

    The Top Spread-Betting Strategies

    What are the most commonly followed spread-betting strategies (in countries where it's legal)?
  6. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  7. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  8. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  9. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  10. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
RELATED TERMS
  1. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  2. Indicator

    Indicators are statistics used to measure current conditions ...
  3. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  4. Forex Spread Betting

    A category of spread betting that involves taking a bet on the ...
  5. Mass Index

    A form of technical analysis that looks at the range between ...
  6. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
RELATED FAQS
  1. How are Wolfe Wave patterns interpreted by analysts and traders?

    An extension of Elliott wave theory, a Wolfe wave pattern is often interpreted to mean that a fight between supply power ... Read Full Answer >>
  2. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  3. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  4. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  5. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!