Harmonic Patterns in the Currency Markets

Traders use chart patterns to determine likely market reversal points, whether bullish or bearish. Some take it further, using harmonic patterns based on Fibonacci ratios.

Harmonic patterns can be applied to any asset class, including stocks and commodities, but are most frequently used by forex traders.

Understanding Harmonic Patterns

Like other price patterns, harmonic patterns are shapes within a price chart that can be used to predict where prices are headed based on historical behavior. What makes harmonic patterns different is that they utilize Fibonacci ratios to locate precise turning points.

Traders use these patterns to do two things:

• Predict price reversals.
• Predict how long the predicted move will last.

There are different harmonic patterns, each with its own shape and Fibonacci ratios. Most of them are named after an animal, based on what they look like on a chart, and consist of five price points:

• X: The beginning price.
• A: The next price point.
• B: A retracement of the X-to-A move.
• C: A retracement of A-to-B move.
• D: The last price point and entry point.

Those five points form four legs: XA, AB, BC, and CD.

Each pattern indicates where to enter a trade and where to place a profit target or stop loss. The key component is the potential reversal zone, which is where the price is expected to reverse direction. A bullish harmonic pattern suggests a falling market is about to rise, while a bearish harmonic pattern implies the opposite.

The Role of Fibonacci Numbers

Harmonic trading relies on the Fibonacci sequence to identify potential reversal zones. Fibonacci is a series of numbers in which, with the exception of the first two, each number is the sum of the two preceding numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and so on. As the sequence progresses, the ratio of successive numbers approaches the Golden Ratio (about 1.618), which has significance in nature and design. It also gives traders clues about future price movements.

The key to harmonic patterns are Fibonacci retracements and extensions. Fibonacci retracements are used to measure the depth of price changes from peak to valley and identify pullback entries. Fibonacci extensions, on the other hand, indicate potential profit targets.

Key Harmonic Patterns

There are four main harmonic patterns, each of which has a bullish and bearish version and a unique set of Fibonacci measurements.

Gartley Pattern

Gartley patterns, named after their creator, H.M. Gartley, must show two key features to be valid:

• Point B must mark a 0.618 retracement of XA.
• Point D must mark a 0.786 retracement of XA.

As you can see in the chart above, the bullish pattern is M-shaped while the bearish pattern is W-shaped. In both cases, D is the potential reversal zone where long or short positions can be entered, although it’s often advisable to wait for price to start rising or falling before executing the trade.

Consider positioning the stop loss at or near X and setting the profit target at or near C.

Butterfly Pattern

The butterfly pattern, introduced by Bryce Gilmore, is composed of four legs and forms a distinct “M” or “W”, depending on whether it’s bullish or bearish. The right Fibonacci ratios to use here are:

• AB is 78.6% of XA.
• BC is 38.2% to 88.6% of AB.
• CD is 161.8% to 261.8% of AB or 127% to 161.8% of XA.

Again, the reversal zone is established by the D point, the stop loss can be placed above or below X, while the profit target should be around C.

Bat Pattern

The bat pattern was created by Scott Carney and forms when a trend temporarily reverses its direction before continuing on its original course.

To qualify as a bat pattern:

• The AB line should be a 38.2% or 50% retracement of the move from X to A
• BC can retrace 38.2% to 88.6% of AB but mustn’t exceed 88.6%.
• The CD line can extend 161.8% to 261.8% of the length of AB but mustn’t exceed 88.6% of XA0.

Here, the entry point is D and a stop loss should be placed at X or further below or above, depending on whether you’re going short or long.

Crab Pattern

Scott Carney claims the crab pattern is the most reliable harmonic. It’s a reversal pattern that consists of five points (X, A, B, C, and D) and four legs (XA, AB, BC, and CD.)

The rules are:

• AB is 38.2% to 61.8% of XA.
• BC can retrace 38.2% to 88.6% of AB but mustn’t exceed 88.6%.
• The CD line should extend to 161.8% of XA and can extend 261.8% to 361.8% of the length of BC.

With the crab, you enter at D and place a stop loss at a reasonable distance above or below it, depending on your appetite for risk.

Risk Management and Stop-Loss Strategies

As with all technical analysis tools, harmonic trading patterns aren’t guaranteed to materialize and pay off every time. Risk management is essential. No single trade should risk more than a small percentage of your trading capital. And stop-loss orders should be used to shield against significant losses.

There isn’t a specific rule for how far above or below the D entry point the stop loss should be placed. It depends on individual risk-reward preferences.

Risk-averse investors might want to place stop losses just below a long entry or above a short entry, while more adventurous ones might place them outside the furthest projection of the pattern, meaning the position stays open until the pattern invalidates itself.

Generally speaking, you don’t want stop losses to be too wide or tight. Tight stop losses mean good positions getting closed off with a little bit of volatility. Wide stop losses can leave you too exposed and susceptible to heavier losses.

Challenges and Considerations

Plenty of traders swear by harmonic patterns. However, as with any technical analysis tool, they aren’t flawless.

One of the biggest criticisms of harmonic patterns is that they can be complicated and aren’t very beginner friendly. There are lots of patterns to memorize and details to get right, which can cause confusion and errors. Traders may struggle without using specialized software or indicators.

There’s also a chance of getting kicked out of trades before they go the right way. Harmonic patterns are often celebrated for providing precise entry and stop-loss levels. The flip side is that these levels can be easily breached by a little volatility, kicking the investor out of a trade before it comes to fruition.

Another potential drawback is suitability. Harmonic patterns are generally used in swing trading and demand much more patience than day traders usually need to have.

The Bottom Line

Linking price movements to Fibonacci ratios has made some forex traders a lot of money. On the occasions when these patterns form and are plotted correctly, they can effectively predict price reversals as well as precise entry and profit targets. Of course, they can also generate false signals and lead investors to lose money. As with any trading strategy, harmonic patterns aren’t flawless and discipline is key.