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A Few Notes on Harmonic Trading, Volume One

| | Posted in: Technical Trading

In his 2010 book entitled Harmonic Trading: Volume One, Profiting from the Natural Order of the Financial Markets, author Scott Carney presents “an important advancement of the gamut of technical trading strategies that seek to define opportunities in the financial markets through the identification of price patterns and the analysis of market structure. …Most important, Harmonic Trading possesses unique and effective technical measurement strategies that define critical new patterns and expound upon the existing knowledge base of general Fibonacci and price pattern theories to establish precise guidelines and extremely effective predictive tools to define and analyze market trends.” Focusing on the first three chapters, which provide background on the harmonic trading methodology, key points from the book are:

Chapter 1, “Harmonic Trading” (Pages 7-8): “Harmonic Trading is a methodology that utilizes the recognition of specific structures that possess distinct and consecutive Fibonacci ratio alignments that quantify and validate harmonic patterns. These patterns calculate the Fibonacci aspects of these price structures to identify highly probable reversal points in the financial markets. …When applied to the financial markets, this relative analysis of Fibonacci measurements can define the extent of price action with respect to natural cyclical growth limits of trading behavior. …the collective entity of all buyers and sellers in a particular market follow the same universal principles as other natural phenomena exhibiting cyclical growth behavior. …Harmonic Trading identifies specific repetitive situations within the chaos of the financial markets.”

Chapter 2, “Fibonacci Numbers” (Pages 17-18, 34): “…Harmonic Trading techniques identify price action that reacts to these defined levels of support or resistance. The gamut of Fibonacci numbers utilized in Harmonic Trading is either directly or indirectly derived from the primary ratios 0.618 and 1.618 from the Fibonacci sequence. The primary numbers, when utilized in combination with the derived ratios from the sequence, validate harmonic patterns and define the potential areas of change in price action. …The true uniqueness and effectiveness of these numbers can be found in the combination of their specific ratio alignments. …The principles of Harmonic Trading are instilled in the origins of natural laws that govern many of life’s cyclical growth processes. When applied to the financial markets, these measurements offer an effective means to assess the state of price action. Furthermore, these ratios serve as the primary basis that validates price structures as harmonic patterns. …Harmonic Trading demystifies the frequently misappropriated use of Fibonacci analysis with respect to the financial markets.”

Chapter 3, “Pattern Identification” (Pages 35, 37, 39-40): “Harmonic patterns are defined by specific price structures quantified by Fibonacci calculations. Essentially, these patterns are price structures that contain combinations of distinct and consecutive Fibonacci retracements and projections. By calculating the various Fibonacci aspects of a specific price structure, harmonic patterns can indicate a specific area to examine for potential turning points in price action. …harmonic patterns are probably the most specific technical price patterns due to the specific Fibonacci measurements of each point within the structure. These measurements provide a tremendous advantage in that they serve to quantify and categorize similar price structures as distinct…potential trading opportunities can be differentiated, offering pattern-specific strategies for each situation. …Like a combination to a safe, Harmonic Trading’s precise Fibonacci price alignments unlock valid market signals in an unprecedented fashion. …this approach generates valid trading signals based upon pure price action that is quantified by Fibonacci measurements and pattern recognition techniques. …the Harmonic Trading techniques will always provide critical information regarding the state of future price action.”

Chapters 4-8 define and give examples of the following patterns: AB=CD, Bat, Gartley, Crab and Ideal Butterfly.

Chapter 9, “Trade Execution” (Pages 171-173, 181): “Since the same patterns yield different results, it can be difficult to try to “outguess the market” and know which setups will work. …preparing and determining which positions to execute follows a set of identification rules that quantifies patterns, assesses price action, and defines the parameters of each trade, including the entry, the stop loss and the profit objective. Such preparation is critical to prevent execution mistakes and to determine the optimal entry… The completion of a pattern creates a unique ‘technical window’… The ability to interpret a pattern’s validity within this technical window will improve with experience, as the same set of circumstances continually manifest traits of a valid reversal well before the big move begins. …Harmonic Trading frequently looks better in the past than it does in the present or the future. It is easy to identify past patterns in price charts and lay claim to what could have been. Unfortunately, the uncertainties involved with real-time executions frequently alter the true outcome.”

Chapter 10, “Price Action in the Reversal Zone” (Pages 185, 202): “An ideal reversal usually possesses several characteristics that clearly separate it from other types of price reactions. …The type of price bars that form at the completion of a pattern can provided extensive information regarding the potential state of the future trading action.”

Chapter 11, “The Harmonic Trade Management System” (Pages 205, 231): “In the same sense that effective pattern recognition rules the Harmonic Trading techniques are employed to identify potential opportunities, it is critical to have guidelines that maximize the management of positions and gauge the price action after a setup has been executed. The trade management rules address all possibilities in advance, enables you to respond to any situation, and instills confidence in your execution skills. …each position must be must be handled properly to maximize profits and minimize losses. Although two harmonic trades may possess the same patterns with identical Fibonacci ratios, their outcomes can be completely different.”

Chapter 12, “Pattern Violations” (Page 250): “Although valid patterns are quite accurate and identify excellent trading opportunities, there are many cases where the predominant trend overwhelms the anticipated completion of a pattern. Despite the failed reversal, the distinct price action at the completion of a pattern frequently possesses extraordinary behavior that acts as a clear signal for the continuation of the predominant trend.”

The author relies on selective sampling (examples) to illustrate the potential effectiveness of the methodology presented. This sampling approach is susceptible to data snooping bias (especially for complex rules/alternatives) and confirmation bias, and leaves any sense of profitability implicit. In general, the author asserts but does not quantify on either a per-trade basis or a portfolio level the statistical and economic significance of featured timing methods, patterns and trading practices.  Examples of such assertions, in addition to the above excerpts, are (underlining added):

Page 7: “This methodology assumes that harmonic patterns or cycles, like many patterns and cycles in life, continually repeat. The key is to identify these patterns and to enter or to exit a position based upon a high degree of probability that the same historic price action will occur.”

Pages 7-8: “The evidence of harmonic patterns in the financial markets can be found in price charts. …Patterns that form over a particular period of time reflect a signal or technical ‘signpost’ that can indicate the state of potential future price action. Furthermore, these situations have been historically proven to repeat and can identify significant potential trading opportunities with favorable risk-to-reward considerations.”

Page 8: “Many events in the markets have repeated historically through the years. Significant corrections have occurred in October, which are usually preceded by a late summer peak. In addition, many common events such as defined levels of support and resistance or trend lines define repeating market action on a daily basis.”

Page 9: “Harmonic Trading techniques utilize historically proven and repetitive price patterns that capitalize on overbought and oversold signals generated by the market’s technical price action.”

Page 38: “…Harmonic Trading utilizes quantifiable price patterns that have repeated historically…”

Page 40: “Past patterns and historically significant Fibonacci levels are an effective means of identifying important areas of support and resistance….Harmonic Trading requires a belief that the markets provide the signals necessary to understand price action.”

Page 96: “The Bat pattern is probably the best harmonic pattern of them all! Bat structures represent powerful corrective signals that identify excellent trading opportunities that are retesting significant levels of support or resistance.”

Page 148: “The Crab is an incredibly accurate and consistently effective pattern within the Harmonic Trading arsenal to identify critical turning points in the markets.”

Page 172: “…in my research of harmonic price action, I have found that the stronger and quicker the reversal, the greater potential for a nice move.”

Page 175: “History has proven that a convergence of Fibonacci ratio projections, especially specific harmonic price patterns, can identify critical technical areas of support and resistance.”

Page 233: “Despite the potentially volatile price action associated with a failed pattern, these situations when identified correctly do offer excellent trading opportunities.”

Page 251: “Although Harmonic Trading techniques are extremely effective in long-term and general market analysis…”

The author could greatly strengthen these assertions by presenting rigorous statistical evidence that they translate to consistent, material profitability at the portfolio level (sufficient in both frequency and typical profitability of trading opportunities).

In summary, Harmonic Trading: Volume One describes an approach to developing expectations for the behavior of financial asset and asset class prices based on the belief that these prices naturally follow trajectories (form patterns) generated by a process governed by Fibonacci ratios. Although the book offers many examples of pattern analysis, it does not quantify any benefits of such analysis empirically in terms of per-trade or portfolio level profitability.

For discussion of rigorous empiricism, see “Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals (Chapter-by-Chapter Review)”, which quotes author David Aronson: “[Technical analysis] must evolve into a rigorous observational science if it is to deliver on its claims and remain relevant.”

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