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Why Do Patterns Form?
The primary theory behind Harmonic patterns is price/time movements which adhere to Fibonacci ratio relationships and its symmetry in markets. Fibonacci ratio analysis works well with any markets and on any timeframe charts. The basic idea of using these ratios is to identify key turning points, retracements, and extensions along with a series of the swing high and the swing low points. The derived projections and retracements using these swing points (Highs and Lows) will give key price levels for Targets or Stops.
Harmonic patterns construct geometric pattern structures (retracement and projection swings/legs) using Fibonacci sequences. These harmonic structures identified as specified (Harmonic) patterns provide unique opportunities for traders with potential price movements and key turning or trend reversal points. This factor adds an edge for traders as Harmonic patterns attempt to provide highly trustful price entries, stops and targets information. This may be a key differentiation with other indicators/oscillators and how they work.
Examples of Harmonic Patterns
The following chart shows another 5-point Harmonic pattern (Butterfly Bearish). This pattern is similar to the above 5-point Gartley pattern, but in reverse. Here the pattern is “W” shaped with “B” being the center (eye) of the pattern. It shows trade entry, stop and target levels from “D” levels using “XA” leg.
List of Harmonic Patterns
- ABC Bullish/Bearish
- AB=CD Bullish/Bearish
- 3-Drives Bullish/Bearish
- Gartley Bullish/Bearish
- Butterfly Bullish/Bearish
- Bat Bullish/Bearish
- Crab Bullish/Bearish
- Shark Bullish/Bearish
- Cypher Bullish/Bearish
The series of Fib Numbers begin as follows: 1,1,2,3,5,8,13,21,34,55,89,144,233,317,610….
There are plenty of materials and books about the theory of how these numbers exist in nature and in the financial world. A list of the most important Fib ratios in the financial world which are derived by squaring, square-roots and reciprocating the actual Fibonacci Numbers are depicted below:
Key Set of Fibonacci Derived Ratios in Trading are: 0.382, 0, .618, 0.786, 1.0, 1, 1, 2.0, 2.62, 3.62, 4.62
Secondary Set of Fibonacci Derived Ratios in Trading are: 0.236, 0, 0886, 1.13, 2.236, 3.14, 4.236
There are many applications of Fibonacci in Technical Analysis. Some of the applications include Fibonacci retracements, Fibonacci projections, Fibonacci Fans, Fibonacci Arcs, Fibonacci Time Zones, Fibonacci Price and Time Clusters etc.
Most trading software packages have Fibonacci drawing tools which can show Fib retracements, Fib Extensions, and Fib Projections. In addition. Fib Numbers are also applied to “time” and to “price” in trading.
In the following graphic, Types of Fibonacci are shown to depict how retracement, extension, projection and expansion swings are applied using Fibonacci ratios.
Advantages & Disadvantages of Harmonic Patterns
- Harmonic Patterns provide future price projections, stops in advance. This makes them leading indicators.
- Harmonic Patterns are frequent, repeatable, reliable and do produce high probable setups.
- The trading rules are relatively standardized (Credit: Scott Carney and Larry Pesavento) using Fibonacci ratios.
- Works well with defined Market Context, Symmetry, Measured Moves rules.
- Work in all timeframes and in all market instruments.
- Other indicator theories (CCI, RSI, MACD, DeMark…) can be used along with them.
- Harmonic patterns are complex and highly technical to understand and master them.
- Correct identification and automation (coding) of harmonic patterns is difficult.
- Conflicting Fibonacci retracements/projections make them difficult to identify reversal or projection zones.
- Complexity arises when opposing patterns form either from same swings or other swings/timeframes.
- The risk/reward factors from un-symmetric and low-ranked patterns are pretty low.
How to Trade Harmonic Patterns
All 5-point Harmonic patterns (Gartley, Butterfly, Crab, Bat, Shark, Cypher) have similar principles and structures, and they differ by their ratios to identify them and locations of key nodes (X, A, B, C, D) but once one of the patterns is understood it may be relatively easy to grasp knowledge of others. It may help for traders to use an automated pattern recognition software to identify these patterns than using naked eye to find or force these pattern identification.
Example: The following chart shows an example of Bullish Bat pattern with embedded ABC Bearish pattern. The identification pivots and ratios are marked on the pattern. The pattern also shows the Entry, Stop and Target levels.
Pattern Completion Zone (PCZ)
As an example, Pattern Completion Zone (PCZ) for Bullish Gartley pattern is constructed using following Fibonacci extensions and projections:
AB = CD
Here is an example of Potential Completion Zone (PCZ) formation:
Here is an example of Potential Completion Zone (PCZ) formation:
Market Context Conditions
The Confluence of these levels in the Fib. Grid structure along with emerging pattern structure (and pattern target/stop levels) helps a trader make a clear trade decision. Pattern trading is very precise as each pattern has specific rules to entry/stop and targets. When combined Harmonic Pattern analysis with market context gives a great edge to trade. Harmonic Patterns also fail but their failure levels are well defined and that information is clearly known prior to the trade. Hence, Harmonic pattern trading has much more advantage than trading other trading methods.
Other Market Context/confirmation conditions and indicators: Divergence, Multiple Timeframes, Fib. Bands, Andrew's Pitchfork Analysis, Moving Averages, Pivots, Channels, Trendlines, Volume, Volatility etc.
Example: The following example shows how Market Context is used with pattern analysis. This example shows AAPL (date: Feb. 07, 2014) formed a Bullish Crab pattern above 200-SMA and outside the Fib. Bands (A, C points) and D point is formed near lower Fib. Bands with Crab pattern. Also, notice the pattern traded below mid-Fib. Band level and trading near lower Fib. Band to signal a potential exhaustion setup. After completing Bullish Crab setup, price traded above the EL to signal a Long entry to the setup. The overall trend of APPL is also Bullish as price slope is positive above 200-SMA. On Feb. 07, 2014, a Long bullish trade is entered above 73.71 with a Stop below 70.50 (-3.21). Target levels are 77.7 to 79.7 for the Target Zone1, 85.3 -89.4 for Target Zone2.
The following chart (June 9, 2014) shows APPL Bullish Crab pattern progression and completion of targets.
Trade Entries and Stops
Most Harmonic Pattern trade entries occur around “D” point within the reversal zone. It could be a Buy (in bullish patterns) or a Sell (in bearish patterns). Usually, “D” is identified by a confluence of projections, retracements, and extensions of prior swings (legs), universally called as “reversal zone.” In my view, when prices started to reach this zone, it is signaling an opportunity for potential trade, not a signal to trade yet. The entry criteria and pattern validity are determined by various other factors like current volatility, underlying trend, volume structure within the pattern and market internals etc. If the pattern is valid and the underlying trend and market internals agreeing with the Harmonic pattern reversal, then Entry levels (EL) can be calculated using price-ranges, volatility or some combination. Stop is placed above/below the last significant pivot (in 5 and 4-Point patterns it is below D for the bullish pattern, above D for bearish patterns).
Target Zone1: (D + XA*0.62) to (D+XA*.786)
Target Zone2: (D + XA*1.27) to (D+XA*1.62)
It is important to note that potential target zones in harmonic patterns are computed from probability standpoint and not from the certainty. Strong money and risk management rules and full working knowledge of the pattern are necessary for any pattern trading success.
Example: The following chart shows a Bullish Gartley Pattern, entry level, stops and target zones. The Target zones are projected using XA swing length and Fibonacci ratios from D. Ranges of 62%-79% is TargetZone1 and 127%-162% is TargetZone2.