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 and Gartleys are among many chart patterns that can help guide profitable trading decisions. To learn more about recognizing chart patterns, check out the Technical Analysis course on the Investopedia Academy, which includes videos and interactive content to help you boost your trading skills.]
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.
Figure 1: Bullish Wolfe Wave Pattern; Figure 2: Bearish Wolfe Wave Pattern
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:
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 it 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). (For more, see: Trading Failed Breaks.)
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.
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. 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. (See also: Launching Elliott Wave Into the 20th Century.)
The Gartley trading pattern was created by H. M. Gartley, who first illustrated it in his 1935 book "Profits in the Stock Market." 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. Following Fibonacci ratios, retracement AB should be 61.8% of the price segment A minus X. This percentage is shown by the segment XB.
Figure 4: Bullish Pattern
Figure 5: Bearish Pattern
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:
Figure 6: Chart provided by http://www.chart.nu
Figure 7: Chart provided by http://www.chart.nu
The Bottom Line
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. (For additional reading, check out: Channeling: Charting a Path to Success.)