Harmonic Trading - Scott Carney.pdf

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Harmonic Trading What is Harmonic Trading?  Harmonic Trading is a methodology that utilizes the recognition of specific price structures that possess distinct and consecutive Fibonacci-derived ratio alignments to quantify and validate harmonic patterns.  These patterns calculate the ratio aspects of each price structure to identify the natural reaction / reversal points in the financial markets.

 Harmonic Trading respects the natural phenomenon of cyclical movements of growth and decline within the markets. Order within the Chaos of Life (&The Markets): Many have argued that the financial markets are a random entity. According to the Random Walk Theory, popularized in the book, The Random Character of Stock Market Prices, by Paul H. Cootner (ed.), (MIT press, 1964), price action is "serially independent," claiming that price history is not a reliable indicator nor of predictive value of future action. Principle of Harmonicity Despite the randomness of the markets, J.M. Hurst argued in favor of the relative importance of price history in his Principle of Harmonicity, which states: “The periods of neighboring waves in price action tend to be related by a small whole number.” (Hurst, J.M., J.M. Hurst Cycles Course, Greenville, S.C.: Traders Press, 1973.) Harmonic Trading adapts this Principle to measure “neighboring waves” through the use of Fibonacci-derived ratios instead of a “small whole number.”

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Fibonacci Foundation - Origin of the Fibonacci Sequence Fibonacci numbers are based upon the Fibonacci sequence discovered by Italian mathematician Leonardo de Fibonacci de Pisa (b.1170-d.1240). The series was devised as the solution regarding rabbits reproductive capabilities. The Mathematical Problem: If a newborn pair of rabbits requires one month to mature and reproduce at the end of the second month and every month thereafter, how many pairs will one have at the end of “n” months? The answer is: un This answer is based upon the following equation: un +1 = un + un -1. The sequence of the Fibonacci numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,144, 233, 377……

(infinity)

Beginning with zero and adding one is the first calculation in the numeric series. The calculation takes the sum of the two numbers and adds it to the second number in the addition. The sequence requires a minimum of eight calculations. (0+1=1)...(1+1=2)...(1+2=3)...(2+3=5)...(3+5=8)... (5+8=13)…(8+13=21)…(13+21=34)…(21+34=55)…(34+55=89) After the eighth sequence of calculations, starting with the sum of the eighth calculation (34) as the numerator and using the sum of the ninth equation (55) as the denominator, the result yields 0.618. 34/55 = 0.618181 ~ 0.618 Repeating the process, the next division of the ninth calculation (21+34=55) and the tenth calculation (34+55=89) equals 0.617978 or 0.618. 55/89 = 0.617978 ~ 0.618 HarmonicTrader.com, L.L.C. Copyright 2010

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In the inverse calculation of these numbers, the same rules apply 55/34 = 1.676471 ~ 1.618 Repeating the process, the next division of the tenth calculation (34+55=89) over the ninth calculation (21+34=55) equals 1.618182 or 1.618. 89/55 = 1.618182 ~ 1.618

Fibonacci Phenomenon - This methodology assumes that harmonic patterns or cycles, like many patterns and cycles in life, continually repeat.  Plants - Fibonacci Phyllotaxis is the discipline of studying and classifying the number of visible spirals, called parastichies, of flowers and seed growth patterns within plants. Most commonly, various plants grow seeds or leaves in patterns of successive elements exactly related to the Fibonacci sequence. A survey of plants of 650 species and 12,500 specimens displaying spiral or multiple phyllotaxis estimated that about 92% of them have Fibonacci phyllotaxis. (R. V. Jean 1994. Phyllotaxis: A Systemic Study in Plant Morphogenesis. Cambridge University Press: Cambridge, 1994).

 Human Body – The human body demonstrates many of the same Golden Proportion relationships, as well. Each tooth is related to each other based on type. DNA molecules measure 34 angstroms long by 21 angstroms wide for each full cycle of its double helix spiral. The numbers 21 and 34, are the 7th and 8th results of the Fibonacci sequence, respectively and possess golden proportions.  Astronomic examples - Venus takes 225 days to complete a revolution around the sun. As we all know, the Earth requires 365 days to complete one revolution. If you divide 225 by 365, the result is approximately 0.618 of a year (225/365 = 0.616 ~ 0.618) and the inverse (365/225 = 1.622 ~ 1.618) results in 1.618 of a year.

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Related to the Markets: The key is to identify complex cyclical situations with phi and phi-derived ratios that pinpoint discernable segments of price action. These levels define the “natural” levels of support and resistance that can be anticipated. Applied to the markets, these measured segments within the relative larger cycle define trade opportunities.  Measured Moves – Each situation is measured to gauge the “readings” of the situation.  Structural price measurements are applied the same regardless of timeframe – intraday vs. daily.  Harmonic patterns define order within the chaos of the markets but require specific conditions to be met to generate valid technical signals. What Harmonic Trading is Not…There has been a great deal of misunderstanding regarding Fibonacci ratios and their application to the financial markets.  Not Astrology  Not Voodoo  Not a secret code Harmonic Trading employs Fibonacci-derived ratios (aka Harmonic Ratios) to quantify the natural cycles (price patterns) that are manifested within the chaos of the markets. Wave Theory: Harmonic Trading is similar to other Wave Theory approaches in its examination of the structure of price history on a chart. However, this approach applies precise ratios derived directly or indirectly from the Fibonacci sequence. Harmonic Trading focuses on the combination of such ratios to define patterns as precise structural signals. Elliott Wave and Harmonic Trading: Harmonic Trading is similar to Elliott Wave as both focus on the structure of price history segments to quantify technical signals. W.D. Gann and Harmonic Trading: Although Gann Theory is more complex, including the use of his Natural Squares Calculator, both approaches utilize relative geometric price calculations of cyclical trends in an attempt to define critical turning points in the markets. The premise of Mr. Gann’s approach should be considered as one of the primary forerunners to Harmonic Trading with HarmonicTrader.com, L.L.C. Copyright 2010

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one of the earliest references to Harmonic Trading mentioned in his 1927 book, The Tunnel Thru the Air. Mr. Gann stated: "But mathematical science, which is the only real science that the entire civilized world has agreed upon, furnishes unmistakable proof of history repeating itself and shows that the cycle theory, or harmonic analysis, is the only thing that we can rely upon to ascertain the future.” (The Tunnel Thru the Air; Lambert-Gann Publishing; Pomeroy Washington; 1927; pg. 77.) Merrill’s Filtered Waves and Harmonic Trading: Arthur Merrill examined a variety of price waves – in particular M- and W-type structures - in his 1977 book, “Filtered Waves, Basic Theory: A Tool for Stock Market Analysis” (Analysis Press 1977). Merrill differentiated a gamut of price structures as unique technical events. Although many of these structures seemed similar, he argued that they were unique. Harmonic Pattern Ratio Alignments  As Merrill asserted, many price patterns may appear to be similar in structure but are not and require precise quantification.  The differentiation of patterns is the underlying basis and primary effectiveness of Harmonic Trading identification techniques.  In real trading situations, the specification of similar price structures that possess different Fibonacci alignments can substantially reduce overall risk.  The ability to differentiate price structures is essential for identifying the best trade opportunities and handling each situation in the most effective manner. Harmonic Trading Technical Tools    

Fibonacci / Harmonic Ratios Price Patterns Trend Channel Analysis Price Bar (Candlestick) Analysis  Relative Strength Index (RSI)  Other Considerations: Volume, Volatility Bands, Time and Sales HarmonicTrader.com, L.L.C. Copyright 2010

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Harmonic Trading Ratios Primary Ratios: (Directly derived from the Fibonacci Number Sequence)  0.618 = Primary Ratio  1.618 = Primary Projection

Primary Derived Ratios: 

____ 0.786 = Square root of the 0.618 (0.618)



0.886 = Fourth root of 0.618 or ____ Square root of the 0.786 (0.786)



1.13 = Fourth root of 1.618 or ___ Square root of the 1.27 (1.27) ____ 1.27 = Square root of the 1.618 (1.618)



Complimentary Derived Ratios:         

0.382 = (1-0.618) or 0.6182 0.50 = 0.7072 0.707 = Square root of 0.50_ (0.50) 1.41 = Square root of 2.0 (2 ) 2.0 = (1+1) __ 2.24 = Square root of 5 (5 ) 2.618 = 1.6182 3.14 = Pi (See page 34) 3.618 = (1+2.618) HarmonicTrader.com, L.L.C. Copyright 2010

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Harmonic Patterns – The Importance of Differentiation  Pattern analysis often too vague.  Similar structures must be differentiated to define the most relevant structural signals.  Harmonic Trading employs the Fibonacci-derived ratios to measure price segments as the primary means of classifying distinct structures and quantifying zones of support and resistance. Potential Reversal Zone (PRZ) Although a variety of technical approaches have measured zones of support and resistance based upon structural analysis, the concept of a convergence of ratios to define these areas – termed first Potential Reversal Zone (P.R.Z.) - was originally outlined in “The Harmonic Trader.” “History has proven that a convergence of Fibonacci numbers and price patterns provides a highly probable area for a reversal…This area of convergence is called the potential reversal zone. When three, four or even five numbers come together within a specific area, you must respect the high probability for some type of reversal.” (The Harmonic Trader, pg. 11. Nevada: HarmonicTrader.com, L.L.C. 1999.) The effectiveness of these structural considerations is dependent upon the application of the correct ratio alignments to quantify the most ideal formations. (Harmonic) Head and Shoulders    

One of the first price patterns identified “Technical Analysis of Stock Trends” 1966 Edwards and Magee Oversimplified = Least Measured, Most Cited The general characteristics of the Edwards & Magee definition requires symmetry. Harmonic Trading ratios applied to the pattern can refine the most symmetrical situations and define the most precise structural points, resulting in a measured Head and Shoulders.  Such a refined structure pinpoints the price level for the pattern completion and offers a distinct price level for trade execution.  Look for pattern that completes at the reciprocal ratio (1/x) of the prior shoulder. HarmonicTrader.com, L.L.C. Copyright 2010

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Inverted Harmonic Head and Shoulders

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Japanese Yen (JPY_A0-FX): Daily

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Harmonic Head and Shoulders

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Xinhua China 25 Index ETF (FXI): Weekly

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M&W-Type Pattern Differentiation Arthur Merrill differentiated a variety of M&W type price formations but did not apply relative ratios to the structure. Although others have applied ratios to such price structures, Harmonic Trading has refined these much further to include specific measurements for each point in the pattern. The prescribed Harmonic Trading rules are designed to filter potentially flawed structural formations and develop pattern-specific trading strategies for each situation. The Bat vs. Gartley Pattern The Bat Pattern The Bat pattern is a precise harmonic pattern that I released in 2001.

Bullish

Bearish

 B point at a less than a 0.618 retracement of XA, preferably a distinct 50% or 38.2% retracement.  BC projection must be at least 1.618.  AB=CD pattern is usually extended.  0.886 XA retracement.  C point with range between 0.382 and 0.886.

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Intel (INTC): 60-Minute This following intra-day example of the Intel shows a perfect Bullish Bat pattern with a precise Potential Reversal Zone (PRZ). The ratio alignment was quite precise, especially the 50% B point and extended BC projection. The three numbers of the PRZ defined a tight zone in the 15.80 area to get long. Specifically, the set-up possessed a 1.27 AB=CD pattern at 15.75, with the 2.0 BC projection and the 0.886 retracement competing at 15.80.

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NASDAQ 100 Tracking Stock (QQQQ): 5-Minute The Bearish Bat in this example possesses a perfect structure with a precise alignment of the required Fibonacci ratios to validate the pattern. Starting with a perfect 50% B point retracement, the price action formed an Alternate 1.27 AB=CD pattern that completed in the same exact area as the 2.0 BC projection. In combination with the 0.886 XA retracement, the Potential Reversal Zone (PRZ) possessed three numbers in a 5-cent range that defined resistance just above $30 a share.

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The Gartley Pattern These rules for the ideal Gartley pattern was released in “The Harmonic Trader” (1999) and it has become the standard in the technical community.

    

Precise 61.8% B point retracement of XA leg. BC projection must not exceed 1.618. Equivalent AB=CD pattern is most common. 0.786 XA retracement. C point within range of 0.382-0.886 retracement.

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Dow Jones Industrial Average Tracking Stock (DIA): Daily The Dow Diamonds formed this Bullish Gartley on the following daily chart with three numbers in a tight range between 118-120. The pattern possessed a distinct structure with a perfect 0.618 B point retracement.

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Swiss Franc (CHF_A0-FX): 60-Minute The next example of a Bearish Gartley in the Swiss Franc shows another excellent harmonic pattern in the currency markets. The 60-minute chart possessed a distinct pattern, clearly defining the critical harmonic resistance. The pattern formed the required Fibonacci alignment to validate the structure, especially the precise 0.618 B point. The price action stabilized nicely after testing the entire PRZ and the pattern represented an excellent intra-day selling opportunity.

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Other Harmonic Patterns: In addition to the (Harmonic) Head and Shoulders, Bat and Gartley patterns, the other structures within the Harmonic Trading arsenal include:       

AB=CD Alternate AB=CD Alternate Bat 5-0 Butterfly Crab Three Drives For more information, go to www.HarmonicTrader.com

Case Study: S&P500 Double Dip Scenario The current situation in the S&P 500 underscores the effectiveness of Harmonic Trading strategies to define current state of the predominant trend. There has been much discussion lately regarding a “dounle-dip” scenario for the equity markets. Despite the recent pessimism, I believe it is important to review the long-term significance of the action in the Standard and Poor’s 500 index since last year’s low to define what this truly means. From a broader view, the index rallied in March to take out the weekly Bearish 50% retracement @ 1120. The weekly price action has formed a distinct Bearish 5-0 pattern at this retracement. In fact, this structure has developed in each of the last four bear markets that declined more than 30% - going back to1974. This is significant for two reasons: 1 The breakout of a 5-0 pattern typically results in an accelerated move to the 88.6% retracement of the measured leg, regardless of the time frame. In this case, the weekly chart points to the 88.6% retracement level at 1475.

2 This historic precedent defines price limits for the current market, as the S&P 500 pullback in each of the prior cases did not retrace any more than 50%. Currently, this would establish the 940 area as a make-or-break support point. HarmonicTrader.com, L.L.C. Copyright 2010

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Standard and Poor’s 500 (^GSPC): Weekly

Bearish 5-0 Violation  Historically, the S&P 500 has experienced accelerated price action after testing the 50% retracement area of a prior multi-year bear market. The index has consolidated at this critical 50% level for the past 6 months.  I have analyzed prior bear markets of the past 40 years in the S&P 500 index. There have been four major market declines that have exceeded 30% and formed a Bearish 5-0 pattern structure following the completion of their respective ultimate low.  In each case, the price action rallied to the 50% area and reacted nominally on the first test of the pattern's completion. However, this structure served only as temporary resistance. In each case, the eventual breakout resulted in a decisive rally to the corresponding 88.6% retracement. The following charts outline each case.

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Standard and Poor’s 500 (^GSPC): Weekly Bearish 5-0 Violation 2004 In 2004, the S&P 500 formed a distinct structure on the weekly chart. After losing nearly 50 percent of its value, the S&P 500 rallied sharply from the 2002 low. The price action tested the 50 percent retracement at 1160 and reversed approximately 10 percent over the course of a few months before resuming the multiyear up trend.

The index was able to rally to the weekly 88.6% retracement. Despite an eventual collapse that resulted in an entire retracement of this rally, the breakout in 2004 accurately defined the predominant trend for the next three years. In the same manner, the current situation in the S&P 500 is clearly pointing to further upside with an eventual test of its relative 88.6% retracement.

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Standard and Poor’s 500 (^GSPC): Weekly Bearish 5-0 Violation 1988

The price action following the crash of 1987 possessed the same structure as in the 2004 example. The market tested the Potential Reversal Zone (PRZ) of the pattern, reacted nominally after the completion and rallied decisively after the initial reaction. The interesting aspect of this situation is the accelerated breakout that occurred following the violation of the pattern.

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Standard and Poor’s 500 (^GSPC): Weekly Bearish 5-0 Violation 1976 In 1974, the market was cut in half from its peak. Following the devastating decline of the 1973-1974 bear market, the index formed a 5-0 pattern structure on the weekly chart. The price action reversed briefly at the initial completion of the pattern. The index rallied above this reaction peak and eventually tested the 88.6% retracement within a few years after the initial breakout.

The index did pullback nearly 50% for most of 1977 before reaching for the upside objective. It is common for the retest of a prior Potential Reversal Zone (PRZ) to occur after being violated. The 1977 situation defines the pull back limit within this historic precedent.

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What This Means from an HT Perspective This simple ratio analysis establishes a historic technical precedent that is relative to the current state of the index. The “Double-Dip” scenario will only be triggered below the previous limit – the 1976 general limit or the price action will violate the long-term upside bias segment. Recent Developments: Standard & Poor's 500 Index (^$SPX) Bullish 38.2% Retracement Last month, the index reversed exactly at an important harmonic ratio - a 38.2% weekly bullish retracement. This is extremely significant, as it exemplifies the degree of Harmonicity that the price action is exhibiting.

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Standard & Poor's 500 Index (^$SPX) Bullish 5-0 One other consideration from an HT perspective is a Bullish 5-0 pattern that completes slightly lower. The exact 50% retracement pattern completes 943.

The Double Dip scenario must be assessed from a pure price perspective. Although the recent rally from the 38.2% retracement has stabilized this year’s correction, these larger pattern and historic retracement considerations are undeniable technical evidence that the market must hold this support or truly face a double dip – more like, a double dump!

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Harmonic Trading Conclusion

My goal in this presentation was to offer a general overview of Fibonacciderived ratios combined with prescribed price patterns. Harmonic Trading possesses many unprecedented technical strategies that can define the state of price action within trends in a unique fashion. Each pattern possesses statistically validated strategies to optimize trading decisions. The finer points and research can be found at www.HarmonicTrader.com. In conclusion, it is important to be mindful of a few of the following concepts:  If there is anything that I have learned in 20 years of following the markets, it is the importance of respecting the clear structural signals that price action provides.  The current situation in the S&P500 clearly demonstrates the importance in understanding simple ratio analysis and defined pattern considerations.  There is a great deal of technical information that can be garnered from such analysis.  Harmonic Trading seeks to refine general structural signals to offer precise levels of support/resistance based upon prescribed pattern specification.  The inherent value of Fibonacci-derived ratios is effective when related to the markets. Although these situations are not found in every market at all times, the key is to wait for those conditions to develop and employ HT strategies to capitalize on such order within the chaos of the financial markets.  It is important to remember that pattern and ratio analysis are a starting point but offer effectively reliable technical tools unlike any other approach.

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