Harmonic Patterns: How to use them when trading
Chart patterns are often used by traders as part of their technical analysis, enabling them to identify trends and make predictions. There are multiple geometric chart patterns that can be studied, some fairly basic and simple to interpret - such as the classic rectangles - and others of a more complex nature. All chart patterns, however, are able to demonstrate whether a direction is in reverse or continuation.
Advanced chart analysis, such as harmonic patterns, are predominantly used by the more experienced trader, someone who can more easily recognise and understand trends of a particular nature and identify a true pattern as opposed to a misrepresentation, or false flag.
We'll explore in depth what constitutes a harmonic trading pattern, where it might be useful and the various types available to a seasoned trader.
What are harmonic patterns?
Just like other chart patterns, harmonic patterns are used to gauge trends and predict a future market. However, harmonic trading patterns are unique in the fact that they are based on the mathematical ratios of Fibonacci, where the sum of two numbers provides the next number in the sequence, i.e. 0, 1, 1, 2, 3, 5, 8, 13 and so on.
Using this as a tool in their analysis, a trader will look to identify certain ratios between the legs of a chart pattern, signifying a specific harmonic pattern, and therefore a potential opportunity to place a trade.
Forming the backbone of many elements in nature such as tree branches, flowers and the human body, this geometric pattern (also known as the golden ratio or number - 1.618 - due to the ratio between each number in the sequence) can similarly be found in designs and architecture around the world.
Using Fibonacci sequences in calculations across finance, analysis and market charting can help to create successful predictions and, as harmonic patterns are based on Fibonacci ratios, traders can apply these to get a gauge of movements and how long a particular trend might last.
Why are harmonic patterns useful?
Fibonacci retracements are often applied as an analytical tool as they're based on the premise of prices repeating past movements when following a reverse direction. Similarly, harmonic price patterns can also be useful in determining changes in the price of an asset or identifying a reversal in a trend.
Adapting harmonic patterns as part of a trading strategy in the forex market, or other markets, can help to identify suitable entry and exit points for trades. Using indicators, just as a trader would when applying other tools and strategies, a pattern can then be drawn to create a visual image, based on Fibonacci retracement; representative of either a bullish or a bearish harmonic pattern, depending on the price movement. This then allows for opportunities to elevate and capitalise on market sentiment.
The different types of harmonic trading patterns
There are various types of harmonic patterns that can be utilised by traders, with each one enabling different trends to be uncovered. However, as it's essentially an advanced analytical tool, traders should already possess reasonable confidence and experience in working with technical analysis to interpret the patterns and to be able to make sound and timely decisions.
Harmonic trading patterns range from simpler strategies to the more complex, but they all feature four or five touch points, with each point representing the sentiment. We'll take a look at five of these patterns and explain the history and theory behind each one.
Featuring four touch points and three price swings, this harmonic price pattern can show either continuation or reversal of trend and is classed as a directional move or retracement.
A directional move indicates a bullish or bearish change in the value of assets, while a retracement signals a correction to a prevailing high or low. ABCD patterns use the Fibonacci retracement ratio levels of 38.2% (0.382), 50.0% (0.50) and 61.8% (0.618).
The ABCD harmonic pattern can be used to trade both bearish and bullish markets across any stock, asset or forex currency, with the formula signifying clearly defined up- and downtrends. This pattern can also be applied to any time-frame duration.
This harmonic pattern was first introduced by HM Gartley in the 1930s and features five touch points on a chart. A bullish Gartley chart pattern closely resembles the letter 'M' while the bearish inversion is represented by a 'W'. When the price swings on this type of chart (X to A, A to B, B to C to D and A to D) align with Fibonacci levels, it's confirmed to be a Gartley harmonic pattern.
Many traders will choose to apply a stop loss order at the 'X' position and use 'C' as the take-profit point. This pattern allows flexibility over trades, offering successful buying and selling opportunities, and can be utilised across all markets.
First discovered by Bryce Gilmore, the butterfly is a five-point configuration consisting of four legs (X to A, A to B, B to C and C to D). Although similar to the Gartley, butterfly harmonic patterns differ slightly to others in that point 'D' extends past point 'X' and the Fibonacci levels align with different ratios. Therefore, instead of retracing, as seen in other patterns, the C to D leg continues to a 127% extension.
A trade will usually take place at point 'D', with a trader selling in a bearish market and buying in a bullish market. This point marks a price reversal, allowing for opportunity to capitalise on extreme price highs or lows.
Discovered by Scott Carney and creating an accurate basis for a trading strategy, the crab produces a similar image to the butterfly harmonic patterns, yet with slightly different ratios. The configuration also represents a reversal pattern - however, the extension leg features a 1.618% swing point.
When a trader identifies the crab harmonic pattern, it's generally a reliable way of signalling the end of a price trend and the start of a new one, whether this be bullish or bearish and over a short time frame or a longer duration.
As with other harmonic patterns, a trade will usually be placed at point 'D', with a stop loss at point 'X'.
A relatively recent discovery by Scott Carney in 2011, the shark pattern can identify market reversals and is also based on a five-point image. However, the shark features its own individual ratio levels as well as an additional point, labelled 'O', giving the pattern a unique structure. Consequently, the legs are represented as O to X, X to A, A to B, and B to C.
The market entry point for shark harmonic patterns is 'C', as opposed to 'D'. This is also a favourable point for traders to place their stop loss, due to the fact that the pattern ceases to exist if the price extends below 'D'. The point between the B to C leg provides a clear and precise take-profit mark.
A bullish shark harmonic pattern will signal a price upturn from point 'C', whereas a bearish shark harmonic pattern will create an inversion of this and show a downward movement in trend from point 'C'.
As this is a relatively complex harmonic pattern, it's not usually recommended for those new to trading tools and technical analysis. However, for the more experienced, it can offer clear entry and exit points and ideal risk-vs-reward ratios, particularly across short-term trading opportunities.
Why use harmonic patterns in forex trading?
Although the harmonic patterns as described above can be applied to any trading market, including stocks, assets and futures, they are particularly suited to forex trading due to the time-frame flexibility. Real-time trading, 24 hours a day, gives way to regularly occurring harmonic patterns, based on historical data, across a variety of durations - minutes or hours, or even daily.
Whether harmonic patterns are profitable depends somewhat on the experience of the trader and their ability to correctly identify the Fibonacci ratio levels for each pattern. Used in the right way, however, this form of analysis can accurately predict sudden reversals and movement of trends within the forex market.
Get started with harmonic price indicators today
Feel ready to expand your trading tools with harmonic price indicators? It's easy with FXCM.
- Use this guide to get to grips with the different harmonic trading patterns and decide how to incorporate them into your strategy.
- Feeling bullish or bearish? The choice is yours on how you wish to trade.
- Open an account with FXCM and gain full access to the forex market. Alternatively, try a demo account to polish up your harmonic pattern trading skills risk-free.
- Start spotting the patterns and begin creating trading opportunities that could lead to attractive returns.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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