Harmonic Pattern

HARMONIC PATTERNS

Harmonic price patterns take geometric price patterns to the next level by using Fibonacci numbers to define precise turning points. Unlike other trading methods, Harmonic trading attempts to predict future movements. This is in vast contrast to common methods that are reactionary and not predictive. Let's look at some examples of how harmonic price patterns are used to trade on the market. (Extensions, clusters, channels and more! Discover new ways to put the "golden ratio" to work.
Combine Geometry and Fibonacci Numbers
Harmonic trading combines patterns and math into a trading method that is precise and based on the premise that patterns repeat themselves. At the root of the methodology is the primary ratio, or some derivative of it (0.618 or 1.618). Complementing ratios include: 0.382, 0.50, 1.41, 2.0, 2.24, 2.618, 3.14 and 3.618. The primary ratio is found in almost all natural and environmental structures and events; it is also found in man-made structures. Since the pattern repeats throughout nature and within society, the ratio is also seen in the financial markets, which are affected by the environments and societies in which they trade. (Don't make these common errors when working with Fibonacci numbers - check out Top Fibonacci Retracement Mistakes To Avoid) By finding patterns of varying lengths and magnitudes, the trader can then apply Fibonacci ratios to the patterns and try to predict future movements. The trading method is largely attributed to Scott Carney, although others have contributed or found patterns and levels that enhance performance.

Issues with Harmonics
Harmonic price patterns are extremely precise, requiring the pattern to show movements of a particular magnitude in order for the unfolding of the pattern to provide an accurate reversal point. A trader may often see a pattern that looks like a harmonic pattern, but the Fibonacci levels will not align in the pattern, thus rendering the pattern unreliable in terms of the Harmonic approach. This can be an advantage, as it requires the trader to be patient and wait for ideal set-ups.

Harmonic patterns can gauge how long current moves will last, but they can also be used to isolate reversal points. The danger occurs when a trader takes a position in the reversal area and the pattern fails. When this happens, the trader can be caught in a trade where the trend rapidly extends against them. Therefore, as with all trading strategies, risk must be controlled.

It is important to note that patterns may exist within other patterns, and it is also possible that non-harmonic patterns may (and likely will) exist within the context of harmonic patterns. These can be used to aid in the effectiveness of the harmonic pattern and enhance entry and exit performance. Several price waves may also exist within a single harmonic wave (for instance a CD wave or AB wave). Prices are constantly gyrating; therefore, it is important to focus on the bigger picture of the time frame being traded. The fractal nature of the markets allows the theory to be applied from the smallest to largest time frames.
To use the method, a trader will benefit from a chart platform that allows the trader to plot multiple Fibonacci retracements to measure each wave.

The Visual Patterns and How to Trade Them 

There is quite an assortment of harmonic patterns, although there are four that seem most popular. These are the Gartley, butterfly, bat and crab patterns.

GARTLEY PATTERN
The Gartley was originally published by H.M. Gartley in his book Profits in the Stock Market and the Fibonacci levels were later added by Scott Carney in his book The Harmonic Trader. 

Figure 1: The Gartley Pattern.

 The bullish pattern is often seen early in a trend, and it is a sign the corrective waves are ending and an upward move will ensue at point D. All patterns may be within the context of a broader trend or range and traders must be aware of that (see Elliott Wave Theory). Point D is a 0.786 correction of the XA wave, and it is a 1.27 or 1.618 extension of the BC wave. The area at D is known as the potential reversal zone (PRZ). This is where long positions could be entered, as some price confirmation of reversal is encouraged. A stop is placed just below the PRZ.

More About  Bullish / Bearish Gartley Pattern.

Bearish Gartley 

The bearish gartley pattern formation is similar to head and shoulders pattern, but as you can see the point C is below the point A, hence it is not head and shoulder pattern. 

Formation and trading strategy of Bearish Gartley pattern:

1. Point B must retrace 61.8% of AX movement.
2. Point C must retrace anywhere from 38.2% to 88.6% of BA movement.
3. Point D must be 138.2% or 161.8% extension of the BC movement.
4. Point D must retrace 76.8% of AX movement. This is our selling area.

Bullish Gartley 

The bullish pattern is as seen below, its formation is quite similar to inverse head and shoulders pattern, but as you can see below point C is not on the same level as point A.

Formation of Bullish Gartley pattern and trading strategy:

1. Point B can retrace 61.8% of XA movement.
2. Point C can retrace anywhere from 38.2% to 88.6% of AB movement.
3. Point D can be 138.2% or 161.8% extension of the CD move.
4. Point D can retrace 76.8% of XA movement. Point D is our buying area.

Stop loss in this is always very strict and hence we get very cool risk reward ratio, many times around 1:5 or more. The very important reason for trading this pattern is that it is based on uncertain places where traders are most afraid to take positions, hence giving better meaning for risk.

Butterfly Pattern

Figure 2: The Butterfly Pattern

The butterfly pattern is different than the Gartley in that it focuses on finding reversals at new lows (bullish) or new highs (bearish). D is a new low and a potential reversal point if the Fibonacci figures align with the structure. D would need to be an extension of BC in the magnitude of 1.618 or 2.618. This should align with an extension of XA in the magnitude of a 1.27 or 1.618. Entry is taken near D with price confirmation of the reversal encouraged. Stops are placed slightly below the potential reversal area (bullish). 

Bat Pattern

Figure 3: The Bat Pattern

The bat pattern is similar to Gartley in appearance, but not in measurement. Point B has a smaller retracement of XA of 0.382 or 0.50 (less than 0.618), but the extension of the BC wave into D is at minimum 1.618 and potentially 2.618. Therefore, D will be a 0.886 retracement of the original XA wave. This is the PRZ: when selling has stopped and buying enters the market, enter a long position and take advantage of the bullish pattern. Place a stop just below the PRZ.

Crab Pattern

Figure 4: The Crab Pattern

The crab is considered by Carney to be one of the most precise of the patterns, providing reversals in extremely close proximity to what the Fibonacci numbers indicate. This pattern, similar to the butterfly, looks to capture a high probability reversal at a new (recent) low or high (bullish or bearish respectively). In a bullish pattern, point B will pullback 0.618 or less of XA. The extension of BC into D is quite large, from 2.24 to 3.618. D (the PRZ) is a 1.618 extension of XA. Entries are made near D with a stop-loss order just outside the PRZ.

Fine-Tuning Entries and Stops

 
Each pattern provides a PRZ. This is not an exact level, as two measurements - extension or retracement of XA - creates one level at D and the extension of BC creates another level at D. This actually makes D a zone where reversals are likely. Traders will also notice that BC can have differing extension lengths. Therefore, traders must be aware of how far a BC extension may go. If all projected levels are within close proximity, the trader can enter a position at any area. If the zone is spread out, such as on longer-term charts where the levels may be 50 pips or more apart, it is important to wait to see if the price reaches further extension levels of BC before entering a trade.

Stops can be placed outside the largest potential extension of BC. In the crab pattern, for example, this would be 3.618. If the rate reversed before 3.618 was hit, the stop would be moved to just outside the closed Fibonacci level to the rate low (bullish pattern) or rate high (bearish pattern) in the PRZ.

Figure 5 is an intra-day example of a butterfly pattern from May 3, 2011.

Figure 5. Bearish Butterfly Pattern - EUR/USD, 15 Minute

 The price touches almost exactly the 1.618 extension level of XA at 1.4892 and the extension of BC to 2.618 is very close at 1.4887 (there are two Fibonacci tools used, one for each wave). This creates a very small PRZ, but it may not always be the case. Entry is taken after the rate enters the zone and then begins to retreat. The stop is placed just outside the most significant level that was not reached by the rate, in this case a few pips above the 1.618 XA extension. Targets can be based on support levels within the pattern; therefore, an initial profit target would be just above point B.

 The Bottom Line

 
Harmonic trading is a precise and mathematical way to trade, but it requires patience, practice and a lot of study to master the patterns. Movements that do not align with proper pattern measurements invalidate a pattern and can lead traders astray. The Gartley, butterfly, bat and crab are the better-known patterns that traders can watch for. Entries are made in the potential reversal zone when price confirmation indicates a reversal, and stops are placed outside the nearest significant (for the pattern) Fibonacci level that was not hit by the BC or XA extensions/retracements into the D (PRZ) area.

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Top Fibonacci Retracement Mistakes To Avoid

Top Fibonacci Retracement Mistakes To Avoid 

Every trader will use Fibonacci retracements at some point in their trading career. Some will use it just some of the time, while others will apply it regularly. But no matter how often you use this tool, what's most important is that you use it correctly each and every time. (For background reading on Fibonacci, see Fibonacci And The Golden Ratio.)

Improperly applying technical analysis methods will lead to disastrous results, such as bad entry points and mounting losses on currency positions. Here we'll examine how not to apply Fibonacci retracements to the foreign exchange markets. Get to know these common mistakes and chances are you'll be able to avoid making them - and suffering the consequences - in your trading.

1. Don't mix Fibonacci reference points.

When fitting Fibonacci retracements to price action, it's always good to keep your reference points consistent. So, if you are referencing the lowest price of a trend through the close of a session or the body of the candle, the best high price should be available within the body of a candle at the top of a trend: candle body to candle body; wick to wick.

Misanalysis and mistakes are created once the reference points are mixed - going from a candle wick to the body of a candle. Let's take a look at an example in the euro/Canadian dollar currency pair. Figure 1 shows consistency. Fibonacci retracements are applied on a wick-to-wick basis, from a high of 1.3777 to the low of 1.3344. This creates a clear-cut resistance level at 1.3511, which is tested and then broken.  

Figure 1: A Fibonacci retracement applied to price action in the euro/Canadian dollar currency pair.

Figure 2, on the other hand, shows inconsistency. Fibonacci retracements are applied from the high close of 1.3742 (35 pips below the wick high). This causes the resistance level to cut through several candles (between February 3 and February 7), which is not a great reference level.

Figure 2: A Fibonacci retracement applied incorrectly.

By keeping it consistent, support and resistance levels will become more apparent to the naked eye, speeding up analysis and leading to quicker trades.  

2. Don't ignore long-term trends.

New traders often try to measure significant moves and pullbacks in the short term - without keeping the bigger picture in mind. This narrow perspective makes short-term trades more than a bit misguided. By keeping tabs on the long-term trend, the trader is able to apply Fibonacci retracements in the correct direction of momentum and set themselves up for great opportunities.

In Figure 3, below, we establish that the long-term trend in the British pound/New Zealand dollar currency pair is upward. We apply Fibonacci to see that our first level of support is at 2.1015, or the 38.2% Fibonacci level from 2.0648 to 2.1235. This is a perfect spot to go long in the currency pair.  

Figure 3: A Fibonacci retracement applied to the British pound/New Zealand dollar currency pair establishes a long-term trend.

 But, if we take a look at the short term, the picture looks much different.

Figure 4: A Fibonacci retracement applied on a short-term time frame can give the trader a false impression.

After a run-up in the currency pair, we can see a potential short opportunity in the five-minute time frame (Figure 4). This is the trap.

By not keeping to the longer term view, the short seller applies Fibonacci from the 2.1215 spike high to the 2.1024 spike low (February 11), leading to a short position at 2.1097, or the 38% Fibonacci level.

This short trade does net the trader a handsome 50-pip profit, but it comes at the expense of the 400-pip advance that follows. The better plan would have been to enter a long position in the GBP/NZD pair at the short-term support of 2.1050.
Keeping in mind the bigger picture will not only help you pick your trade opportunities, but will also prevent the trade from fighting the trend.

3. Don't rely on Fibonacci alone.

Fibonacci can provide reliable trade setups, but not without confirmation.

Applying additional technical tools like MACD or stochastic oscillators will support the trade opportunity and increase the likelihood of a good trade. Without these methods to act as confirmation, a trader will be left with little more than hope of a positive outcome.

Taking a look at Figure 5, we see a retracement off of a medium-term move higher in the euro/Japanese yen currency pair. Beginning on January 10, 2011, the EUR/JPY exchange rate rose to a high of 113.94 over the course of almost two weeks. Applying our Fibonacci retracement sequence, we arrive at a 38.2% retracement level of 111.42 (from the 113.94 top). Following the retracement lower, we notice that the stochastic oscillator is also confirming the momentum lower. 

Figure 5: The stochastic oscillator confirms a trend in the EUR/JPY pair.

Now the opportunity comes alive as the price action tests our Fibonacci retracement level at 111.40 on January 30. Seeing this as an opportunity to go long, we confirm the price point with stochastic - which shows an oversold signal. A trader taking this position would have profited by almost 1.4%, or 160 pips, as the price bounced off the 111.40 and traded as high as 113 over the next couple of days.

4. Don't use Fibonacci over short intervals.

Day trading the foreign exchange market is exciting but there is a lot of volatility.

For this reason, applying Fibonacci retracements over a short time frame is ineffective. The shorter the time frame, the less reliable the retracements levels. Volatility can, and will, skew support and resistance levels, making it very difficult for the trader to really pick and choose what levels can be traded. Not to mention the fact that in the short term, spikes and whipsaws are very common. These dynamics can make it especially difficult to place stops or take profit points as retracements can create narrow and tight confluences. Just check out the Canadian dollar/Japanese yen example below.

Figure 6: Fibonacci is applied to an intraday move in the CAD/JPY pair over a three-minute time frame.

In Figure 6, we attempt to apply Fibonacci to an intraday move in the CAD/JPY exchange rate chart (over a three-minute time frame). Here, volatility is high. This causes longer wicks in the price action, creating the potential for misanalysis of certain support levels. It also doesn't help that our Fibonacci levels are separated by a mere six pips on average - increasing the likelihood of being stopped out.

Remember, as with any other statistical study, the more data that is used, the stronger the analysis. Sticking to longer time frames when applying Fibonacci sequences can improve the reliability of each price level.

The Bottom Line

As with any specialty, it takes time and practice to become better at using Fibonacci retracements in forex trading. Don't allow yourself to become frustrated; the long-term rewards definitely outweigh the costs. Follow the simple rules of applying Fibonacci retracements and learn from these common mistakes to help you analyze profitable opportunities in the currency markets.  

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