– Theory –
Kriss, Passionate Developer, Trader
CEO of AzurItec sas – Founder of Ninja-Addons.com
Many of you have asked me to explain the theory of Harmonic Trading and its practical use. Here is a series of articles that will first explain the theory of the Harmonic Trading, then through some examples of trades, show how to take advantage of the and find automatically high potential trading opportunities. This article was originally written by fredifly a few years ago and I took the liberty to add the Shark Pattern to this excellent article.
The Harmonic trading is a technique that uses the recognition of specific figures (see below) based on the Fibonacci ratios and applied on prices to determine the reversal points (potential reversal zone – PRZ) highly probable.
As often in chartist analysis, the goal is to identify the figures, and the entry and exit of a position by the assumption that the price action in the past will happen again in the future.
One of the first references to Harmonic Trading can be found in the work of J. M. Hurst. And over the past 25years, Scott Carney has been considered as the father of what we call today “Harmonic Trading”.
The important concept to understand is that the separate price movements of each other are actually related. In addition, the Fibonacci ratios and patterns on prices of their relationship provide a way to determine where the turning points will occur. When these points are identified correctly, trades are executed at a price level where the cycle is potentially changing.
These trades are executed “in harmony” with the market. Transactions are executed in areas where the rhythmic nature of the market is changing. In addition, these technical measures can provide a lot of technical information about the potential direction of future price action.
This is particularly evident when the calculation of several harmonics converge in a specific price zone, defining a support or resistance. This area is known as the “potential Reversal Zone” or (PRZ). Applied manually Harmonic trading techniques can not be applied to any time frame.
The reason is that this technique is enormously time-consuming in terms of analysis. It is best to use on daily, weekly and monthly charts or to use an indicator that can detect harmonic patterns automatically such as the Harmonic indicator.
II. Specific figures of Harmonic trading
The ABCD pattern
The AB=CD pattern is the basic figure of the Harmonic trading. This figure is constituted such that each segment is equivalent. Fibonacci ratios in the pattern must occur at specific points. In an ideal AB=CD point C must retrace 0.618 or 0.786 of the segment AB. This projection of the segment BC converges to the completion of the AB=CD pattern which must be 1.27 or 1.618 to point B. It is important to note that the 0.618 retracement at point C will result from a 1.618 projection of the segment BC layout to C. A 0.786 retracement at point C will result in a 1.27 projection of segment BC layout at point C.
The most important is to remember that the projection of the segment BC must converge closely to the completion of the AB=CD pattern.
The Crab Pattern
The Crab pattern is a Harmonic Figure discovered by Scott Carney in 2000. This pattern is one of the most accurate. The critical aspect of this pattern is the potential reversal zone created at point D, 1.618 of XA segment from X, and the extreme projection of the segment BC at point B (which can be 2.24, 2.618, 3.14 or 3.618).
The pattern requires a tight stop loss and usually provides a good reversal in the potential reversal zone.
The Butterfly Pattern
The structure of the butterfly pattern was discovered by Bryce Gilmore. The butterfly pattern requires a specific relation between the Fibonacci ratios to define the structure, including a mandatory retracement of XA segment 0.786 to B because it offers areas for potential reversals (PRZ) more accurate, and more meaningful trading opportunities.
Also the butterfly pattern must include the AB=CD pattern for a valid signal. Often the AB=CD pattern will have a segment CD equal to 1.27 or 1.618 times the segment AB.
While this is an important requirement for a valid trade signal, the largest ratio in the pattern is 1.27 of XA segment. XA calculation is usually completed by extreme projection of the segment BC (2, 2.24 or 2.618).
These ratios creates a potential reversal zone (PRZ) that can produce powerful reversals especially when the pattern is in the extreme price levels (higher high or lower low).
The Bat Pattern
The bat pattern is a harmonic pattern discovered by Scott M. Carney in 2001. It takes into account the 0.886 retracement of XA segment as the element defining the potential reversal zone. The B Retracement point must be less than 0.618. Preferably, the retracement is between 0.382 and 0.5 XA segment.
The bat pattern uses a minimum projection of 1.618 times the BC segment (from point B). Moreover, this pattern includes AB=CD pattern. However, the segment AB is generally extended to 1.27 times from C, which means that CD = 1.27AB.
This pattern is a generally accurate and requires a stop loss smaller than most other patterns.
The Gartley Pattern
Although the pattern is named after its creator Gartley, his book does not allude to the Fibonacci ratios. This was the case when he realized that the retracement of XA segment to point B was 0.618 and that was the point D for its part of 0.786.
This pattern uses a variety of Fibonacci ratio at points B and D. Despite these variations, Fibonacci retracements that produce the safest reversals are 0.618 to B and 0.786 to D. In addition, it includes the pattern AB=CD which converges in the same area as the retracement of XA segment 0.786 and projection to B 1.27 times the BC segment.
The Gartley preferably requires a retracement B must be 0.618 of the XA segment.
The Shark Pattern
The shark is a harmonic pattern discovered by Scott M. Carney. It is the result of the failure of two consecutive impulsive waves. First wave BC should not exceed 1.13 / 1.618 AB (first failure), then the impulse wave CD must not exceed 1.13 XA (second failure). It is this second failure that defines the potential reversal zone.
The retracement point B has no particular constrained to the XA segment, but by construction must allow to obtain a CD wave of the order of 1.618 / 2.24 AB.
The shark pattern requires active management of the position as it represents a strong market indecision that tends to break the market extremes before going back.
The Three Drive Pattern
Although it is not specifically identified, one of the first references to three drives pattern was described in the book “Elliot Wave principle” by Robert Prechter. He describes the general nature of the price action that has either a structure in three or five waves. Adapted from this principle, symmetrical movements in prices that have identical projections Fibonacci price structure in a 5 wave pattern is a three drives. In Harmonic trading the importance of other larger models and their projections or retracement improve the accuracy of the model. The book was one of the first to focus on one of the critical aspects of this model that each “drives” should be accurately complete a series of harmonic numbers, 1.13, 1.27 or 1.618. Also prices must be clear and symmetrical segments, and each “drive” must have equivalent periods.
III Potential Reversal Zone
Price convergence and the number of Fibonacci offers a significant probability of reversal. When a “gathering” in a specific area of Fibonacci ratios occurs, it is possible to estimate an optimal point to make a trade, while setting a stop loss compared to the limited potential profit.
If a valid reversal occurs, often the price action will rebound in the region, or sometime will remain in the spill area. However, if the inversion zone is not valid, the price action will often be extreme and provide a clear signal that the opportunity of trade should be avoided.
If the price action is reversed in this area, the reversal potential could be considered important. But if the price did not reverse, it suggests that the predominant trend is very strong.
IV Important notes
In general, the higher the ratio is, the better it is. This means that the Fibonacci ratio calculated from a large segment (trend) is generally more significant as an entry point for a trade in a spill area. Another rule is that the larger the pattern, the more the reversal potential is significant. For example, a setup based on a weekly chart will be more important than the daily setup. Also, if there is a smaller pattern into a larger pattern, the greater will be generally more significant.
Another important note about harmonic numbers is their potential in the reversal zone. The key to harmonious use of these measures in the graphical analysis of prices is to determine the area where the greatest amount ratios converge in the same area. When three, four or even five Fibonacci ratios are combined in one specific area, as defined by their structure, the region should be considered very harmonic.