How Do Harmonic Trading Patterns Work?

The technical analyst does not dogmatically interpret his price charts according to fixed formulae, expecting the markets to follow a pre-established list of rules. Rather, he “realizes that, although stock market history repeats itself… details are never the same”, in the words of the famous stock market specialist, H.M. Gartley. The trading signals used in technical analysis are best viewed as useful perspectives on the market, through which we might hope to gain some foresight into future price action, but which are always open to being re-assessed or re-plotted should the need arise. They are not like a list of instructions in a DIY manual for building a bookshelf.

Today, we’re going to learn about a group of charting patterns that Gartley helped popularize back in the 1930s, and which are very handy items to keep in your online trading toolkit: Harmonic Trading Patterns. These tools should appeal to you if you prize precision in your trading strategy. They depend on price action forming geometric shapes of exact proportions and, when it does, we can derive a powerful reversal signal with which to open a buy or sell deal, and hopefully benefit from a sharp surge or dip in prices.

Remember, as we look at the four main types of Harmonic patterns, that each of them could be included within a larger movement of your price charts. Since these patterns are fractals, it follows that they occur on both the micro and macro levels equally. You should, then, be prepared to spy them on a scale where you had not expected to find them, even if it’s very small. In addition to going through the four types of patterns, we’ll explain how traders employ them in the Harmonic trading strategy. But first things first: It’s time to meet the Bat.

Types of Harmonic Patterns

The Bat – Proportions

 If you believe you have captured a Bat – on your price chart – the above diagram shows you the proportions it should show in order to check out as genuine. Prices rise sharply in XA and then follow the solid blue line, pulling back in AB, shooting up again in BC, and finally going for a deeper dip in CD. Here’s what all the numbers mean:

Dotted line XB indicates that the drop in AB has cancelled out 38.2% to 50% of the original bullish surge XA. When we say, “38.2% to 50%”, we mean that any percentage in between these two will suffice to validate the pattern. However, some hardline Harmonic pattern traders insist that the figure be one or the other of those two. Whenever we use the language of “X% to Y%” below, this difference in opinion will be implied.

The rise in prices signified by BC makes up 38.2% to 88.6% of the loss effected by AB. This is the meaning of dotted line AC. The final bearish plunge CD brings prices 88.6% of the way back from where XA initially took them, leaving behind only an 11.4% remnant of that progress. This is the meaning of XD. As to BD, this is meant to show that CD is a deeper price drop than AB by some way. Specifically, CD is 1.618 to 2.618 times the length of AB.

Veteran technical analyst Scott Carney says the Bat pattern is “probably the most accurate pattern in the entire Harmonic Trading arsenal”. One reason for this is that it rests on the 88.6% retracement ratio, which Carney regards as particularly powerful. In the paragraph below, we’ll discuss the practical use of the Bat pattern within your trading strategy.

The Bat – Employed in Harmonic Trading Strategy

The diagram shows the bullish version of the Bat pattern, from which we want to flush a buy signal for our security. At the end of it all, after our Bat is confirmed as genuine, we expect prices to shoot off in a bull run from point D, and it’s from this movement that we hope to benefit. The reason we expect this is that, ultimately, we believe the original bullish surge of XA is going to determine the trend direction – after the self-doubt signified by corrections AB and CD has worked its way out of the market’s system.

The time to open a buy deal is once you’ve seen that prices start to climb from point D, confirming your analysis of the situation. Place a stop loss order near your entry point in case the bull run fails. As to a target where we’d expect the new surge from D to run out of steam, this could occur when prices make up 161.8% of XA. This means we anticipate the fresh surge will be over one-and-a-half times the size of the initial bullish push.

The way we arrive at this price target is through referring to the Fibonacci ratios – special geometric proportions that govern growth cycles in nature. It wasn’t Gartley who applied these ratios to Harmonic trading patterns, but Carney, many years later. Still, the power of these ratios to describe waves in trading behaviour has become widely accepted in recent times, so many traders plot Fibonacci levels on their charts, using them as price targets or support and resistance levels.

In the paragraphs to come, we’ll show you the other three Harmonic patterns for which traders tend to search on their price charts. There is both a bullish and bearish version of each pattern but, for the sake of simplicity, we’ll represent the bullish version in each case. The bearish version is the exact inverse of the bullish, and it translates into a sell rather than a buy deal at point D. The Harmonic trading strategy for these patterns is essentially the same as that outlined above for the Bat.

The Butterfly

Caught a Butterfly in your net? Let’s check to make sure: After surging from X to A, prices correct themselves by 78.6% through AB. BC then re-asserts the bullish trend and compensates for the losses of AB by 38.2% to 88.6%. CD pulls prices down again and measures 1.618 to 2.24 times the size of AB. CD is also 1.27 times the length of XA. Take note that this four-stage pattern brings prices considerably below their starting point at X, but still signifies a bull run is around the corner.

The Crab

The Crab looks a lot like the Butterfly, but the proportions are different. AB retraces the surge of XA by 38.2% to 61.8%. BC re-asserts the bullish trend and makes up for the losses of AB by 38.2% to 88.6%. Following this, CD drags prices below their starting point at X, measuring 2.618 to 3.618 the size of AB. CD is also 1.618 the length of XA.

The Gartley

The last Harmonic Trading pattern is named after H.M. Gartley himself. After climbing through XA, prices retrace their steps by 61.8% in AB. When prices rise again in BC, they compensate for the loss of AB by 38.2% to 88.6%. And then, after the pattern is completed with the movement to D, we find that CD is 1.13 to 1.618 the size of AB. By the end at point D, prices have retraced 78.6% of the original bullish push of XA.

Special Considerations in harmonic trading patterns

Before acting on the bullish signal in each case above, traders will tend to wait and see that prices indeed manage to get off the ground from D. They also may consult other technical indicators, but you won’t want to bring up every technical indicator on each of your trades since this could drive you bonkers.

In the event you find prices change direction at D with a clear, unhesitant movement, this could be a sign prices are going to reach high places. If, however, you observe that prices hover in the region of D, unsure whether they should climb or fall, this might mean your pattern is invalid. The reason could be that the bearish price drop at CD has solid motivation behind it and won’t so easily be pushed off in favour of a trend reversal. You did your best, but this particular Bat or Butterfly won’t fly.

Harmonic Patterns - Wrapping Things Up

There are many trading strategies that make use of Fibonacci ratios, but Harmonic Trading is “the most specialized and effective” of them all, so says Carney, who employed them in the turbulent markets of September 2000 and March 2003 to great effect. During those periods, the Gartley and Bat patterns proved their ability to identify crucial reversal points in the markets, from which it would have been possible to reap rich rewards.

When studying and practicing your Harmonic Trading patterns, do so with patience because Rome was not built in a day. The main thing is to understand that each one of them is telling you something specific about future price action, and that this prediction is based on the Fibonacci ratios, which (according to many) govern human beings’ behaviour in the financial markets. For various reasons, the power of the Harmonic patterns may not be expressed on a given day, but this doesn’t mean they won’t come into prominence the next.