Marcel Czeczko THE UTILISATION OF HARMONIC PATTERNS IN DAYTRADING ON THE FOREX MARKET INTRODUCTION

Marcel Czeczko THE UTILISATION OF HARMONIC PATTERNS IN DAYTRADING ON THE FOREX MARKET INTRODUCTION It is well noticeable, that in recent years all the investment techniques based on analysing price harmonics of financial instruments are rapidly gaining more and more popularity. The market geometry analysis is most often conducted with harmonic patterns, in other words unique, repeatedly occurring structures, which are based on Fibonacci numbers. The main purpose of this article is to give a comprehensive presentation of constructing a trading plan mounted over harmonic patterns, which could be subsequently applied in daytrading on the international currency markets. Therefore, in this publication have been described all components of the abovementioned plan in terms of their utility in daytrading on the Foreign Exchange market HARMONIC PATTERNS DAYTRADING STRATEGY Harmonic patterns are usually divided into ABCD and XABCD structures 1. First-mentioned are very well known to those, who are familiar with The Elliott Wave Principle (an ABCD pattern is nothing else but a typical 5-3-5 corrective wave - also known as a "zigzag") 2. 1 Łyjak, A.: Inwestowanie Harmoniczne. "Equity Magazine" 2010, nr 10. 2 J. Kane: Kane Trading on: Trading ABCD Patterns. United States of America: Published by Kane Trading 2003 s. 6

Figure 1. A general structure of an ABCD harmonic pattern Source: Based on: J. Kane: Kane Trading on: Trading ABCD Patterns. United States of America: Published by Kane Trading 2003 s. 5. The most important criteria which allows to distinguish numerously indentified ABCD patterns is the relationship between the AB and CD legs, measured by a technique called Alternate Price Projections (APP). What is worth to notice is that there is not any particularly often recognised ABCD price pattern because of numerous variations of Fibonacci ratios between each waves. However a pattern with equal AB and CD parts (Fibonacci ratio 1.000) is generally considered to be the strongest one. Moreover, those shapes where the price projection of the CD leg is either slightly smaller or longer than the AB price action (Fibonacci ratios: 0.786, 0.886, 1.128, 1,272) are also said to be powerful, effective and, therefore, worth to trade 3. Last but not least, there is also a setup 1.618AB = CD, yet it is less considered as a single structure, being more often a part of a XABCD pattern instead. Harmonic XABCD price patterns are, in general, an extensions of abovementioned ABCD structures. They consist of an ABCD setup preceded by a strong, well-noticeable market trend - the XA wave 4. 3 Kane, J.: Kane Trading on: Trading ABCD Patterns. Kane Trading, United States of America 2003 s. 93-94 4 Kane, J.: Kane Trading on: Multiple Timeframes and Context. Kane Trading, United States of America 2004 s. 137

Figure 2. Harmonic XABCD price patterns The most important feature of those structures is the relationship between the ABCD setup and the preceding price action (the XA leg). For instance, in case of "The Gartley Pattern" and "The Bat Pattern" the 5-3-5 zigzag corrective wave is just an internal retracement of the XA part 5. Exactly contrary conclusions can be drawn after analysing both "The Butterfly Pattern" and "The Crab Pattern", were the ABCD market movement extends beyond the XA wave, being ipso facto its external retracement 6. Other relationship between particular waves (with exact Fibonacci ratios) have been shown on Figure 2. Harmonic patterns should always be considered in accordance with technical analysis basic rule, which is "The trend is your friend" 7. Thus, in reference to this principle, bullish ABCD and XABCD setups create around the "D-point" a potential support area for an uptrend, giving by the fact itself a buy signal. On the other hand their bearish equivalents 5 Harmonic Trader, http://www.harmonictrader.com/harmonicpatterns.htm, 13.05.2012 6 Danielewicz P.: Geometria Fibonacciego. Warszawa, WIG-PRESS 2006 s.136 7 Murphy, J.: Analiza Techniczna Rynków Finansowych. WIG-PRESS, Warszawa 2009 s. 43

form a potential resistance area, which should result opening a short position. Identification of an investment signal (a harmonic pattern) ought to be only a part of a trading strategy. For experienced daytraders, emergence of a harmonic structure is simply the very first step in their investment plan. Apart from recognising a pattern, it is vital to: estimate the risk/reward ratio, conduct a multiple timeframe analysis, get an entry trigger, properly manage an open position, settle an exit strategy 8. The initial level of a stop-loss order estimates the maximum capital exposure. The main advantage of harmonic trading is the fact that those patterns usually create a very tight potential trade area (in the form of a densely grouped retracements and price projections of each previous price action). Therefore for an investor it means precise, objective and, first of all, low investment risk, understood as a maximum acceptable loss. It is especially important while investing on the FOREX market, which is, usually, a highly leveraged market (brokers most often offer a 1:100 or even a 1:500 leverage). In most available literature it is advised that a trader should settle a stop-loss order one or two ticks below/above the potential support/resistance area (the D-point). Yet setting a stop-loss order at least a few or even a dozen or more ticks below/above the PTA seems to be more reasonable. It could help to avoid such phenomena as "false breakout" or "stop-loss hunting" 9. Chart analysis should be carried out on at least three different time intervals - the medium timeframe, where the patterns are identified, the higher timeframe, which shows a major market trend and, finally, the 8 Kane Trading - Education for Serious Traders, http://kanetrading.com/free_art/elements.html, 13.05.2012 9 Dolan B., Galant M.: Forex dla bystrzaków. Gliwice, Helion 2010 s. 274

lower timeframe, where traders look for an entry trigger 10. The main purpose of context analysis is to emplace the pattern within a broader market context and, therefore, filter out those, which try to call the end of a well-established trend 11. To do so, it is worth to use either some technical analysis basics (trend lines, channels, support/resistance lines) or momentum indicators, for instance Relative Strength Index or Stochastic Oscillator 12 (those mentioned indicators can also be applied in the medium timeframe in order to confirm the D-point as a tradable area). The lower timeframe enables to receive an entry trigger, which confirms the PTA and allows to "fine-tune" the entry, which becomes more precise 13. It protects from entering the market before the pattern has been verified, and hence reduces the amount of unsuccessful trades. In terms of daytrading, harmonic patterns are most easily to recognise both on 15- minute charts (with a context on 1-hour charts and an entry trigger on 5- minute charts) and on 5-minute charts (with a market context on 30- minute charts and entry triggers on 1-minute charts). One of the simplest entry techniques is a strategy called trendline violation. The signal is received after an issue, on the lower timeframe, breaks through the drawn trendline. This technique occurs to be most effective when an issue is oscillating along an axis as it heads into a potential trade area (lack of well established trend with noticeable local tops and bottoms, yet with major price gaps instead) 14. However, in order to avoid a false breakout, the position should not be opened right after the 10 Kane, J.: Kane Trading on: Multiple Timeframes and Context. Kane Trading, United States of America 2004 s. 5-9 11 Ibis., s. 8 12 Rockefeller, B.: Analiza techniczna dla bystrzaków. Gliwice, Helion 2012 s. 262-263 13 Kane, J.: Kane Trading on: Entry Techniques. Kane Trading, United States of America 2003 s. 7 14 Ibid., s. 73

violation - it is reasonable to use one of the popular filters, for example a price filter or a time filter 15. This technique should not be used in dynamic market trends, as breaking through a steep trendline could only mean that the trend is losing its momentum instead of changing direction 16. The "trailing one-bar-high/low (TOBH/L)" strategy is also said to be a simple and objective way to enter the market. It allows to trail the buy-stop or sell-stop to enter the trade one tick above the high or below the low of the last completed bar 17. If the order is not put into action, its price level needs to be likewise adjusted to the newest price bar (therefore this entry technique is called trailing). The biggest advantage of this strategy is a small capital exposure determined by the short price distance between the entry point and the initial stop-loss level 18. Although the "swing entry (SE) strategy" jeopardise a trader to a higher capital exposure, it tends to have a higher success-rate 19 - mainly because of considering not only the last bar's price range but also the local context in the form of last mini-highs and mini-lows. When utilising this technique a trade is triggered one tick above the previous local top (while trading bullish) or one tick below the local bottom (while trading bearish). Both the "swing entry" and the "trailing one bar high (low)" strategies are very similar. The choice between those two techniques should depend on the trader's preference. Once a trade has been initiated and the market price goes in a desirable direction, the most important thing is to effectively manage an 15 Murphy, J.: Analiza Techniczna Rynków Finansowych. WIG-PRESS, Warszawa 2009 s. 63 16 Ibid., s. 59 17 Miner, R.: High Probability trading Strategies. John Wiley & Sons, Inc., United States of America 2009 s. 140 18 Ibid., s. 146 19 Ibid., s. 154

open position in order to protect acquired profits. It can be, for instance, done by activating a trailing stop order, which purpose is to automatically move the initial stop loss level, allowing to keep the profits in case of a sudden market situation change 20. Right after entering the market it is also worth to estimate the minimum profit target, at which the position is likely to be closed. According to the harmonic pattern definition, connected with some technical analysis basics, for a minimum profit target should be acknowledged the area of the "A-point", as the market, which is in a well established trend, should at least retest the previous high or low 21. The trade closure can be executed either automatically by activating the take profit order or with utilising beforementioned momentum indicators (calculated for the higher timeframe). The indicator exit is said to be far more efficient as it allows to get an exit trigger much further from the initial profit target and, therefore, gain bigger profits. 20 Kane, J.: Kane Trading on: Trailing Stops. Kane Trading, United States of America 2003 s. 3-4 21 Murphy, J.: Analiza Techniczna Rynków Finansowych. WIG-PRESS, Warszawa 2009 s. 43

CONCLUSIONS This publication was focused on presenting a comprehensive investment strategy based on analysing price harmonics on the international currency markets. In reference to all before described trading plan components, it can be said, that determination of a potential support or resistance area is carried out with using objective, clearly specified criteria. Moreover, those areas mark out with a very tight price range, which is especially crucial while investing on highly leveraged markets, such as the FOREX market. Furthermore, those signals, due to the high market liquidity, can be considered as very credible. If to combine this with an accurate entry trigger, a proper open trade management and a right timing in position closure, emerges a system, that undoubtedly is an interesting choice for all FOREX market participants.

REFERENCES Books: 1. Danielewicz P.: Geometria Fibonacciego. Praktyczny kurs inwestowania na rynkach finansowych. Warszawa, WIG-PRESS 2006 2. Dolan B., Galant M.: Forex dla bystrzaków. Gliwice, Helion 2010 3. Kane, J.: Kane Trading on: A Totally New 5-Point Pattern. Kane Trading, United States of America 2004. 4. Kane, J.: Kane Trading on: Entry Techniques. Kane Trading, United States of America 2003. 5. Kane, J.: Kane Trading on: Multiple Timeframes and Context. Kane Trading, United States of America 2004. 6. Kane, J.: Kane Trading on: Trading ABCD Patterns. Kane Trading, United States of America 2003. 7. Kane, J.: Kane Trading on: Trailing Stops. Kane Trading, United States of America 2003. 8. Miner, R.: High Probability trading Strategies. John Wiley & Sons, Inc., United States of America 2009. 9. Murphy, J.: Analiza Techniczna Rynków Finansowych. WIG-PRESS, Warszawa 2009 10. Rockefeller, B.: Analiza techniczna dla bystrzaków. Gliwice, Helion 2012 Periodicals: 11. Łyjak, A.: Inwestowanie Harmoniczne. "Equity Magazine" 2010, nr 10. Websites: 12. Harmonic Trader, www.harmonictrader.com, 13.05.2012 13. Kane Trading - Education for Serious Traders, www.kanetrading.com, 13.05.2012