There are two main approaches traders use when analyzing markets, technical analysis and fundamental analysis. Within those methods, various tools help in understanding market mentality, predicting price action, and advising trades. Within the realm of technical analysis, there are many chart patterns and indicators which help traders. One popular technical analysis method is finding patterns like harmonic patterns and using the models to make predictions.
Harmonic patterns trace price and time movements using Fibonacci ratio relationships and symmetry in markets. Fibonacci ratios create support and resistance lines and identify key turning points or trend continuations. By indicating support, resistance, trends, and reversals, harmonic patterns give the trader key price levels for targets or stops.
Although it may seem complicated, the patterns used are natural and understandable, applicable to any chart or asset. This article will explain the forms of harmonic patterns and how one can apply them in trading.
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Table of Contents
What Are Harmonic Patterns?
Harmonic patterns use geometry to predict future trends. Harmonic patterns are named as such because the individuals who developed this tool saw the “wave” of price action on a chart and compared it to repeating and symmetrical harmonic patterns in nature.
While other patterns or geometrical shapes may be used, it is essential to use Fibonacci Sequencing. The Fibonacci Sequence is a formula manifested in many natural phenomena, and applicable to markets as well.
Fibonacci Sequencing is a series in which each number is the sum of the two preceding numbers. When starting with 0, a Fibonacci Sequence runs as follows: 0, 1, 1, 2, 3, 5, 8, 13… However, Fibonacci Sequencing may begin with any integer or fraction thereof.
Note: A Fibonacci Ratio, also known as the Golden Ratio, is 1:1.6180. When calculating numbers in a Fibonacci Sequence, a number divided by its preceding number will result in a fraction. The results will oscillate around and closer to 0.6180 as the numbers increase. If one divides a number in the sequence by the larger number following it, the output will oscillate around 1.6180.
Harmonic patterns appear in charts if the distances and prices of peaks and troughs are sequenced in this manner. In short, chartists track turning points and attempt to spot a Fibonacci Sequence, thus resulting in a harmonic pattern. The pattern can then be used as a tool for prediction and trade executions.
Seasoned analysts may see harmonic patterns in the market, but it is not a true harmonic pattern if the Fibonacci Sequencing is not present.
Typically, when looking at Fibonacci Sequences data, one would follow the four most recent turning points leading up to the current price. Should a harmonic pattern be present, use that data to predict where prices are likely to move.
Theory Behind Harmonic Patterns
The theory behind harmonic patterns, and technical analysis, in general, is that one can use past data to predict future movement.
Technical analysts use history and charts to study markets; thus, technical analysis tools are rooted in mathematics and past data; this is where harmonic patterns come in. The pattern itself relies on a natural geometric phenomenon, while other indicators and tools come into play.
History of Harmonic Patterns
As a concept, harmonic patterns were developed by Harold M. Gartley, for whom the most famous harmonic pattern is named.
Gartley was a trader and financial advisor in the early 20th century. He wrote a trading guide entitled “Profits in the Stock Market,” which was influential due to technical analysis’s groundbreaking development. The guide was re-published as a book in 1981, and the term “Gartley Pattern” became more widely used for a specific pattern he developed.
A few years later, Larry Pesavento improved on the pattern by using Fibonacci ratios and rules to trade the Gartley pattern. Other people have added to the harmonic pattern theory over time, most notably Scott Carney, who developed several harmonic patterns on his own.
Principle Behind Harmonic Patterns: Geometry and Fibonacci Numbers
Harmonic patterns are not created consciously by traders. They simply appear (or don’t appear) in the data if the prices and elapsed time relate to each other in specific ways.
When looking for harmonic patterns, the key variables used when using charts in general are time and asset price. These variables are then recorded and compared against Fibonacci Ratios and geometry to confirm that they are harmonic patterns and then used to predict the future price. The principles behind harmonic patterns are thus geometry and mathematical ratios (Fibonacci numbers).
Geometry and Fibonacci numbers are combined into a precise method based on the theory that patterns repeat themselves. While the primary ratio for this theory is 0.618 or 1.618, the ratios oscillating around these numbers (referred to as complementary ratios) include the following:
- 23.6%
- 38.2%
- 50% *not originally included in the Fibonacci Sequence, but helpful for traders
- 61.8%
- 76.4%
The primary ratio, or “Golden Ratio,” as previously mentioned, is also found extensively in nature. Financial markets follow suit, so the ratio is often found in the markets.
Charting from turning point to turning point and measuring the ratios between each creates a geometric pattern—a specific shape that may correspond to a harmonic pattern. These shapes can be square or triangular, and their proportions are used by traders to determine trends or future price movements.
Note: The lines of a harmonic pattern are not measured from Point to Point, but rather measure their change in value on the Y-axis, that is, the change in price.
Why Do Harmonic Patterns Work in Trading?
As stated, harmonic patterns are useful because specific patterns repeat themselves. If a trader can plot a harmonic pattern in the shapes mentioned below, the probability for correctly predicting future prices increases. Harmonic patterns work because they have in the past, and history tends to repeat itself.
The idea of history repeating itself is a key tenet of technical analysis. This is often the case with Fibonacci Sequences in nature, society, and aesthetics. Because certain phenomena, both natural and man-made, repeat themselves or occur in a specific sequence, traders assume that the financial markets, which are a product of society, will similarly repeat themselves.
Thus, cycles of bull controlled markets are predicted to occur at certain times and for a specific time in relation to the last cycle. The same idea goes for bear markets.
Because harmonic patterns work via ratio comparisons to make their prediction, there is no set volume, price, or time frame that must be traded to see these patterns. The patterns can occur over any set of trading periods, so long as the proportions match the numbers mentioned above.
Examples of Popular Harmonic Patterns
There are several harmonic patterns, all related to the Fibonacci Ratios. However, each tells a different story as to the way prices are moving. The most used harmonic patterns are as follows:
Gartley Pattern
Probably the best known of the harmonic patterns, the Gartley pattern is a 5-point, typically bullish, pattern. They will first present themselves as “M” or “W” patterns and have five key pivot points, all associated with Fibonacci Ratios. Here’s how to read the pattern:
- Price starts at X and moves to A
- Point A then corrects
- Point B is a 0.618 correction of Point A; in other words, Point B will be 61.8% retracement from Point A
- The price moves up again to Point C to a 0.382 to 0.886 correction of point B. Also, Point C will see a complimentary (see above numbers) Fibonacci AB retracement from Point B.
- Price moves down with an extension of 1.13 to 1.618 correction of point C
- Point D is exactly 0.786 of the XA leg, and a correction of Point C
It’s important to note that point D could also be a reversal zone. D is the standard action point where trades are taken.
Bat Pattern
The bat pattern looks like the Gartley Pattern, but the ratios are different. Here’s how to read the pattern:
- Price starts at X and moves to A
- Point A then corrects
- Point B is a 0.382 to 0.5 correction of XA (less than 0.618)
- Point C is a minimum of 1.618 up to 2.618
- Point D is a retracement of the original XA line with a 0.886 ratio
Point D is the spot where trades are taken and is also a potential reversal area.
Butterfly Pattern
The butterfly pattern is different from the Gartley in that it specializes in finding new lows or new highs. This is how to identify the butterfly pattern:
- Leg XA is formed
- Bear Market: price falls
- Bull Market: price rises
- Leg AB retraces leg XA with a 78.6% rise or fall in price
- Leg BC price falls (or rises) again 32.8% to 88.6% of the retracement
- Leg CD should equal AB; however, it can be 127% or 161.8% of that leg
- Point D is an extension of Point BC by 1.618 or 2.618
- Point D should align with Point XA by 1.27 or 1.618
- Point D is a potential reversal point
Make sure the Fibonacci numbers align correctly!
Crab Pattern
This is also known as the 5-0 pattern. The crab pattern looks very similar to the butterfly pattern. The difference between the two is that, in the crab pattern, the CD swing leg has a bigger extension. The crab pattern must fulfill the following Fibonacci rules:
- Point AB is between 0.382 and 0.618 of the Point XA leg
- Point BC is a minimum of 38.2% and a maximum of 88.6% of Point AB leg
- Point CD should be between 2.24 and 3.618 of the Point AB leg or 1.618 of the XA leg
Make sure to have the correct Fibonacci numbers charted before trading based on this pattern. Being exact is an integral part of succeeding in trading harmonic patterns.
Shark Pattern
The shark pattern has not been around for very long, initially formulated in 2011. It is like the bat pattern, except that, in the shark pattern, the C point exceeds the Point BC leg. An interesting part of the shark pattern is that it contains the points O, X, A, B, and C. Here’s how to identify the shark pattern:
- Price starts at X and moves to A
- Point A then corrects 0.886
- Point AB retraces between 1.13 and 1.618 of the Point XA leg
- Point BC extends to 113% of the Point OX leg
- The point CD leg poses a target of 50% retracement of the Point BC leg
Instead of trades taking place at Point D, trades occur at point C in the shark pattern.
How to Identify Harmonic Patterns?
Harmonic patterns measure the distances between and of peaks and troughs; thus, they are always composed over a series of trading periods with shifts in market mentality.
The typical harmonic pattern consists of five points, four connecting lines, and three reversals.
The five points are as follows:
- O or X
- A
- B
- C
- D
The four lines—or legs—are as follows:
- The line between the X and A point is called the XA leg.
- Point A then reverses course, for a retracement of the initial leg, leading to Point B. The AB leg is developed.
- Another retracement leads to Point C and creates the BC leg.
- C leads to D, which finishes the geometric structure.
It is assumed, then, that after the swing at point D, there will be a point E continuing the trend. Point E, however, is not a part of the harmonic pattern shape.
Harmonic patterns will frequently look like an M for a bullish pattern and a W for a bearish pattern. A bullish market is one that is on the rise, while a bear market is one that is sinking.
However, there’s more to it than just identifying an M or a W, as many other charts can have these shapes. Once these characteristics have been spotted, the pattern must be measured to confirm that it is, in fact, a harmonic pattern.
The key to harmonic patterns is in the geometry and the ratios between the points. Connecting the dots gives a powerful visual to a trader. The patterns are made up of retracement and projection legs using Fibonacci Sequences. By plotting these geometric shapes, traders can tell whether to buy or sell and when.
How to Draw Harmonic Patterns?
Although harmonic patterns were developed long before trading software, today, that is the only reasonable way to calculate and chart them.
If desired, the measurements can be calculated by hand. This is done by recording the changes in the price of an asset between its high and low points over 5 price swings (in total, however, start calculating after the 2nd swing), and then calculating using division the ratios of price changes. Triangles and squares can then be overlaid on the pattern to confirm the type of harmonic pattern and the locations of trade entry and exit.
The faster and easier way to do this is on a computer. Trading software should already have the tools included to identify and validate harmonic patterns in Candlestick charts.
TIP: Another type of chart would be fine, but candlestick patterns within the Japanese Candlestick Charts are useful indicators to confirm reversals predicted using harmonic patterns.
Steps for using the Fibonacci tool to assess harmonic patterns:
- Click on the harmonic pattern indicator, sometimes called simply a Fibonacci Tool, in the toolbar
- Identify starting point X, which can be a swing high or swing low point. It is usually a reversal, which can be confirmed with other indicators.
- X is a swing high if the market is in a bearish trend
- X is a swing low if the market is in a bullish trend
- Identify point A, which will signal that it is time to use the Fibonacci Tool.
- Measuring by hand would be very time consuming if one measures every swing – by using this tool, it saves a lot of time and wasted effort, and allows traders to test multiple swings in a trend for harmonic patterns.
- Drag the tool from point X down (in a bearish trend) or up (in a bullish trend) to point A.
- The tool will then draw horizontal lines at the appropriate Fibonacci Ratio numbers.
- Bearish Market: -27.0%, -61.8%, 0% (point A), 23.6%, 38.2%, 50%, 61.8%, 76.4% and 100% (point X)
- Bullish Market: 0% (point X), 23.6%, 38.2%, 50%, 61.8%, 76.4%, 100% (point A), 127%, 161.8%
- As the trading continues, verify the 5 points forming the harmonic pattern using these horizontal lines as a guide.
- Also, validate every leg by the Fibonacci ratios to confirm specific harmonic patterns and guide trades.
If the swings and leg lengths are part of the Fibonacci Sequencing, it is a harmonic pattern.
Using a Fibonacci retracement tool is a great way to gauge when institutions will be selling and when resistance should come into play.
Once one has identified these harmonic patterns a few times, it becomes easier to continue to do so and easier to spot harmonic patterns accurately without needlessly measuring using the Fibonacci tool.
Typical Structure of Harmonic Patterns
There are two types of harmonic patterns:
- 5-point retracement structures
- 5-point extension patterns
Retracement structures can tell one how deep pullback can be, while extension patterns measure the waves in the trend direction. The Gartley and Bat patterns are examples of retracement structures, while the Butterfly and Crab are examples of extension structures.
While it can seem complicated, the patterns are easy to see if one uses the trading tools mentioned below to validate the Fibonacci numbers.
How Reliable Are Harmonic Patterns?
Any trader wants an edge over other traders, and harmonic patterns can often deliver just that. One study notes success rates of 80-95%. While one may not experience the same high results, one can probably benefit from trading harmonic patterns.
The success rate of harmonic patterns may also rise in combination with other favorable trading patterns or market conditions. (Specific examples are listed later.)
When Harmonic Patterns Do Not Work in Trading?
If one plans on using harmonic patterns, there are some warnings to heed:
- Harmonic patterns work better in range (flat, no-clear-trend, etc.) markets than trending markets. A range market is when the price is contained between support and resistance. It’s in these markets that one will find most harmonic patterns. Harmonic patterns appearing in trending markets usually go against the trend.
- They are highly technical and require the trader to be exact. One must be accurate in using the Fibonacci Sequence in harmonic patterns. It is very easy to misread a potential harmonic pattern and have it fall apart.
- Opposing patterns can form the same swings. Occasionally, opposing harmonic patterns can develop from the same market swings. Beware of these and use other indicators to confirm theories.
How to Improve the Reliability of Harmonic Patterns in Trading?
Several patterns and conditions work well with harmonic patterns and can be used to validate findings and research.
Harmonic Patterns and Candlestick Patterns
A chartist may use Japanese candlestick patterns (indicating trend continuation, reversal, or market indecision) to validate the trends predicted by the harmonic patterns. When used with harmonic patterns, traders can validate their findings to ensure their correct path.
Harmonic Patterns and Elliot Wave
Harmonic patterns contain waves, and understanding those can be key to knowing when to buy or sell. One of the most powerful waves is the Elliott wave. The principle behind this wave is that markets alternate between an impulsive phase and a corrective wave.
Elliott waves also use Fibonacci numbers, making it a perfect partner for harmonic patterns. Noticing Elliott waves inside a harmonic one can consolidate one’s theory.
Harmonic Patterns and Divergence/RSI
Divergence/RSI (Relative Strength Index) is an indicator that can be used in conjunction with harmonic patterns. The tool is based on two properties:
- It helps measure the direction and momentum of a particular stock or commodity.
- Divergence indicates whether it’s time to buy or sell.
When combined with harmonic patterns, traders have a better chance of knowing when to get out of or get into a trade.
Harmonic Patterns and MACD
MACD stands for moving average convergence divergence and shows the relationship between two moving averages of a price. It is the difference between exponential moving averages for 26 and 12 days. Whenever the MACD crosses the zero upward, there is a buying opportunity.
Conversely, whenever the MACD crosses the zero downward, there is a selling opportunity. MACD can incorporate trend and momentum in a single indicator, making it a powerful tool for traders.
How to Trade Harmonic Patterns?
One ought to have a strategy when trading harmonic patterns. Most successful traders agree on the following methods:
Trading the Bullish Gartley Pattern
There are five steps to trading the Gartley pattern. It is important to note that each pattern has a potential reversal zone (PRZ); sometimes, this is called the potential completion zone (PCZ). Point D is often seen as the PRZ in harmonic patterns. Long positions could be entered at this point.
- Identify the Pattern – Identify the pattern on the third leg and confirm validity.
- Determine the Tradable Pattern – Determine whether it is bullish or bearish. Draw it out and mark each price action swing.
- Trade Entry – CD finds support at 127.2% or 161.8% of BC level.
- Trade Stop-Loss – Place a stop right below Point D.
- Trade Take Profit Target – 38.2% – 61.8% CD retracement from D.
One won’t be able to tell there is a tradable harmonic pattern until the third leg starts. Confirm the validity of the model using the other tools mentioned above.
Marking each price action swing allows one to gauge the size of the parameter. The bearish Gartley is the inverse of the bullish Gartley.
One may enter a full position after the D bounce and set different levels for the take profit. It’s important to note that the potential completion zone is computed from a probability standpoint. It’s not an exact science.
Trading the Bullish Bat Pattern
For almost all the harmonic patterns (and many other patterns), one can use the same five basic steps as the above strategy and simply change the parameters. For instance, here is how to trade a bullish bat pattern:
- Identify the Pattern – Identify the pattern on the third leg and confirm validity.
- Determine the Tradable Pattern – Determine whether it is bullish or bearish. Draw it out and mark each price action swing.
- Trade Entry – Just above Point D
- Trade Stop-Loss – Place a stop right below Point X.
- Trade Take Profit Target – 38.2% – 61.8% of retracement level of AD.
Placing a profit target is highly subjective and will depend on market conditions, objectives, and risk tolerance.
The CD leg is, on this and most other harmonic patterns, the most important portion of the pattern. With this leg, one can confirm when to go long. The difference in the bat pattern is that one waits until CD has had an 88.6% retracement of the XA leg. It would be ideal if Point D represented a 161.8% to 261.8% extension of the BC leg.
Advantages and Limitations of Trading Harmonic Patterns
Described below are the primary advantages and limitations of trading the Harmonic Patterns –
| Advantages of Harmonic Patterns | Limitations of Harmonic Patterns |
|---|---|
| Can be used with other patterns and indicator theories | Can be difficult to compute without software |
| Works in all timeframes and across markets | Correct coding of patterns is difficult |
| Provides future projections and stops in advance | Opposing patterns can emerge from the same swings |
| Trading is standardized using Fibonacci Ratios | Conflicting Fibonacci retracements can create difficulty |
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Conclusion
Trading, regardless of the financial vehicle used, is a serious and potentially costly activity. Although it is easy to start trading, becoming proficient and wealthy with trading takes skill and knowledge.
Harmonic patterns require keen eyesight and patience. One must not only spot and calculate a harmonic pattern but also wait for the pattern to complete before entering a trade.
However, by using the correct tools and indicators to help validate theories and predictions, one can profit off these 5-point reversal structures. They are very specific in projecting price moves. Make sure to study the market and use other tools to confirm trends, reversals, support, and resistance.
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