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By Sanjeet Kumar
This article is the final project submitted by the author as a part of his coursework in Executive Programme in
Algorithmic Trading (EPAT™) at QuantInsti®. Do check our Projects page and have a look at what our students
are building.
Project Abstract
Harmonic trading combines patterns and math into a trading method that is precise and based on the premise
that patterns repeat themselves. 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.
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.
Harmonic Patterns
Harmonic price patterns take geometric price patterns to the next level by using Fibonacci numbers to define
precise turning points. Unlike other common trading methods, Harmonic trading attempts to predict future
movements. Let’s look at some examples of how harmonic price patterns are used to trade currencies in the
Forex market.
The Gartley
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’. The levels discussed
below are from that book. Over the years, other traders have come up with some other common ratios. When
relevant, those are mentioned as well.
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 following point D. All patterns may be within the context of a broader trend or range and
traders must be aware of that. (For related insight, see “Elliott Wave Theory”).
It’s a lot of information to absorb, but this is how to read the chart. We will use the bullish example.
The price moves up to A, it then corrects and B is a 0.618 retracement of wave A.
The price moves up via BC, and is a 0.382 to 0.886 retracement of AB.
The next move is down via CD, and it is an extension of 1.13 to 1.618 of AB.
Point D is a 0.786 retracement of XA. Many traders look for CD to extend 1.27 to 1.618 of AB.
The area at D is known as the potential reversal zone. This is where long positions could be entered, although
waiting for some confirmation of the price starting to rise is encouraged. A stop loss is placed not far below
entry, although addition stop-loss tactics are discussed in a later section.
For the bearish pattern, look to short trade near D, with a stop loss not far above.
The Butterfly
The butterfly pattern is different from the Gartley in that the butterfly has point D extending beyond point X.
Here we will look at the bearish example to break down the numbers.
The price is dropping to A.
The up wave of AB is a 0.786 retracement of XA.
BC is a 0.382 to 0.886 retracement of AB.
CD is a 1.618 to 2.24 extension of AB.
D is at a 1.27 extension of the XA wave.
D is an area to consider a short trade, although waiting for some confirmation of the price starting to move lower
is encouraged. Place a stop loss not far above.
With all these patterns, some traders look for any ratio between the numbers mentioned, while others look for
one or the other. For example, above it was mentioned that CD is a 1.618 to 2.24 extension of AB. Some traders
will only look for 1.618 or 2.24, and disregard numbers in between unless they are very close to these specific
numbers.
The Bat
The bat pattern is similar to Gartley in appearance, but not in measurement.
Let’s look at the bullish example.
There is a rise via XA.
B retraces 0.382 to 0.5 of XA.
BC retraces 0.382 to 0.886 of AB.
CD is a 1.618 to 2.618 extension of AB.
D is at a 0.886 retracement of XA.
D is the area to look for a long, although wait for the price to start rising before doing so. A stop loss can be
placed not far below.
For the bearish pattern, look to short near D, with a stop loss not far above.
The Crab
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 is similar to the butterfly, yet different in measurement.
In a bullish pattern, point B will pullback 0.382 to 0.618 of XA.
BC will retrace 0.382 to 0.886 of AB.
CD extends 2.618 to 3.618 of AB.
Point D is a 1.618 extension of XA.
Take longs near D, with a stop loss not far below.
For the bearish pattern, enter a short near D, with a stop loss not far above.