The first who expressed the idea of harmonic patterns were the stock theorists Larry Pesavento, Harold M. Gartley, and Scott M. Kearney, moreover, the leader of these three was Larry.
Nevertheless, Gartly’s book “Profits In The Stock Market” (1935) with a detailed description of the general models revolutionized the technical analysis and the first limited edition copies were sold at a higher price than a car.
Both classical and modified Pesavento patterns are based on the Fibonacci correction levels, and therefore they forecast the key market points at any asset and timeframe with high precision and are perfectly scaled in the process.
Now anyone can use these trading methods absolutely for free, and the majority of technical indicators will automatically find and build the patterns on the price chart, so let’s begin.
Harmonic models are built on the standard Fibo levels in the strict order. For visibility, let’s look at the Gartley butterfly pattern — a reversal of the upward trend is expected.
Main price movement — the [X-A] section (sometimes [0-A]), basic Fibo net is built on it. From point A the market must give the first adjustment wave upwards, which must end in the level 61,8% zone (point B).
We remind: if the adjustment for [A-B] movement is less than 61,8%, then there is a high probability of continuing the current trend and entry at the market in point D is canceled.
The formation time of separate pattern areas must be roughly equal; it is undesirable for any of them to be formed at speculations (1-2 bars).
The emergence of harmonic patterns is accompanied by divergence on one of the oscillators (MACD, Stochastic, RSI), then the probability for the reverse at point D increases.
The classic model requires the fulfillment of the key condition [C-D]=[A=B], other parameters allow variations.
The adjustment of [A-B] may reach the level 50%, and the movement of [C-D] — to get stuck at 61,8%, but the equality of these sections must be followed (with a deviation no higher than 5%) with any configuration of the butterfly (see Using Graphic Tools).
The main problem of harmonic patterns is that ideal compliance of parameters at the real market is met very rarely. Usage of additional compliances between the Fibo levels allows using non-standard harmonic patterns.
Let’s look at it in detail.
We remind that tick volumes act in the same way in all models (regardless of direction):
Today over 20 models are considered harmonic, though most of them are modifications of the most stable ones, which are shown below. The main differences lay only in correlations between the position of the key points.
With entering the market by the classic Gartley model (see above), Stop Loss can be placed behind the extremum of the main movement.
If the Pesavento option is used, then we set Stop Loss behind the next Fibo level or on the chosen money management system. It is recommended to enter the market with a pending order.
At the entry, Stop Loss is set above/below point 0 with some margin. One may enter both with pending order and by the market price — it doesn’t really affect the result.
When working with such a model, a fixed Stop Loss is used, which is defined by the money management system and depends on the timeframe.
Basically, Gartley has no relation to this model — it was tested and justified only in 2011.
This is an option of the ‘5-0’ pattern, but the entry is made in point 4 and gives a chance to take a profit already in the moment of forming section [4-5] and to turn over after its forming. The Take Profit level is suggested in about the middle of range [3-4].
The model is hard for trading because of strict requirements for the mutual placement of separate elements. It is rarely diagnosed in the real market, but it is considered more reliable than standard patterns.
The entry is at the market price or by a pending order; Stop Loss is on the next Fibo level; no strict rules for Take Profit.
Pattern ‘Tree movements’
The model is three sequential max/min (in the interpretation by Linda Raschke — the ‘Three Indians’ pattern). There is the trend reverse happening at the point or at least the beginning of a strong adjustment.
A human being is lazy by nature, that’s why calculations and graphic constructions of harmonic patterns have been automated long ago: various options for the ZUP indicator can be easily found on the web. It significantly facilitates the trader’s life.
What this means is ZUP will define and ‘draw’ a model, show the key points (entry, Take Profit/Stop Loss) and if the correlation between the pattern elements is failed, it gets removed from the current graph.
Harmonic patterns are formed on any timeframes, but constructions at D1 are considered the most stable.
The emergence of analogic patterns on multiple timeframes simultaneously significantly increases the probability of working the standard scenario.
Entering the market with a pending order is possible in the event that all the pattern form is close to ideal, otherwise one should wait till the final point is formed and enter at the market price.
Even externally ‘correct’ Gartley’s Butterflies or Pesavento patterns are rather hard constructions, absolutely unbalanced in time, they don’t guarantee the real reverse.
That’s why Take Profit is better to be placed at 0,7-0,8 from the model height at the points or to pull up Stop Loss by tailing.
Patterns can be used as ready-made strategies, but it is still recommended to check their signals with additional indicators, candlestick combinations or additional graphic constructions. (see Using Indicators)
Gartley’s Butterfly remains the most understandable and hence the most popular figure, but the effectiveness of all model options is very high: up to 85% of deals based on these signals are closed in a profit.
Trades who have mastered working with harmonic patterns, always have statistic advantages, if they can wisely control risks of course.
As you can see, backtesting is quite simple activity in case if you have the right backtesting tools.
To check this (or any other) graphical analysis you can download Forex Tester for free.
In addition, you will receive 20 years of free historical data (easily downloadable straight from the software).