Full Trading Circle: The Complete Underground Trader System

By Jea Yu
Copyright © 2010 by Jea Yu

APPENDIX A

HARMONIC PATTERN TRADING

by Suri Duddella of Surinotes.com
Financial markets exhibit the natural ebb and flow cycles which are in
sync with the growth and decline phases of the markets. These natural
cycles exhibit harmonic price behavior in the financial markets. This har-
monic phenomenon occurs in all walks of life and is usually determined
by specific harmonic patterns. Harmonic pattern detection includes rec-
ognition of key price swings aided with Fibonacci ratios to identify key
reversal points and levels.

Some of the great pioneering research in harmonic patterns, along with

cycles, was done by H.M. Gartley, William Garrett, Bryce Gilmore,
Larry Pesavento, and Scott Carney. To my knowledge the best work
on harmonic patterns is done by Scott Carney in his two-volume text,
Harmonic Trading of the Financial Markets.

Before I address the harmonic patterns and harmonic ratios that exist in

the market, I need to address the Fibonacci series and Fibonacci ratios.

Most traders and analysts who have any exposure to technical analysis
have at least heard of Fibonacci numbers, Fibonacci ratios or retrace-
 TRADING FULL CIRCLE
236

ments, etc. Many analysts use a series of numbers to derive Fibonacci

ratios, and common numbers are 0.382, 0.5, 0.618, and 1.618.

FIBONACCI RATIOS
Fibonacci numbers are pervasive in the universe and were originally de-
rived by Leonardo Fibonacci. The basic Fibonacci ratio (“Fib ratio”) is
equal to 1.618. A Fibonacci sequence is a series of numbers where each
number is the sum of the previous two numbers.

The series of “Fib Numbers” begin as follows: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55,
89, 144, 233, 317, 610, and so on.

There are plenty of materials and books about the Fibonacci theory of
how these numbers exist in nature and in the financial world. Fibonacci
number sequences produce a great pattern between the numbers (up or
down). The ratio of any number to the next higher number is 0.618, while
the ratio of the next lower number is 1.618. In the mathematics world,
these values are also known as phi (0.618) and Phi (1.618). The ratio
1.618 is also referred to as the “The Golden Ratio.”

A list of the most important Fib ratios in the financial world which are
derived by squaring, square roots, and reciprocating the actual Fibonacci
numbers are depicted below:

•K
 ey Set of Fibonacci Derived Ratios in Trading are:
0.382, 0.500, .618, 0.786, 1.0, 1.272, 1.618, 2.0, 2.62, 3.62, 4.62
•S
 econdary Set of Fibonacci Derived Ratios in Trading are:
0.236, 0.486, 0.886, 1.13, 2.236, 3.14, 4.236

Most trading software packages have Fibonacci drawing tools which can
show Fib retracements, Fib extensions, and Fib projections. In addition,
Fib numbers are applied to time and price in trading.

FIBONACCI RATIOS IN THE FINANCIAL MARKETS

Most technical analysts extensively use some sort of ratio analysis for po-
tential entry and exit strategies. The application of Fibonacci numbers to
this ratio analysis lead to terms like Fibonacci retracement, or Fibonacci
 A • H a r mon ic Pat t e r n T r a d in g
237

extensions, etc. Financial markets exhibit pullbacks and extensions with

enough frequency that Fibonacci retracements to ratios like 38.2%, 50%,
or 61.8% have become common jargon in traders’ language.

The backbone behind Fibonacci studies is made up of the price retrace-

ments and extensions. The study of these retracements and projections
enables traders to identify price swings and support and resistance areas.

Markets demonstrate repetitive patterns where prices oscillate between

one set of price ratios to another, making price projections possible.
Market trends can be defined by geometric relationships as they exhib-
it harmonic relationships between the price and time swings. Markets
also form cycles around the price and time levels. Many investors and
traders use cycles and harmonic relationships to project future swing
prices and times.

Each price swing consists of high and low prices and many bars in be-
tween them, followed by a reversal swing consisting of the same high and
low prices, but in the opposite direction. If the prior swing is an up swing,
then the following down swing is a reversal swing, or retracement. A high
swing occurs when the current high bar has a lower-high bar before and
after. A low swing occurs when the current low bar has a lower-low bar
before and after.

STUDY OF RETRACEMENTS AND EXTENSIONS

Fibonacci retracements and extensions, illustrated in Figure A.1, offer
key support and resistance areas. Here are some definitions of retrace-
ments and extensions.

•R
 etracements: Retracement is defined as when a price re-traces a
portion of the prior swing. This portion could be defined in Fibo-
nacci ratios like 0.38, 0.5, or 0.618.
•E
 xtensions: Extensions occur when the price expands the entire
prior swing (100%) and travels beyond the entire swing. The exten-
sion swing could be 127% or 162% of prior swings.
•P
 rojections: Projections are defined as when the price extends
away from a completed retracement swing in the same length (or
more) as the first swing.
 TRADING FULL CIRCLE
238

Figure A.1
Fibonnacci
Retracements
& Extensions
For a closer
look, please visit
TradersLibrary.com/
TLECorner.

SYMMETRY AND CONFLUENCE

Gann, Fibonacci, and Elliott all studied market symmetry and found
valid theories. These patterns exist in all forms in nature and certainly
exist in the markets. One of the best ways to confirm symmetry in
the markets is to check price and time using two or more cluster con-
firmations. Another key method to compute these patterns is to use
percentage change of price between market highs and market lows.
Symmetry is a science by itself, and traders take great advantage of
knowing the potential turning points and levels using these methods.

SYMMETRY
Symmetry is visible in all markets and in all time-frames. Symmetric
rallies and declines give traders an advantage to determine the key
turning points. A cluster of similar extensions and similar retrace-
ments at key price ranges, or some important levels provide insights
into future significant resistance and support levels. In addition to
knowing key turning points, the benefits of trading symmetric price
and time cluster levels include low-risk trades.
 A • H a r mon ic Pat t e r n T r a d in g
239

Figure A.2
Symmetry
Pattern:
Russell
2000 Futures
For a closer
look, please visit
TradersLibrary.com/
TLECorner.

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Figure A.2 illustrates the symmetry pattern from the Russell 2000
futures (ER2) 610 tick chart. Symmetrical swing lengths are shown
after a 50% retracement at BC swing. Market symmetry of 100% ex-
tension is expected after a retracement of less than 50% retracement
levels. If the retracement exceeds 50%, the extension may be less than
or equal to 100%.

FIBONACCI CONFLUENCE (FIBONACCI CLUSTERS)

Confluence of multiple Fibonacci retracement or extension levels
signifies a stronger area of support and resistance. The confluence of
multiple Fibonacci retracements in a fairly tight area is computed
using prior swings of both retracements and extensions with certain
criteria. Then each Fib retracement or extension level is grouped to
 TRADING FULL CIRCLE
240

Figure A.3
Fibonacci
Con uence
For a closer
look, please visit
TradersLibrary.com/
TLECorner.

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

generate a confluence within some threshold to find Fibonacci clus-
ters in an area. These cluster levels are more significant than a single
Fib retracement itself. The trades are either initiated or closed at these
confluence levels.

Figure A.3 shows Fibonacci confluence or clusters of various levels.

THE PATTERNS

AB = CD PATTERN FRAMEWORK
In 1935, H.M. Gartley published a book called Profits in the Stock
Market that described the use of the AB = CD pattern along with
some innovative pattern methods. Gartley described a chart pattern
called “Practical Use of Trendlines,” showing the AB = CD pattern.
In this pattern, prices rally to an up sloping trendline in an uptrend
and retrace to a parallel up sloping trendline, forming a channel. This
 A • H a r mon ic Pat t e r n T r a d in g
241

process of “advance-retrace” continues until the price trades outside

of the channel, giving a potential breakout or breakdown to termi-
nate the AB = CD pattern.

AB = CD pattern structure forms in all markets and in all time-

frames. Larry Pesavento modified and described the AB = CD pat-
tern with Fibonacci ratios and its potential targets and reversal areas.
The AB = CD patterns forecast key market turning points and profit
targets for traders. AB = CD patterns pinpoint important pivot levels
with high and low prices and identify key trading zones.

AB = CD pattern formation has three critical areas. The first leg (AB)
is trend. The second leg (BC) is countertrend, or retracement. The last
leg (CD) is resumption of trend. The retracement leg (BC) has a
Fibonacci correction ratio of 0.382, 0.618, or 0.786. The resumption
of the trend (CD) occurs after the correction leg and usually extends
to 100% of AB from C.

Using an auto-ABC pattern algorithm, AB = CD patterns are de-

tected by finding A, B, and C pivot points in a chart. These key pivot
points are searched for various pivot strength levels and used to iden-
tify correction levels. Once the A, B, and C points are determined, a
Fib level algorithm is applied to determine the level of D, which is
the last leg of CD.

The trades are entered after the completion of the D level in the
countertrend direction of the last leg of the pattern.

Figure A.4 shows Figure A.4

the AB = CD pat- AB = CD
terns and its struc- Patterns
tures. The relevant For a closer
look, please visit
ratios are shown. In TradersLibrary.com/
AB = CD patterns, TLECorner.

the trades are en-

tered at D level.
 TRADING FULL CIRCLE
242

Figure A.5
ABC Bullish
Pattern

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

Figure A.6
ABC Bearish
Pattern

For a closer
look, please visit
TradersLibrary.com/
TLECorner.

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

 A • H a r mon ic Pat t e r n T r a d in g
243

ABC BULLISH PATTERN

Figure A.5 shows the ABC bullish pattern in a DXD daily chart. From
October 2007 to December 2007, the A, B, and C pivots completed,
and connecting these pivots, an ABC pattern was developed. After the
completion of the C pivot at about the $46.94 price level, price traded
above a two-bar high to signal a reversal in its prior trend. A long entry
was triggered at about $49. A stop was placed at $46.5. The first target is
placed at 0.62 AB level ($53), and second target was placed at $58.

ABC BEARISH PATTERN

Figure A.6 shows the ABC bearish pattern in Google stock. An ABC
bearish pattern was developed from October 2007 to December 2007,
from $745 to $616. A reversal signal was generated when the price closed
below the two-bar low with a wide-range bar near $700. A short entry
was placed at $700 with a stop above the C level at $725. The first tar-
get was placed at 0.62 AB level at $643, and the second target level was
placed at $595 (1.0 AB).

THE 5-POINT (X5) PATTERNS

In 1932, H.M. Gartley described a 5-point “Gartley” trading pattern
in his book, Profits in the Stock Market. Larry Pesavento improved this
pattern with Fibonacci ratios and established rules on how to trade the
Gartley pattern in his book, Fibonacci Ratios with Pattern Recognition.
Larry Pesavento and Bryce Gilmore invented the butterfly patterns with
Fibonacci ratios. There are many other authors who have worked on this
pattern, but the best work on these 5-point patterns (Gartley, Butterfly,
Crab, and Bat patterns) to my knowledge is done by Scott Carney in
his two-volume text, Harmonic Trading of the Financial Markets. Scott
Carney also was the first researcher to add specific requirements using
Fibonacci ratios to validate the exact structure of the Gartley pattern. He
also identified specific reversal levels using the Gartley pattern structure
and coined the term “Potential Reversal Zone,” or PRZ. Scott Carney
is also the inventor of other 5-point patterns like the Bat and the Crab.

Gartley patterns have 5 points starting at point X, which is the lowest of

all points in a bullish setup, and the highest of all points in a bearish set-
up. For a bullish Gartley, from X, prices rise to form a higher swing high
at “A.” From A, a retracement swing low, “B,” is formed within 0.382 to
0.618 of the XA range. Another swing high, “C,” is formed at 0.618 of
 TRADING FULL CIRCLE
244

AB. Point “D” is formed in the Potential Reversal Zone (PRZ) within
0.618 to 0.786 of the XA swing, or 1.27 to 1.62 of the BC range. D is
the decision or buy trade point in a bullish Gartley setup. Point D is also
a sell trade point in a bearish Gartley setup.

THE BASICS OF GARTLEY PATTERNS

The Gartley pattern (Figure A.7) has two key elements in its structure.
The formation of the AB=CD pattern, and the 0.618 retracement of XA
swing to the “B” level. The Gartley pattern is formed when the action-
point (D) is retraced into XA swing. If D extends beyond X, the pattern
becomes one of the extension patterns (Butterfly or Crab). The action
point (D) is usually formed from 0.786 to 0.886 of XA swing.

Figure A.7
Gartley
Patterns
For a closer
look, please visit
TradersLibrary.com/
TLECorner.

Scott Carney defined that the Potential Reversal Zone (PRZ) area is
constructed by:

• AB=CD
• 0.786 XA
• 1.618 BC

Pattern completion signals for potential reversals:

• W ide range bars from PRZ

• Gap reversals
• Systematic higher highs
 A • H a r mon ic Pat t e r n T r a d in g
245

Potential entry signals from PRZ levels:

• Bullish: Enter a long trade one tick above the high of the con-
firmation bar (higher-high bar or wide range bar).
• Bearish: Enter a short trade one tick below the low of the con-
firmation bar (lower-low bar or wide range bar).

Stop:

• For bullish Gartley setups, the Gartley pattern fails if price

closes below the “X”. Place your trade a few ticks below the
low of the “X”.
• For bearish Gartley setups, the Gartley pattern fails if price
closes above the “X”. Place your trade a few ticks above the
high of the “X”.

Target:

• The first set of targets are the price levels of C and A.

• The second target is set at extensions of 1.27 to 1.62 of AD
range from the “D” level.

Bullish Gartley Example

Figure A.8 shows a bullish Gartley formation from the daily GE
stock chart. From mid-September 2006 to November 2006, GE
formed a Gartley pattern. The B level retracement was 60.1% near
the minimum of Gartley’s requirement. The PRZ level was formed at
88.6% area at D. After the D level, the price action is closely watched
for a long trade entry. GE made higher-highs from the D level, sug-
gesting a completion of the Gartley formation. A long entry is trig-
gered at $35.35 area with a stop below the D level at $34.30. Targets
were placed first at the A level (at $36.48), and from 138% to 162%
of XA range at $37.50.

Bearish Gartley Example

Figure A.9 shows a bearish Gartley pattern formation in the QID
daily chart. QID formed a bearish Gartley from May 2008 to Sep-
tember 2008, from X level at $57.5 to D ($56.5). The center point,
 TRADING FULL CIRCLE
246

Figure A.8
Bullish Gartley
Pattern

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

Figure A.9
Bearish Gartley
Pattern

For a closer
look, please visit
TradersLibrary.com/
TLECorner.

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

 A • H a r mon ic Pat t e r n T r a d in g
247

B, is formed around the $48.60 level with a 57% XA retracement. It

may not be a perfect Gartley pattern but a D pivot was formed below
X at $56. A trade entry is triggered at $49.60 (38% XA) level. This
pattern is still in progress as of this writing.

Butter y Pattern
The Butterfly pattern (see Figure A.10) was discovered by Bryce
Gilmore and Larry Pesavento. It is one of the powerful patterns like
the Gartley pattern. The Butterfly pattern has a distinct retracement
level (0.786) of XA swing. In bullish and bearish 5-point swings, the
pattern must have 0.786 to 0.886 of XA swing to be valid. In perfect
Butterfly patterns, the AB swing will be equal to CD (AB=CD). The
Butterfly pattern is an extension pattern where the action-point (D)
occurs beyond “X.”

Butterfly patterns usually occur at market tops and market bottoms.

The pattern’s success rate is much higher when the retracement and
time ratios are harmonically aligned.

Two primary differences between the Butterfly and Crab

patterns are:

1. The AB retracement must be 0.786 in the Butterfly pattern,

whereas in the Crab pattern, it lies between the 0.382 and
0.618 levels.

2. In both patterns, the D point extends beyond the X, and

the C level can be inside or outside of the XA range. The

Figure A.10
Butter y
Patterns
For a closer
look, please visit
TradersLibrary.com/
TLECorner.
 TRADING FULL CIRCLE
248

retracement of AB defines level D. In Butterfly patterns, if B

is formed at 0.786, the usual retracement of D could be near
1.27 of the XA range.

The Basics of Butter y Patterns

• Minimum AB=CD, up to CD=1.27 AB
• B occurs at 0.786 XA
• CD has at least 1.618 BC projection

Potential Reversal Zone (PRZ) area is constructed by:

• 1.27 AB
• 1.618 BC
• 1.27 XA

Potential Entry Signals from PRZ levels:

• Bullish: Enter a long trade one tick above the high of the con-
firmation bar (higher-high bar or wide range bar).
• Bearish: Enter a short trade one tick below the low of the con-
firmation bar (lower-low bar or wide range bar).

Stop:
• Butterfly patterns considered to be a failure if the price trades
beyond the 2.618 XA area. But if an entry is made at 1.27 XA
for bullish Butterfly patterns, place a stop a few ticks below the
lowest of the pattern.
• For bearish Butterfly patterns, place a stop order above the high
of the Butterfly pattern.

Targets:
• Targets are set at 100% of AD and 162% of XA from D levels.
• In bullish Butterfly patterns, beyond the A level, targets need to
be protected with trailing stops.
 A • H a r mon ic Pat t e r n T r a d in g
249

Figure A.11
Bullish
Butter y
Pattern

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

Figure A.12
Bearish
Butter y
Pattern

For a closer
look, please visit
TradersLibrary.com/
TLECorner.

Created with TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

 TRADING FULL CIRCLE
250

Bullish Butter y Pattern

Figure A.11 shows a bullish Butterfly pattern formation in Amazon
stock. From May 2008 to July 2008, a bullish Butterfly pattern was
formed from level X at $71.56 to A at 84.88, B at 75, and C at 84.47. A
first potential reversal zone (PRZ) was calculated around $68. A second
potential reversal zone was calculated at 1.62 of XA, around $63. AMZN
traded down to the second PRZ without any reversal bars (wide-range
or two-bar high). From the second PRZ, a trade reversal was signaled as
AMZN traded above the two-bar high with a wide-range bar. An entry
was triggered around $70 with a stop below D level at $62.75. The first
target was placed at C level to $84.

Bearish Butter y Pattern

Figure A.12 shows the bearish Butterfly formation in HPQ stock. From
March 2008 to May 2008, the bearish butterfly formed from levels X
at $49.69 to A at $44.50, B at $48.50, to C at $45.19, and D at $49.87.
From the D level, a wide-range bar triggered a trade entry below 38% of
the XA range. A stop was placed above D level at $50.50. The first target
is set at 100% of AB Level to $44.68. The second target was placed at
127% of AB at $43.28.