Harmonic Patterns are one of the powerful advanced price action techniques that are used to detect reactions. The thing that works about Harmonic Patterns is that they use the confluence method, meaning that they expect reactions from clusters of certain levels defined by Fibonacci retracements. The reason they work has nothing to do with mystic or magic whatsoever, it is simply the fact that Fibonacci retracements are used by many traders and their visibility makes reactions more likely, thus increasing the predictive power of the patterns. However, only using Harmonic Patterns on their own might not be sufficient as we will see below, they are best combined with contrarian indicators to increase the chances of a profitable trade.
Introduction to the Fibonacci Sequence
Leonardo Bonacci, known as Leonardo Fibonacci has developed a sequence out of rabbit mating which formed the basis for many mathematical observations. The sequence follows this distinct pattern:
The numbers are found by adding the previous two numbers behind them. In the case of 13, it is calculated as 8 + 5, hence the formula is:
The beauty of these numbers is a certain ratio, called the golden ratio. If we take any two successive numbers in the sequence, their ratio (Xn / Xn-1) gets closer to 1.618 which is what we call the golden ratio:
It is not important how we got to trading from these patterns as much as how important they are, therefore, we will discuss the ratios from a financial trading perspective. Let us keep the 1.618 in mind as for the moment it is one of the two most important ratios that we will use in trading. Our job now is to find the rest of the significant ratios useful to us in trading. They are all variations of 1.618 and its reciprocal 0.618. Notice how the reciprocal of 1.618 is simply 0.618. A reciprocal is when you divide 1 by the number. The below table summarizes the rest of the ratios and how we got them:
We will now proceed to define the Butterfly Pattern and how to detect and trade it.
The Butterfly Pattern
The Butterfly pattern is another complex harmonic configuration that is similar to the Gartley discussed in a previous article but has one distinct difference. The third leg breaks the edge of the second leg. That is, a bullish Butterfly pattern will have an M shape with the second leg lower than the first leg. Here are the conditions for a perfect Butterfly pattern:
- The first leg should retrace back 78.6%.
- The second leg should retrace back 50.0–61.8%%.
- The third leg should retrace back 161.8%.
- The whole retracement from the beginning to the top should retrace 127.2%.
It becomes clear that a bullish Butterfly resembles an M with the second leg lower than the first leg, while a bearish Butterfly resembles a W with the second leg higher than the first leg. We expect a form of reaction around the D point. The pattern is always composed of five points in time XABCD where we trade the last point and manage our risk according to specific measure discussed in the last part of the article.
Detecting the Butterfly Pattern
The Butterfly Pattern can start to be detected around the middle of point C. Therefore, we have enough time to act on it without any hindsight bias or delay. The below plots show how to detect one across time:
The first step above is simply detecting an impulse move following by a reactionary move that should retrace back to 78.6%. After that we have to wait whether the reaction will retrace back to 50%-61.8% of the new leg or not.
Having retraced back of the new leg, we are now looking for 161.8% retracement of the new leg and the break of the B point. We should start to see about now the formation of an M (Bullish Butterfly).
Now, we can even draw the Butterfly. All we need is the expected reaction from the D point defined as the 127.2% retracement from the X point all the way down to the A point as well as the 161.8% retracement of the BC move. This means that the length of the CD leg should equal 1.618x the length of the BC leg.
And finally, we should manage the reaction according to the risk management measures outlined in the last part of the article.
Combining the Butterfly with the RSI
Having a Butterfly Pattern at its D point (pending reaction) and an RSI around extremes or in divergence is a good confirmation of the trade and is a conviction enhancer. But what is the Relative Strength Index?
The RSI is without a doubt the most famous momentum indicator out there, and this is to be expected as it has many strengths especially in ranging markets. It is also bounded between 0 and 100 which makes it easier to interpret. Also, the fact that it is famous, contributes to its potential.
This is because the more traders and portfolio managers look at the RSI, the more people will react based on its signals and this in turn can push market prices. Of course, we cannot prove this idea, but it is intuitive as one of the basis of Technical Analysis is that it is self-fulfilling.
The RSI is calculated using a rather simple way. We first start by taking price differences of one period. This means that we have to subtract every closing price from the one before it. Then, we will calculate the smoothed average of the positive differences and divide it by the smoothed average of the negative differences. The last calculation gives us the Relative Strength which is then used in the RSI formula to be transformed into a measure between 0 and 100.
Trading on the patterns requires touching the implied reversal zone, also referred to as Potential Reversal Zone — PRZ. A basic tule of thumb that we can follow when trading is to place two targets with the first one being at 38.2% of the top to bottom (or bottom to top) retracement and the second one being at 61.8%. The stop will be placed at half the distance between the entry and the second target thus ensuring a 2.0 risk reward ratio. I generally take half the profits at the first target and move the stop to breakeven, that way I ensure that the trade never loses money in case the price comes back unfavorably. Below is an example on the simples of Harmonic Patterns, the ABCD pattern showing clear risk management.
Contrarian trading using price action and indicators is a powerful tool to profit from intermediate market reactions. As is known, no strategy is perfect but with proper risk management, a good strategy will last long and provide the expected outcome. We need to always be aware of any fundamentals when trading the patterns on the higher time frame like Weekly charts as we all know, fundamentals are what push prices over the long-term horizon. Also, on the short-term, we need to be always aware of any expected news of economic releases that may induce short-term noise. Technical Analysis does not work when everyone is panicking or hopping on euphoria. It is a tool for normality combined with a slightly statistical extreme.