An Introduction to Harmonic Trading

What is Harmonic Trading?

Sometime ago, I saw couple of videos where this trader draws these strange looking triangles on a chart and he even went on to name these patterns with names of different animals including the butterfly, which in fact resembled the wings of a butterfly. Obviously, I was curious to say the least. So I went onto my MT4 platform and searched if there were some sort of a built-in indicator to draw these patterns, that I might have missed . You know how that search ended, right. But I didn’t give up. Eventually I started learning bits and pieces about this unique method of analyzing price movements in a chart. I entered into this weird and wonderful world of

Harmonic Trading.

In any market there are two types of market conditions – trending or range-bound (flat) markets. A trending market creates higher-highs or lower-lows depending on the direction of the trend; a bullish trend creates higher-highs and a bearish trend creates lower-lows. However, when price goes into a flat or range-bound market the price moves in weird patterns which look like skewed ‘M’ or ‘w’ shapes, that are more visible in line-charts – see example below.

EURUSDDaily

These price movement patterns in ranging markets have been researched by different professional traders for generations. These patterns are called harmonic patterns. Just like a gem stone or a diamond emerges from dirt, time to time a new repeating pattern is discovered by a harmonic trader and made famous to the rest of the trading world. Usually they are named after an animal. The idea is that, just like the animals live in a jungle in harmony, animals found in the chart live in harmony within the equilibrium.

The Concept of History Repeating Itself

Do you really believe that history repeats itself? I will let you answer this one and I will guide you to the answer. I promise.

I believe that price at any given time has no meaning. Because the price constantly changes and its only a very brief representation of the value of the underlying instrument.  So a similar chain of events occurring just because the price is X or Y is a statement out of context.

I also believe that movement of price has some meaning that we traders can relate to. Price movements consisting of same distance and the same momentum would occur regardless of the price itself, IF the same market conditions are repeated.

Lets take an example in relation to harmonic patterns itself. Let’s assume on day X the dollar strength compared to pound strength is the same as the day Y. If the market had produced a certain movement pattern on day X, the day Y too would produce a similar price movement pattern IF the orderflow is matched to the day X. So it actually is a self fulfilling prophecy because strength or weakness of the instrument initiates similar orderflow which in turn produces similar price movements that represents the strength or weakness of the instrument… we are back to block 1, ain’t we?

So its a vicious circle.

Forex price movement lifecycle
The reason why price moves regardless of the current price of the instrument

 

Fibonacci Ratios

Now to the technical side of things. There are two types of waves or price movements – impulse and corrective. Impulse waves are the strong price movements to the upward direction in an uptrend and vice versa. In a flat market impulse waves are solely differentiated with relation to the time-efficiency of the move or the momentum.

Fibonacci retracement level is calculated in relation to the main impulse wave. So its important to define the main impulse wave accurately in any chart or time-frame analyzed. Lets call it w1. After a correction of the w1 is completed and price reverses in the direction of the w1, the projections for the third wave are plotted as fibonacci  retracement levels in relation to the w1 and fib extension levels in relation to the corrective wave (w2.)

Now we have two completed waves and a third one projected in relation to the w1 and w2. Now the process of pattern expectation depends on how far the w3 would go before it reverses. Very basic of the patterns, the ABCD or AB=CD consists of only three waves. Suppose the w3 reverses at a key fib retracement level plotted in relation to the w2, now we can define a Price Reversal Zone or a PRZ at the pattern completion point, depending on the pattern recognized or expected.

Pictures should illustrate this better I guess…

Harmonic-pattern-skeleton-diagram

This is a visual diagram to explain some of the basic elements in harmonic patterns. The same principals and elements may be used in reverse direction too.

Naming convention for ABCD patterns is as follows. The starting point of W1 is point A, the end point of W1 (the starting point of W2) is point B and so forth. So the D point or PRZ for ABCD patterns will be determined at the end of the W3 (PRZ for ABCD or AB=CD NOT illustrated on the diagram.)

D point or the PRZ labelled on the diagram is for advanced harmonic patterns consisting of 4 waves. So the naming convention for patterns other than ABCD or AB=CD that consists of 4 waves is as follows. The starting point of W1 is point X, the end point of W1 (the starting point of W2) is point A and so forth. So the D point is obviously the end of W4.

The most important part of trading harmonic patterns is that you have to wait for the pattern to complete. Once a valid pattern completes within the defined PRZ the trade is taken to the opposite side of the last wave of the pattern. Yeah, you heard it right. The trade is to be taken against last “micro” trend which is the last wave of the completed pattern. So this is why its of utmost importance to determine the first impulse wave accurately.

Theory of Confluence

The thing with forex trading is that there is no one strategy that fits in for any market , anytime. That’s exactly why we have to work with probabilities. What is the most probable event to happen next? What is the most probable direction for the price? Where is the next most probable reversal point? In order to answer that last question, we have to look at so many elements. Support, resistance, price action, trendlines, fibonacci levels, volume, momentum and orderflow are just a handful of those elements.

So its practically impossible to analyze all of these elements in one go. On the other hand, harmonic patterns provide us with a neat solution. I am not suggesting that you should only use harmonics. Instead, I am suggesting to use these patterns as a starting point and work backwards.

The best way to utilize harmonics is that when a PRZ is determined, look for as many other elements to support the reversal. The more the better. So this is how to take high probability trades using harmonics. In other words this is how harmonic trading becomes highly successful. The key is to use confluence of more elements to support the trade.

In fact, confluence is the most important dimension of trading harmonic patterns.

Zillions of Patterns

By now you have a basic knowledge about trading harmonic patterns. It also helps to know that its practically impossible to keep an eye on all the patterns that exist in the trading world. Its true, there are too many shapes and names. So the solution is simple. Study few of the popular patterns, backtest and forward test each one of them on your preferred instruments and timeframes. Then select and use only the ones that give the best results for you.

Even then, remember this is not a strategy on its own. Harmonic patterns can only project a reversal zone, a slight edge for the positive expectancy of a trade. Moreover, the PRZ could be a range of tens or even hundreds of pips. The point is that you must device a strategy to go along with harmonic analysis.

Remember harmonic patterns are just a piece of the puzzle.

Again, this is a weird yet wonderful way of analyzing price movements.

Sometimes, I wonder if its coincidence that some news event would reverse the price exactly at a high confluence PRZ in the same direction, predicted by a harmonic pattern. You too will find out.

Happy harmonic-pattern-trading!

Facebook Comments