Harmonic trading is a method of analysing financial markets by recognising specific price patterns and their alignment to Fibonacci ratios in order to predict when a trend may reverse itself. Simple, huh? In fact, this article can barely scratch the surface of this topic. Should your interest be piqued, we recommend the book “The Harmonic Trader” by Scott M. Carney, on which some of this text is based.

The harmonic system assumes that trading cycles, like many patterns found in the natural world, repeat themselves. The idea is to identify these patterns and to enter or exit trades based upon the probability that a historic price movement will repeat itself, in some form at some point.

What are Fibonacci ratios, anyway?

Leonardo Fibonnaci was a pre-Renaissance Italian mathematician who discovered a numerical sequence and ratios based on it that turned out to describe numerous natural phenomena, from the proportions the human eye finds most pleasing in art to the way in which flowers arrange their petals.

The same math is also used in technical analysis. In particular, the Fibonacci sequence predicts that a stock’s support and resistance levels (prices at which sellers and buyers, respectively, lose their appetite and action slows) occur at particular percentages of the range between some significant historic high and low. In principle and much of the time, an upward trend approaching these levels will become negative, while a falling stock tends to start rising.

Harmonic patterns to make Fibonacci levels more objective

Something that’s often asked about using the Fibonacci system is: How exactly do you sift through the dozens of ratios and lines on the typical price chart and find something that can actually be of practical use?

There are a number of different Fibonacci levels and, in theory, it is possible to make trading decisions based on any or all of them. But, with that said, this is generally not advisable: the noise starts to overwhelm the signal, and you’re left with something akin to reading tealeaves.

This is where harmonic patterns attempt to make the process more objective. Harmonic patterns match a specific Fibonacci ratio to the particular context in which it occurs. In this way, Fibonacci retracements, extensions, and projections can be used to objectively define which levels are important and which ones are just false positives.

Interpreting harmonic patterns

Below are two typical harmonic patterns, one representing a possible bullish turning point and one associated a possible bearish turning point. It’s amazing how common these kinds of patterns are!

Each letter in the pattern represents a high or low pivot level, with the exception of the D point, which indicates a possible pivot level. When defining a pivot level with harmonic trading, you use the specific Fibonacci levels for each pattern and look for where the price meets the rules and forms a turning point.

The D point is where the trade could be entered, while everything else in the pattern is there to help identify an exact level where the D point will fall.

The relationship between the different points (except the one we mentioned one) constitute an interval of Fibonacci levels. The following five steps show how to find each point (X, A, B, C, D):

1. Identify a distinct starting point (X). Usually, it’s not hard to discern a clear high or low price point by looking at recent historical price movements.
2. The A-point is the first pivot point that occurs at the end of an initial move up or down. This point does not have to be coordinated with a Fibonacci level, but is used when determining where both the B-point and the D-point will fall.
3. The next price move will show us where the B-point will be located and is one of the defining levels when deciding what kind of pattern we are looking at. It is measured by taking the Fibonacci retracement from X to A and will, for example, in the patterns seen above, have to be somewhere between 38.2% and 61.8%. (A 50% retracement is considered most significant).
4. The next move, to the C-point, can end somewhere between 38.2% and 88.6% of the distance between the A and B points – in other words, a Fibonacci retracement of the previous price move from A to B. 
5. The D-point, consisting of several Fibonacci levels to determine the exact level we are looking for, and is in this case an exact ratio of 88.6% retracement of the distance between points X and A.

Making sense of it all

To dig deeper and determine the most important level, here are some extra ideas to consider. 

• Whether the AB=CD structure exists (either encompassed by price swing XA or poking out beyond it) and is somewhere between a 1:1 (AB actually equals CD) or 1:1.618 (the CD leg is longer).
• The ratio the B point falls on (in relationship to the XA swing) tells you what kind of pattern you’re looking at (eg .50 is called a “bat”, .786 is a “butterfly”, etc).
• Knowing the pattern type tells you the primary ratio around which the D point should fall. This ratio, like the B point, is expressed as a percentage of the XA swing.
• The BC extension and AB=CD projection tell you how much further (if at all) to look past the XA-defined level for the pattern to complete.

Once all this is done, you’re left with three levels that form a zone. These are the BC extension level, the AB=CD projection level and the primary ratio for each pattern. Although we call this a “zone”, this whole process is really about finding one number, one ratio level that can be acted upon.

These three ratios don´t always fall in the same order, and so it is the ratio identified to be lowest (bullish pattern) or highest (bearish pattern) that is most important when you continue to identify, verify and execute your trade. 

In conclusion

The harmonic pattern provides the price zone in which the next reversal could most realistically take place. For execution purposes, using a smaller timeframe or other technical analysis techniques like price action, candlestick patterns, and indicators like RSI can strengthen and confirm the trade setup.

Of course, most readers will find the above confusing, verging on incomprehensible. This is not to annoy you, but the natural consequence of trying to give an overview of a complex topic in as few words as possible. It’s no secret, and no surprise, that financial companies are always eager to hire mathematicians and physicists, even if they don’t initially know what a balance sheet is!

Don’t give up on technical analysis completely, though. Start with the basics, read a little, and expand your knowledge as you go. If nothing else, technical indicators and mathematical wizardry can confirm, or throw a little much-needed doubt on, conclusions reached through fundamental analysis.