Trading the Golden Harmonic Pattern
Presenting and Trading the Golden Harmonic Pattern
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.
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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 Pattern and how to detect and trade it.
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The Golden Harmonic Pattern
This pattern is not really a discovery for me, it is merely an attempt to find a confluence of perfect ratios. I have found out that many patterns have intervals of ratios, this makes them vague and have overlapping nature. My attempt was to find a pattern with exact ratios.
Sure, it is rare to find this pattern but in my personal experience, it works well. It is also the only complex pattern that uses solely the perfect ratio with the first leg retracing 61.8%, the second leg retracing back 161.8%, the third leg retracing also 161.8% and the final retracement is a 224.0% which is the sum of the golden ratio (161.8%) and its reciprocal (61.8%). I like to use this ratio in combination with technical indicators or long-term moving averages to really have a strong conviction on the trade.
The beauty of this pattern is that it signals often stronger reversals than the rest of the patterns. It should not however be the expectation as with harmonic patterns, we only want to play reactions and not full trend reversals. Nevertheless, it is interesting to know that the reaction can be strong. I have also called it a Modified Shark pattern because It resembles the original Shark pattern.
Detecting the Golden Harmonic Pattern
The Golden Harmonic (Modified Shark) Pattern can start to be detected around the time a reaction is done at the 161.% level (second retracement) after the below reactions have been done.
The first step above is simply detecting an impulse move following by a reactionary move that should retrace back to 61.8%. After that we have to wait whether the reaction will retrace back again to 161.8% of the new leg or not.
Now, we will wait for the reaction above the 161.8% to continue higher towards the next Fibonacci levels as seen in the below plot.
Now, we can even draw the Golden Harmonic Pattern. All we need is the expected reaction from the D point defined as shown in the below plot.
And finally, we should manage the reaction according to the risk management measures outlined in the last part of the article.
Combining the Golden Harmonic Pattern with the RSI
Having a Golden Harmonic (Modified Shark) 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.
Risk Management on the Golden Harmonic Pattern
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.
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Summary
To sum up, what I am trying to do is to simply contribute to the world of objective technical analysis which is promoting more transparent techniques and strategies that need to be back-tested before being implemented. This way, technical analysis will get rid of the bad reputation of being subjective and scientifically unfounded.
I recommend you always follow the the below steps whenever you come across a trading technique or strategy:
Have a critical mindset and get rid of any emotions.
Back-test it using real life simulation and conditions.
If you find potential, try optimizing it and running a forward test.
Always include transaction costs and any slippage simulation in your tests.
Always include risk management and position sizing in your tests.
Finally, even after making sure of the above, stay careful and monitor the strategy because market dynamics may shift and make the strategy unprofitable.
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