Harmonic patterns represent a type of graphical analysis to identify the trend direction, measure the depth of a possible retracement and calculate reasonable levels for stop-loss and take profit orders. There are several kinds of harmonic patterns depending on their geometry and ratios between legs but they are common in terms of using Fibonacci Retracement Levels to measure how waves of the price action relate to each other. This feature helps harmonic patterns to get an essential distinction from reversal patterns such as head-and-shoulders, double- and triple-tops and bottoms.
What is a harmonic pattern?
The harmonic pattern is a way of graphical analysis similar to Fibonacci retracement levels, Elliott waves, pitchforks and Gann fans. The pattern consists of 5 touchpoints on a price chart, reflecting several waves of the price action, which have a certain ratio to each other. In most cases, those relations are equal to Fibonacci retracement levels. The form and the type of harmonic pattern depend on the exact figure of the Fibonacci row. Different types of trading strategies might be used together with harmonic patterns including reversal, breakout and continuation strategies.
Harmonic patterns are also known as XABCD patterns as those letters are used to name the touchpoints. Those points are used to highlight peaks and bottoms on the price chart and they reflect reversal points of the price action. Distances between two points are called waves or legs as they reflect price changes in accordance with retracements or trend continuations. The essential factor is to measure the ratio between two waves as this proportion will influence the direction of the trend, entry price in the shape of the harmonic pattern. Here is how the harmonic pattern looks like:
In this example, point X is the beginning of the uptrend. The first wave is reflected by the distance XA, while the correction AB followed after reaching the local peak. The wave BC reflects the second attempt to continue the uptrend, while point C is lower than point A. Another retracement is highlighted by the leg CD, the bearish run to the local bottom, which could be considered as an entry point for long positions. The stop-loss order has to be set below the point X, while targets depend on the form and type of the harmonic pattern and ratios between legs indicated on the chart. We’ll come back to this later.
Best time frames to spot harmonic patterns
Harmonic patterns are used to identify sustainable trends. They are more effective and long-term time frames such as weekly and daily charts. However, intraday trading can also use harmonic patterns hourly and four-hourly charts. Shorter time frames are not convenient for such a type of analysis because of too many swings and weeds of the price action and a high level of market noise. Nevertheless, it is recommended to use additional tools of the technical analysis to increase the efficiency and improve the profitability of a trading strategy based on harmonic patterns.
Types of harmonic patterns
Harmonic patterns can be continuation or reversal setups. Depending on the ratios used to calculate the difference between legs and corrections, technical analysts guide for all types of harmonic patterns.
Here is the list of them:
- Gartley pattern;
- Bat pattern and Alternate Bat pattern;
- Butterfly pattern;
- Crab pattern;
- Shark pattern;
- Cypher pattern.
How to draw a harmonic pattern?
As far as harmonic patterns are continuation formations, traders should notice the general trend direction that used to drive prices before the pattern occurred. Another common feature of all types of harmonic patterns is a presence of double top or bottom depending on the previous trend direction. These crucial reversal points can represent a sequence of higher highs or lower highs for the bullish trend and lower lows or higher lows for the bearish action. Distances between retracement points can also differ depending on the exact kind of the formation, while the final point of the pattern can be higher or lower than the starting point of the pentagon. Nevertheless, the main statement of all harmonic patterns says that until the correction's depth is within a certain range concerning the initial wave of the price action, then the reversal is unlikely and continuation of the general trend should follow.
Once a similar to pentagon pattern has been spotted on the price chart, traders should turn the XABCD graphical analysis tool on and connect all of the five touch points consequently. The instrument will calculate ratios between the legs automatically and the result will appear above or below every wave. After that, traders should check if the ratios correspond to the conditions of any type of harmonic patterns. If the requirements are met, traders should proceed with opening trading deals according to trading rules of the pattern that has been identified. Placing correct stop-loss orders and calculating right targets is crucial for profitable trading, so traders should follow the rules thoroughly. If the geometry requirements of harmonic patterns are not met, then traders should just ignore such formation.
How to trade with harmonic patterns?
The key meaning of every harmonic pattern for Forex trading is that it continues the previous price action. So the entry point for every kind of pattern is the final point D, wherever it is placed. The stop-loss order should be calculated precisely depending on the geometry of the pentagon and ratios between legs. For instance, if the counter-trend price actions go further, breaching the distance allowed for the appropriate wave, then the correction is getting strong enough to reverse the trend and the continuation might not happen. In this case, it is better to cut possible losses before they are gone too far. However, one of the main advantages of harmonic patterns is a reasonable reward-to-risk ratio. In all cases, the stop-loss order is placed rather close to the entry point, while the final destination of the price action is far above/below it. This allows traders to impose a minimal risk with a potentially decent profit.
If you like this strategy, you might also be interested in this Crab pattern Forex trading Strategy
Placing postponed orders
There is also a method suggesting that traders should not wait for the pattern to complete at point D but place a postponed order at the distance of the affordable ratio related to the particular pattern. What traders get in this case is that positions will be open automatically without checking if the harmonic pattern is complete. Such an approach could give a more lucrative entry point and potentially larger profit at the end of the day. Of course, traders should not forget placing if-done orders, especially the stop-loss order, because the price action could be volatile and fast enough to miss the chance of closing the deal manually in a worst-case scenario. When it comes to disadvantages of this method, the correction could finish earlier than the entry point calculated by the trader, so the postponed order might not be triggered and the entry opportunity will be missed. So it is always better to wait for the pattern to complete before opening deals.
Using harmonic patterns in conjunction with additional technical indicators
Another way of increasing the efficiency of a trading system based on the graphical analysis in general and harmonic patterns, in particular, is to apply additional technical indicators for the analysis and trading decisions. The key statement of any harmonic pattern is that the retracement is not strong enough to reverse the general trend at some point. So trading positions are opened against the final wave of the price action as the leg CD represents retracement. Thus traders could double-check the technical sentiment of the asset price by adding a powerful indicator to the equation. If the correction is not strong enough, like the harmonic pattern says, then a technical indicator measuring the market momentum with a long-term perspective should maintain the previous bias. It is important to choose an indicator with a correct period as, for example, a too sensitive oscillator would show bearish momentum during the retracement but not the overall picture. So traders need to analyse the technical outlook at point D, considering the whole formation starting from point X. Therefore the period of an indicator should be equal to the length of the harmonic pattern or even larger.
Such technical indicators would help traders to double-check the trading signal:
- Relative Strength Index;
- Average Directional Index;
- Chande Momentum Oscillator;
- Chaikin oscillator.
Disadvantages of harmonic patterns
First of all, harmonic patterns are quite rare formations on the price chart. Traders could spot something similar in terms of five touchpoints and pentagon geometry and interpret such a formation as a harmonic pattern. However, it is extremely important to check all of the ratios between legs in terms of correspondence to Fibonacci levels as harmonic patterns require precise analysis. Sometimes it happens that reversal at point D happens too early or too late compared to traders’ expectations, so trading with harmonic patterns requires patience. Another disadvantage is related to the trading process itself. The markets are not obliged to lift the price in the correct direction right away, it often happens that traders should hold the deal for quite a while, waiting for the target to be achieved, while rates could keep bouncing in a tight sideways range in the middle of the formation. Finally, harmonic patterns work best on long-term charts as the larger timeframe is, the more sustainable the analysis will be. Therefore, some short-term traders might not find harmonic patterns applicable to their trading strategy based on frequent entries.
Harmonic patterns are based on Fibonacci retracement levels and a certain geometry of the price action. Despite the wide variety of harmonic patterns types, the common feature is that they continue the general trend, even though traders open deals against the direction of the final wave of retracement. Ratios between legs of the pattern point to a suggestion that the retracement is not strong enough to reverse the general trend until it is in a certain range compared to the initial leg. Some of the harmonic patterns could remind double-tops or double-bottoms, which are reversal patterns. However, the geometry and ratios help the graphical analysis to discover the key distinction of the formation and point to the correct direction of the upcoming trend. Calculation of the stop-loss order helps Forex traders to maintain a reasonable reward-to-risk ratio, while the efficiency of a trading system based on harmonic patterns could be increased by applying additional technical indicators.