18 March, AtoZMarkets - Traders often hear about harmonic trading or harmonic patterns and keep on wondering what are harmonic patterns? I want to touch base on this subject and explain why an understanding of harmonic movement can assist a Forex trader in analyzing the market.
So if you are one of those traders wondering what are the harmonic patterns, we could draw a simple explanation as a simple harmonic motion, in mechanics and physics, as a type of periodic motion where the restoring force is directly proportional to the displacement and acts in the direction opposite to to that of displacement.
Psychology is as much important for traders as to Financial markets since markets are driven by people’s emotions and this is broadly categorized as fear and greed. These emotions do not change over time and hence markets move in predictable ways. Aggressive moves in the market bring these emotions to the fore.
A simple analogy to illustrate why markets do not move in one direction only; if you were to push a child on a swing you will observe the pendulum effect. As the swing is pushed further in one direction the move in the reverse direction becomes more probable. To use the stock market as an example, when a company’s share price drops after disappointing financial results (E.g. LinkedIn Stock tumble) there will usually be an increase in selling pressure. As the price of the share continues to fall, the momentum in selling increases as more investors start off-loading the stock in the fear of making bigger losses. Consequently, as the share price becomes ‘cheaper’, more investors start buying the stock up again as the price is now perceived to be a ‘bargain’ price. This causes the stock price to increase once again thereby correcting some of the losses. In the Forex market this is also visible in the form of strong moves that occur in the market after a significant economic news announcement. It is usually found that after a significant move in one direction that price will often retrace all or some of the previous move.
In Elliott wave analysis the fractal nature of the environment such as a flower’s petals, a cauliflower, a branch of a tree etc. was discovered by Ralph Nelson Elliott to also explain the fractal nature of the market. Markets move in waves; there is an impulsive move followed by a corrective move. Each of the Elliott impulsive waves 1-5 and the A-B-C corrective waves can be broken into waves of lesser degree. The fractal nature of the markets explains why patterns repeat themselves in different time frames. These patterns use geometric price movements and can be drawn using Fibonacci ratios. The sequence of numbers 0, 1, 1, 2, 3, 5, 8, 13… etc. where each successive number is the sum of the preceding two numbers is known as the Fibonacci sequence. Shapes found in nature such as the famous Nautilus shell below can be explained using this sequence.
In Fibonacci. the ratio of 1.618 is also known as the golden ratio. Using the Fibonacci sequence we find that when one divides a number by the preceding number such as 5 by 3, 8 by 5 and so on, the larger the numbers become the closer the answer approximates 1.618. To find the other ratios such as 0.618, a number in the sequence needs to be divided by the next number such as 3 divided by 5, 5 by 8 and so on. Again, as the numbers grow larger the answer gets closer to 0.618. In calculus this would be notated as the limit goes to infinity.
Harmonic patterns also known as chart patterns using the Fibonacci ratios are also found to occur over and over again in financial markets. These patterns can help to predict possible reversal levels in the market. Additionally if these patterns are used in conjunction with other technical tools traders can then find their high probability buy and sell zones for the specific trading instrument.
Some of these harmonic patterns are called Bat, Gartley, Cypher, Butterfly, Crab, Shark etc. As can be seen in Fig.1 below a Bat pattern is drawn using a combination of Fibonacci ratios which can provide a high probability reversal zone The last sharp drop occurred during FOMC on the 16th March 2016. Observe in the chart below how price is now consolidating around the D leg of the Bat pattern which represents the 88.6 Fib retracement of the X to A Leg.
Bullish Bat pattern
Below is an example of 2 Cypher patterns. The smaller pattern completed and a pending Sell limit order would have been triggered. Price hit the first target which is at a 38.2 Fib retracement of the C to D leg. Furthermore, after the reversal where price almost reached the second target at a 61.8 Fib retracement, price then continued to move higher. Interesting to note here is how the bullish action suddenly started reversing around the 78.6 Fib retracement level of the X to C leg of the Cypher. These reversals tend to happen repeatedly in the market.
Bearish Cypher pattern