Have you heard of Harmonic patterns? Technical analysis can be a polarizing subject in the world of investing. Some traders swear by it, while others can’t be bothered by following the lines on a chart. Stock charts can look bearish or bullish, depending on the person analyzing them. Is technical analysis the end-all-be-all of making a trade? No. Is it a viable way to try and predict what may happen based on historical patterns and previous performance? We’d say yes!
When it comes to technical analysis, a few things are undeniable. Whether stocks, ETFs, foreign exchange, or even cryptocurrencies, certain patterns will appear and re-appear on every chart. Harmonic patterns certainly fall into that category. These patterns consider high-probability reversal areas used to predict a change in trend. This article will explain what a harmonic pattern is and how we can use it to predict the future behavior of a stock.
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What Are Harmonic Patterns?
Harmonic patterns are patterns that consistently appear on the charts of assets and can be used to predict reversal zones of that asset’s price. As you probably know, stocks don’t just go up forever. They pull back and retest the previous zones of demand that determine the price at which buyers and sellers are willing to trade. Harmonic patterns are one way to find a high-probability pivot zone to enter and exit a trade.
These patterns were first introduced to the world in 1932 by the well-known technical analyst Haroly Gartley. He introduced the Gartley Harmonic Pattern in his 1935 book Profits in the Stock Market.
Harmonic Patterns require a bit of advanced knowledge about reading stock charts. First, they utilize what are known as Fibonacci extensions and retracements. Don’t worry; we’ll review Fibonacci levels later in this article. They are mathematical ratios repeatedly appearing on charts as key support and resistance areas.
Next, Harmonic Patterns almost always form a five-pointed geometric figure on the chart. These five points represent repeatable pivot points that mark a potential stock price change and trend change.
Like any pattern on a stock chart, Harmonic Patterns never have a 100% win rate. As a result, you should never rely on a pattern if you see one; rather, you should consider other factors like the macroeconomic environment and the fundamentals of the company in question. Let’s dive deeper into why harmonic patterns often appear on stock charts.
Fibonacci Extensions and Retracements
If you have ever researched a stock chart, you have no doubt come across the use of Fibonacci ratios. But what are Fibonacci levels, and why are they important?
Fibonacci was an Italian mathematician who created several different mathematical patterns. Most famously, he invented the Fibonacci Sequence, which is a series of numbers where every third number is the sum of the two preceding numbers:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, etc.
This sequence provides that the difference between each number is about 1.618, otherwise known as the Golden Ratio. The relativity between these numbers and the 1.618 ratio appears frequently in the world around us. This ratio has been linked to everything from how plants and trees grow to the spirals of a snail shell. Of course, we are interested in it because it is also a magnet for stock prices on a chart.
How to Use Fibonacci Levels on Charts
The key to using Fibonacci levels is identifying a local peak and trough on a stock chart. They provide the full range of calculations for Fibonacci levels. The Fibonacci ratios used for retracements and extensions are 23.6%, 38.2%, 50%, 61.8%, and 100%.
How are the Fibonacci ratios calculated? By taking numbers that are next to each other in the Fibonacci sequence and dividing them. Here is an example:
Let’s take the 10th and 11th Fibonacci numbers: 34 and 55.
34 divided by 55 = 0.618
Now, take two numbers apart from each other: 34 and 89.
34 divided by 89 = 0.382
What about three numbers apart? 34 and 144.
34 divided by 144 = 0.236
These calculations work for any of the numbers in the Fibonacci Sequence as long as they are next to each other. We should note that 50% isn’t significant in the Fibonacci Sequence. However, it’s used because it is frequently a pivot point for stocks looking for an area to retrace.
So, how can we use these on a stock chart? You can calculate 23.5%, 38.2%, 50%, 61.8%, and 100% from the range’s peak or trough. Each level tends to be a magnet for the stock’s price. Even if the price at these levels does not seem significant, you will often find that they will act as a strong support or resistance level.
Types of Harmonic Patterns
There isn’t a consensus on how many harmonic patterns are used for stock charts. Generally, most agree on the top seven harmonic patterns. Look at some more widely used harmonic patterns for bullish and bearish scenarios.
1. The Gartley Pattern
The aforementioned Gartley Pattern is one of the more popular harmonic patterns technical analysts use. The Gartley Pattern is used to identify a pattern change in the trend and predict when the stock will make the next leg up or down.
Bullish Gartley Patterns are shaped like M’s, while bearish Gartley Patterns are shaped like W’s. Both consist of five points of Fibonacci retests before a stock price moves sharply higher or lower.
There are two primary rules with the Gartley Pattern:
- The first retracement from point A to B must be the 0.618 Fibonacci line between the starting price X and the first move to A. XA is generally the peak to trough for the Gartley Pattern.
- The last retracement from point C to D, the final retracement before the ultimate trend change, is to the 0.786 Fibonacci line of XA.
If you can imagine an M or a W, XA is the first stroke in either letter. This is the key to predicting the next points in the shape measured by the Fibonacci lines of XA. The final retracement from C to D is the best place to enter to Buy or Sell the trade.
2. The ABCD Pattern
The ABCD pattern is the simplest harmonic pattern to identify on a stock chart. As you might expect, it has four points, A, B, C, and D, which move in three sequential steps. A to B is the first impulsive move. Next is a period of consolidation or correction from point B to C. Then, C to D is another impulsive move that has to be in the same direction as the initial move from A to B.
This results in a lightning-bolt pattern where AB and CD are identical in length. The one rule this pattern has is that BC should hit the 0.618 Fibonacci line from AB for the corrective move. The ABCD Pattern can be either bullish or bearish in sentiment.
3. The Butterfly Pattern
The Butterfly Pattern is very similar to the Gartley Pattern. Both produce an M or W shape depending on whether the trend is bullish or bearish. The main difference between the two patterns is that the Butterfly Pattern requires two separate Fibonacci retests, while the Gartley only has one from point A to B.
Rules for the Butterfly Pattern are fairly straightforward:
- The first retracement of A to B must be to the 0.786 Fibonacci retracement of the XA leg, where X is the original price.
- Point D is a potential reversal zone for entering a trade.
- The CD is typically longer than AB but can be the same length. Because of this rule, the Butterfly Pattern is often more lopsided than the Gartley Pattern.
4. The Bat Pattern
The Bat Pattern is a slightly more complicated ABCD Pattern with one extra point. The first retracement from A to B must hit the 0.50 Fibonacci line rather than the 0.618 line in the ABCD Pattern. Differences between the Bat Pattern, the Gartley Pattern, and the Butterfly Patterns are subtle. All three end up with M or W shapes for the pattern on the chart.
The primary difference for the bat pattern is a shallower retracement from B before. Also, the CD retracement must be longer than the BC retracement, or the Bat Pattern is invalidated.
Final Thoughts: Harmonic Patterns
So, do harmonic patterns work when predicting stock behavior? Like any form of technical analysis, nothing is a 100% certainty. Anything can happen that can impact the stock and invalidate a pattern that has formed or is in the process of forming.
However, like most technical analysis formations, harmonic patterns seem to happen and are often repeated enough on charts. Should it be the only instrument you use for entering or exiting a trade? Probably not! However, for many analysts, harmonic patterns provide a reliable pattern that can help guide a potential entry or exit area in the future.
Frequently Asked Questions
As with any strategy, this is completely up to a trader’s preference. We discuss four harmonic patterns used: the ABCD Pattern, the Gartley Pattern, the Butterfly Pattern, and the Bat Pattern.
Harmonic patterns are surprisingly successful as far as technical analysis goes. Many estimate that harmonic patterns play out at least 80% of the time. Just because a specific pattern plays out, it does not mean your trade will be successful. Always use harmonic patterns as a tool in your broader trading strategy.
This depends on the harmonic pattern you are following. Most harmonic patterns see retracements to the golden pocket area of the Fibonacci levels. This area is between the 0.236 and 0.618 Fibonacci levels, so you will see the correct patterns or extend back into this area.
The Golden Ratio in stock trading is the same in mathematical sequences like the Fibonacci sequence. This ratio is the 61.8% or 0.618 multiplier in Fibonacci levels. If you watch any chart long enough, you will frequently see the price revert to the 0.618 Fibonacci level as an area to retest.
The best pattern in stocks depends on your trading strategy. Some prefer harmonic patterns as the most reliable, while others prefer triangles or wedges. The head and shoulders pattern has one of the best rates of success in determining the imminent direction of the stock price.
