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Forex Trading Basics: How to Spot and Trade Harmonic Patterns

   

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If you’re serious about forex trading, you need to understand how charts and chart analysis tools can help you identify trades that maximize your potential earnings while minimizing risk. 

Standard chart patterns are easy to identify just by glancing at a chart and spotting certain movements, but advanced patterns, also known as harmonic patterns, require additional tools and information to identify trade opportunities and monitor price movements.

These harmonic patterns offer incredible value to traders who use them to inform their trading plan, and all of the tools you need to spot and track these patterns are available on online platforms such as MetaTrader 5. In general, the key characteristic of any harmonic pattern is the way the chart movement corresponds to the famous Fibonacci levels.

The History Behind Fibonacci Levels

Fibonacci levels are named after the Italian mathematician Fibonacci, who played a significant role in the rising popularity of mathematics in Europe in the 12th and 13th centuries. His most significant contribution was the development of a “golden ratio” and a number sequence that now bears his name as the Fibonacci levels used in investment trading.

The logic behind these levels has to do with the ratios created between this string of numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.

This series of numbers goes on indefinitely, and the next number is determined by adding together the two numbers that precede it. In this example, 89 + 144 = 233, which is the next number in the sequence.

Ratios can be used to measure the relationship between all of these numbers. Dividing one number by the number following it, for example, yields a %age of 61.8. Divide that same number by the second number to the right, and the %age is 38.2. These numbers form the framework for Fibonacci ratios, which the mathematician claimed bore a relationship with the natural order of the world. 

The most common figures used are 11.4 %, 23.6 %, 38 %, 61.8 %, 70.7 %, 76.4 %, 88.6 %, and 100 %. Although it’s not technically a Fibonacci number, 50 % is also regularly used in Fibonacci-based trading.

Here’s a look at how Fibonacci levels are displayed on a EUR/USD chart:

Today, investors use these numbers because they tend to reflect the price movements taking place in forex and other markets. By turning these ratios into levels reflecting the extensions and retracements of a currency pair’s price, traders can estimate when price shifts will occur, and they can time their trades to maximize profits when a currency pair’s movements align with these ratios.

 

The Importance of Fibonacci Levels

Harmonic patterns are named after measurements known as Fibonacci levels, which are mathematical markers, expressed as ratios, that are used to indicate potential lines of support and resistance with a given asset. 

Harmonic patterns develop when an asset’s price movements reach certain Fibonacci markers, moving both up and down in retracements and extensions that can foreshadow price breakouts. Although there are exceptions, most harmonic patterns feature four price movements from a starting point, X.

By studying these retracement levels and using them to time your trades in forex, you can reduce your risk. The graphic below shows the lines of retracement and range of risk associated with an asset that has fallen into a harmonic pattern:

The pattern that has developed indicates a future price breakout. An overeager trader might try to open a position quickly after the fifth point is established, in fear of missing out on the breakout if they wait too long. But the guidance provided by the Fibonacci levels, and the prevailing strategy used when analyzing harmonic patterns, suggests that traders are better off waiting until the price moves closer to the 61.8% retracement level. 

This patience minimizes the potential risk if your prediction is wrong and the price dips to the stop area, and it increases your range of potential profit if your prediction is right.

Advantages and Disadvantages of Fibonacci-Level Trading

Fibonacci levels are a popular tool for forex trading for a few reasons. The first reason is their relative ease of use: Levels are easily displayed on a forex chart, and even amateur traders can monitor price movements in relation to these levels, which can be useful in developing an eye for identifying trades.

Fibonacci levels are also useful for traders embracing a trend-trading strategy, largely because the Fibonacci numbers themselves are designed to identify and predict trending movements. Traders can use levels of resistance, as well as extensions beyond those levels, to identify a strong trading opportunity.

The biggest challenge is that Fibonacci levels are inherently subjective and can be interpreted in different ways based on who is reviewing the chart. Results from using Fibonacci levels can vary widely. 

Whereas some traders are passionate supporters of this strategy, detractors argue that the Fibonacci levels themselves aren’t connected to any concrete financial or economic theory. The most reliable aspect of using these ratios is that, when many other traders are also tracking movements along these levels, the ratios can become self-fulfilling prophecies: Enough traders anticipate the influence of these levels that Fibonacci ratios end up being relevant to the price movements on the forex market.

Although these ratios were developed by a renowned mathematician, the theory behind them does not have any proven logic behind it. The lack of mathematical validity to these ratios can be off-putting to traders who are looking for a more data-driven approach.

Understanding the Gartley Pattern

One of the most famous patterns in history, and the most important harmonic pattern to understand in forex trading, is the Gartley pattern. This pattern has been modified over time since it was first conceived by H.M. Gartley in 1932, and many other harmonic patterns—including butterfly, bat, crab, and cypher patterns—all exist as variations of the Gartley pattern, with different Fibonacci ratios used to define their shape. If you understand the Gartley pattern, it’s easier to apply these other harmonic patterns to your forex evaluations.

To identify a Gartley pattern, you first need a plain chart with no indicators present other than the Fibonacci lines. Any chart being analyzed for harmonic patterns needs to have four price movements that switch directions each time, with points X, A, B, C, and D. In this sequence, point C needs to have a 61.8% or 78.6& retracement from point B. At the same time, the movement of lines AB and CD must match, and point D should be a 78.6% retracement of point X.

If these parameters are all met, you’ve got a Gartley pattern. Points A and C will tell you whether the price setup suggests a positive or negative breakout: If A and C are the highest points on the chart, you can likely expect a price decline. If A and C are lower than X, B, and D, plan for a price breakout. The chart below illustrates a bullish Gartley pattern that has developed on a GBP/USD chart:

Taking a Profit

Because you’re using Fibonacci lines to identify patterns and time your trades, you can also use them to decide when to take a profit. Consider two profit goals, depending on your own evaluation of a forex asset’s potential price movement. One goal comes at a 38.2% retracement, at which point you can safely close your position and claim a profit. Or, if you’re feeling confident in the price, you can consider waiting until a 61.8% retracement, capturing a nice return from your harmonic pattern analysis.

Conclusion

Harmonic patterns may be more complicated to analyze than standard patterns, but they offer clear rules when you’re making trades. Incorporate this analysis strategy into your trading plan to improve your risk management and your ability to time your trades.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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