Harmonic Patterns

Advantages & Disadvantages of Harmonic Patterns

Advantages:

Provide future projections and stops in advance, making them leading indicators

Frequent, repeatable, reliable and produce high probable setups

Trading rules are relatively standardized using Fibonacci ratios

Work well with defined Market Context, Symmetry and 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

Disadvantages:

Complex and highly technical, making it difficult to understand

Correct identification and automation (coding) of harmonic patterns is difficult

Conflicting Fibonacci retracements/projections can create difficulty in identifying reversal or projection zones

Complexity arises when opposing patterns form from either the same swings or other swings/timeframes

Risk/reward factors from non-symmetric and low-ranked patterns are pretty low

How to Trade Harmonic Patterns and 

Pattern Identification

Harmonic patterns can be a bit hard to spot with the naked eye, but, once a trader understands the pattern structure, they can be relatively easily spotted by Fibonacci tools. The primary harmonic patterns are 5-point (Gartley, Butterfly, Crab, Bat, Shark and Cypher) patterns. These patterns have embedded 3-point (ABC) or 4-point (ABCD) patterns. All the price swings between these points are interrelated and have harmonic ratios based on Fibonacci. Patterns are either forming or have completed “M”- or “W”-shaped structures or combinations of “M” and “W,” in the case of 3-drives. Harmonic patterns (5-point) have a critical origin (X) followed by an impulse wave (XA) followed by a corrective wave to form the “EYE” at (B) completing AB leg. Then followed by a trend wave (BC) and finally completed by a corrective leg (CD). The critical harmonic ratios between these legs determine whether a pattern is a retracement-based or extension-based pattern, as well as its name (Gartley, Butterfly, Crab, Bat, Shark, and Cypher). One of the significant points to remember is that all 5-point and 4-point harmonic patterns have embedded ABC (3-Point) patterns.

All 5-point harmonic patterns (Gartley, Butterfly, Crab, Bat, Shark, Cypher) have similar principles and structures. Though they differ in terms of their leg-length ratios and locations of key nodes (X, A, B, C, D), once you understand one pattern, it will be relatively easy to understand the others. It may help for traders to use an automated pattern recognition software to identify these patterns, rather than using the naked eye to find or force the patterns.

Example: The following chart shows an example of the Bullish Bat pattern with embedded the ABC Bearish pattern. The identification pivots and ratios are marked on the pattern; the pattern also shows the entry, stop and target levels.

Trade Identification

In harmonic pattern setups, a trade is identified when the first 3 legs are completed (in 5-point patterns). For example, in Gartley Bullish pattern, the XA, AB and BC legs are completed and it starts to form the CD leg, you would identify a potential trade may be in the works. Using the projections and retracements of the XA and BC legs, along with the Fibonacci ratios, we can build a price cluster to identify a potential Pattern Completion Zone (PCZ) and D point of the pattern.

Pattern Completion Zone (PCZ)

All harmonic patterns have defined Pattern Completion Zones (PCZ). These PCZs, which are also known as price clusters, are formed by the completed swing (legs) confluence of Fibonacci extensions, retracements and price projections. The patterns generally complete their CD leg in the PCZ, then reverse. Trades are anticipated in this zone and entered on price reversal action.

As an example, the Pattern Completion Zone (PCZ) for the Bullish Gartley pattern is constructed using the following Fibonacci extensions and projections:

0.78 XA

1.27 BC

1.62 BC

AB = CD

Market Context Conditions

Most technical traders use chart analysis with market context concepts to trade. Market context concept is described as how current price is reacting to certain levels (pivots, support and resistance, MAs), how indicators are performing relative to historic price conditions (like oversold, overbought) and where/how patterns are developing in the current timeframe or multiple timeframes, etc. Each trader develops his own market context to trade. One of the elegant ways to define market context is through a Fibonacci Grid structure.