The ebb and flow of investor sentiment generates price trends and consolidation. When Forex rates move sideways, they generate patterns. These patterns are used by analysts to predict future movements of a currency pair. This process of pattern recognition is an important part of technical analysis. As you become expert at recognizing patterns, you will learn to determine the difference between reversal and continuation patterns.
Introduction to Harmonic Patterns
One of the pioneers of pattern recognition was H.M Gartley. Gartley describes patterns that contain 5-points and generally form either an “M” or “W” which leads to a potential reversal pattern. The driving mechanism or catalyst for a change in an exchange rate is the Fibonacci ratio. The Fibonacci ratio is used to define the specific length of different waves and helps determine trading rules which adds risk management to the original Gartley harmonic patterns.
What Can You Trade using Harmonic Patterns?
Determining key reversal patterns using harmonic patterns, applies to nearly every asset that has continuous price action. This includes the Forex markets. Rakuten Securities Australia offers charts with historical currency pairs, even through its MT4 trading platform. As long as you have access to a chart that has historical data, you can trade using harmonic patterns.
The Main Harmonic Patterns and How to Trade Them?
There are several harmonic patterns including the original Gartley pattern which is in bullish and bearish forms. There is also the Butterfly pattern as well as the Bat and Crab patterns. If you have never attempted to use harmonic patterns, initially they might be difficult to spot. With some practice, you will be able to see these patterns as they are forming, which will allow you to take advantage of their predictive nature. All of these patterns use the Fibonacci ratio to link one point to the next. Several patterns stem from the original Gartley, including the Butterfly, Crab, Bat, Shark, and Cypher patterns. As the patterns form, they create either an “M” or “W” shape. The initial move up or down is referred to as the impulse move that is followed by an ABCD wave (AB, BC, CD, and then and extension). The ratio between these points determine whether a currency pair is consolidating and will then form a retracement-based or extension-based pattern. Each 5-point pattern has an embedded ABC 3-point pattern.
What is a Fibonacci Ratio?
For you to identify different harmonic ratios, you need to use the Fibonacci ratio to evaluate the distance between each point in the pattern. The Fibonacci ratio was invented by an Italian mathematician, Leonardo Pisano Bigollo. Fibonacci numbers are formed by a ratio, namely the total sum of the previous two numbers. The basic Fibonacci ratio is the Golden Ratio (1.618). There are several ways to apply a Fibonacci ratio through technical analysis. This includes Fibonacci retracements, projections and fans, as well as arcs. The MT4 platform offered through Rakuten Securities Australia provides access to Fibonacci tools.
Pros and Cons of Using Harmonic Patterns
Pros
- Provides reliable setup patterns
- Evaluates future projections
- Standardized trading rules using a Fibonacci ratio
- Harmonic patterns can use used in all timeframes and with all market instruments
Cons
- This is a technical process which can be confusing
- Correct pattern recognition in not intuitive
- There are several conflicting Fibonacci retracements and extensions that create confusion
The Gartley Pattern
The original harmonic pattern was invented by Gartely and bares his name. There is a Gartley pattern that works in an uptrend and one that works in a bear trend. These are 5-point patterns. There are several ways to determine a potential reversal in a currency pair. The Gartley pattern has an ABC wave that begins with an impulse wave which is the setup of the pattern. An impulse wave is generally a bullish or bearish movement that has robust acceleration and volume. The Gartley bullish pattern can be first recognized as the impulse waveforms within an uptrend. This bullish impulse movement is called the “XA” wave which ends at point A. After point A, the movement of a currency pair retraces and forms a second wave, which is called “AB” and ends at point B. In a Gartley bullish wave pattern, the retracement of “XA” by “AB” is a Fibonacci retracement that is 61.8% of the “XA” wave. The next movement in the Garley pattern is a reversal of the “AB” retracement which is the formation of the “BC” line, which has a line that increases 61.8% to 78.6% of the “AB” line. This move higher is shown as a ratio of the retracement (the dated line “AC). The last leg of the Gartley pattern is the “CD” line that moves lower to point D. This has a 61.8% move of the initial impulse wave which moves into the buying zone. While point D is not an exact point, it becomes a region where you can consider a purchase of the currency pair you are evaluating. The Gartley bearish pattern is very similar but initially moves lower with an impulse wave forming the “XA” move down. It also follows with a pattern that includes an “AB” line, a “BC” line and a “CD” line, ending at point “D”. This is the selling point of the bearish Gartley pattern.