110118 - Float like a Butterfly, sting like a.... errr ... Crab? - Harmonic Patterns

Oooh Daddy, look at the beautiful butterflies ....

I have long been interested in harmonic patterns. The basic premise is that there are certain shapes in the price series which empirically suggest what will happen next. Whether or not you give this any credence or not, it is an interesting study, the by-product of which can be much valuable market insight.

Harmonic patterns are based on Fibonacci retracements, i.e determining where a "golden" ratio of peaks vs troughs exist, and buying/selling accordingly. Putting the numbers to one side (we will come to that in a moment), to me it is quite intuitive to say that a price may rise after it has made a significant fall (bullish signal), or fall after it has made a significant rise (bearish signal).

Gartley 222, named after page 222 of Gartley's book!

There are many websites that describe both harmonic patterns and Fibonacci ratios, so I will not repeat that work here. My favorite site is http://www.harmonictrader.com/price_patterns.htm

Whether or not you believe that Fibonacci numbers actually work, there are perhaps so many market participants who do, that it is a self-fulfilling prophecy, and that could be true of any such empirical signal. Imagine 25,000 harmonic pattern traders saying "OMG, there's a bearish bat formation, sell the farm ......".

One of the drawbacks with Harmonic Patterns, for many retail traders, is that to see a significant amount of patterns, you need a lower timeframe. If you study 4 hour charts, classic patterns except for Fibonacci retracements are few and far between, that is why most pattern indicators have a tolerance input, which you can increase to get more patterns. Of course, this potentially invalidates some signals. I think this explains the continuing amount of new patterns being invented, as the majority of retail FX traders don’t make trades based on H4 signals and then keep the trade on for a month. Probably due to boredom. My pattern indicator detects and displays:

AB=CD

Bat

Butterfly

Crab

Fibonacci Retracements

Gartley

5-0

Bearish AB=CD

You will observe many more Fibonacci retracements than full classic patterns. If you recall that ALL classic harmonic patterns have some Fibonacci retracement component, then that’s not surprising. By default, my indicator has Fibonacci retracements turned off. Not that I don’t think they are valid, merely because most people who are interested in the indicator want to see the larger patterns. Of course you can reverse this, and just trade the Fibos alone.

The majority of commercial indicators are repainting, and use a method of determining retracements which means they miss the trade entry by a considerable margin. They do not include easily accessible signal buffers.

You can tell that these indicators have been written by very clever individuals, given the amount of signals and measurements produced. Do users really want to see the results in a zillion different muddy colours, or would they rather understand that the patterns are displayed on a colour cycle that is easy on the eye when the user is staring at the screen for 8 hours? Does the indicator perform well in real-time? Try setting your favourite pattern indicator to have a 10,000 bar history, and attach it to an EA in the strategy tester. In visual mode, move the speed control to the extreme right (fastest). Does it keep up or does it stutter with the load? This is a measure of  “On-Off” ratio and shows how much of your system resources the indicator will use. In the same test, does it give multiple signals at slightly different bars on each bar open? That is the difference between writing code and production engineering.

Bearish 5-0

For most types of trading, stops and profit targets are the key to successful trades. When the indicator gives you a valid bullish signal, you still need to know how big your stop should be and where your profit target is. There is a whole other layer that needs to be put on top of this or any other indicator to achieve that automatically.