What is the Harmonic Pattern? How does it help in trading?

Trading means buying and selling assets with the objective of making money in the short run, like a day, week, or month, whereas investing involves holding onto an asset for a longer time frame.

Every trader wants to become successful at trading.

Learning to trade the market using harmonic patterns is not hard if the patterns are plotted correctly. It helps the traders understand potential price movements in the underlying stock using a geometric shape.

Harmonic pattern was introduced to the trading world by Harold McKinley Gartley in 1932.

Let us understand the key element called the Fibonacci sequence and the numbers that one must know before knowing what the harmonic pattern means. 

What are Fibonacci numbers? Why is the Fibonacci number important to understand harmonic patterns?

Leonardo Pisano Bigollo originally derived the Fibonacci numbers. It is the sequence of numbers where each number is the sum of the two previous numbers. It means 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233.

The basic Fibonacci ratio, or “Fib ratio,” is the ‘Golden Ratio’ (1.618).

Every harmonic pattern includes Fibonacci numbers, as these patterns use Fibonacci ratios extensively to verify every wave within the pattern, as well as highlight potential profit targets once the way has been completed. It helps in drawing up the harmonic patterns for the analysis of price movements.

What is the harmonic pattern?

In simple terms, a harmonic pattern is a method wherein future prices are predicted by analyzing price movements.

It is like a chart that forms part of a trading strategy and it can help traders to spot pricing trends based on price predictions assumptions.

It also helps to understand transitions between rising and falling trends which are often signaled  by price patterns.  

How does the harmonic pattern work?

By joining all the endpoints on price movements, the harmonic pattern creates a geometric shape that helps to suggest trades.

So by using harmonic patterns, traders enter the trade with a theory. They are a precise instrument, helping identify specific price movements.

It is important to analyze that before following the harmonic patterns, one should be confident in his/her ability to perform technical analysis, and the fastest – trading decisions.

There are various types of Harmonic Patterns and each harmonic pattern follows its own set of rules. Also, they have different geometrical shapes and Fibonacci ratios.

Let us understand different types of Harmonic Patterns one by one.

Types of Harmonic patterns that one can apply in trading

1. ABCD Pattern:

It is the most straightforward pattern of all, the ABCD (or AB=CD) pattern is composed of three movements and four points. First, there is the impulsive movement (AB), then a corrective movement (BC), and then another impulsive movement (CD) that goes in the same direction as AB.

As this is based on fib ratios, the rule of the ABCD pattern says that in a move from B to C & C to D, the market should not go beyond a certain fibonacci range. In a bullish ABCD, point C must be lower than A and D must be lower than B.

2.  Butterfly Pattern:

The harmonic butterfly is a five-point reversal chart pattern used in technical analysis by traders to help identify turning points in the market.

There are two different types of butterfly patterns; bearish butterflies and bullish butterflies. These patterns are designed to reveal when a trend reversal is stronger than the original trend. Using the triangles created within the butterfly, traders can determine whether holding a short or a long position is the most profitable.

They also help traders in spotting the end of the current move so that they can take the trade.

3.   The Gartley Pattern

It is a simple harmonic pattern that is preceded by a significantly low or high. It is also known as the ‘222’ pattern based on the page number outlined by Harold McKinley Gartley in his book, Profits in the Stock Market.

This pattern is usually seen in the early phase of a trend. These waves show the corrective waves are coming to an end and a new bullish trend is about to emerge.

Gartley patterns usually form when a correction of the overall trend is taking place. Bearish Gartley patterns look like ‘M’ while bearish patterns are W-shaped.

These patterns help in identifying instances of breakouts, resistance, and support. 

4.      The BAT pattern

It gets its name from the bat-shaped end product.

When compared to the other patterns, the bat pattern is still a trapezoid, but more symmetrical. For both the bearish and the bullish patterns, the right side and the left side will be nearly the same heights. 

The Bullish Bat Harmonic pattern is a little different from the Gartley pattern.

The Bat pattern forms when a trend temporarily reverses its direction but then continues on its original course.

This pattern allows traders to enter a trend at a good price just as it is resuming.

5.      The Crab Pattern

It’s the most effective harmonic pattern to use when trading.

One main advantage of using the Crab pattern instead of other types of harmonic patterns is the high risk/reward ratio because these setups allow you to have very tight stop losses.

It is ideal for traders trying to identify precise price movements and allows traders to enter the market at extreme lows or highs.

It also enables traders to maximize returns on securities with low volatility. Though it is similar to the butterfly pattern it is more condensed.

6.      The Cypher Pattern

The cypher pattern has five touchpoints and four waves or legs between them. Every touchpoint represents reversal levels, while each leg highlights a price action.

It is an advanced trading pattern that combines Fibonacci trading with other indicators.

The cypher uses tighter Fibonacci ratios (usually less than 1), which creates a “steeper” visual appearance.

When traded correctly, this advanced harmonic price action pattern can achieve a truly remarkable strike rate and a pretty good average reward-to-risk ratio.

7.      The Shark Pattern

The shark pattern is the newer harmonic trading pattern that traders have been using since 2011.

The pattern got its name because its steep outside lines and shallow dip in the middle form a chart.

All shark-patterned trades are taken based on point C, while the D point is used as a pre-defined profit target.

How to decide which harmonic pattern to be used?

Depending on the market movements one can split the harmonic pattern into two categories: Bearish and Bullish.

1. Bullish traders believe that their market is about to experience an upward price movement

Bearish traders operate under the belief that the market is on a downward trajectory.

2. If a series of harmonic patterns indicate that the market is on an upswing, bullish traders might use this insight to take a long position on their chosen market, to profit from any upturn.

If a trader notices a bearish harmonic pattern, they may want to start shorting their market, by trading stock or commodities under the assumption that the price will fall.

Advantages of Harmonic patterns

• The Harmonic patterns provide a scientific method for future price projections.
• These patterns are stable and reliable and the accuracy percentage is high.
• By finding patterns of different magnitudes and lengths and applying Fibonacci coefficients to them, one can forecast the future movement of financial instruments like stocks, options, and more.
• The use of Fibonacci ratios makes them use standardized set-ups.
• The trading pattern is more objective. Do not depend on the traders’ subjective views.
• These patterns work well in all time frames and all market conditions.

Disadvantages of Harmonic patterns

• Highly technical and complex patterns so they are not easy to understand.
• Establishing where each patterns entry and exit points are sometimes is difficult to understand
• Correct identification of patterns is required.
• Automatic trading through coding is difficult.
• Conflicting retracement or projection levels can create confusion while identifying the projection or reversal zones.
• Complexity arises if multiple patterns are formed within the same swings/ timeframes or other time frames/swings.
• The risk/reward ratio does not always favor the traders in all these patterns. 

Final Word

Harmonic patterns are a precise way to trade and they can be helpful for traders who enjoy studying price charts and trading patterns. It is important to remember that harmonic patterns are not always successful. The price may not move as far as expected.

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