Guide to Precision Harmonic

Pattern Trading

Subtitle: Mastering Turning Point Strategy for Financial Trading

Author: Young Ho Seo

Financial Trader, Engineer, and Quantitative Developer

Book Version: 7.7 (25 June 2020)

Publication Date: 9 November 2016

Total Pages counted in MS-Word: 178

Total Words counted in MS-Word: 29,000

www.algotrading-investment.com

Risk Disclaimer

The information in this book is for educational purposes only. Leveraged

trading carries a high level of risk and is not suitable for all market

participants. The leverage associated with trading can result in losses, which

may exceed your initial investment. Consider your objectives and level of

experience carefully before trading. If necessary, seek advice from a financial

advisor.

Copyright Notices

Copyright © 2016-2018 by Young Ho Seo. All rights reserved. No part of

this publication may be reproduced, distributed, or transmitted in any form or

by any means, including photocopying, recording, or other electronic or

mechanical methods, without the prior written permission of the publisher,

except in the case of brief quotations embodied in book reviews and certain

other non-commercial uses permitted by copyright law.

Computerized Research with Patterns in Financial

market

I have to say millions of thanks to people worked with tradable patterns for the financial market before

me including R. N. Elliott, H.M. Gartley, W.D. Gann, R. Schabacker, L. Pesavento, S. Shapiro and S.

M. Carney. This book was published after the intensive computerized research with tradable patterns in

the financial market. Now, the new concept of Pattern Completion Interval and Potential Continuation

Zone is used and appreciated by many traders. If you are using this book to train other forex and Stock

market traders, I am happy with it but please do not forget to credit my work and this book. In addition,

if you are from hedge fund or fund Management Company and you need someone to carry on the

computerized research about the financial market data in the similar topics to this book, please do not

hesitate to contact me on: [email protected] for future research and development.

About this book

Harmonic Pattern trading uses the direct pattern recognition from the price

chart to predict the potential turning point of the financial market. Although

the history of the harmonic pattern goes back to the Gartley’s book “Profits in

the Stock Market” in 1935, Harmonic Pattern trading became popular in last

few decades. In comparison to many contemporary predictive techniques,

there are far less literature available to study this technique in several

different scientific angles. Most of harmonic pattern trader focuses on the

visual aspect of the pattern keeping very small attention on the precision

aspect. In this book, we want to introduce the brand new precision concept,

Pattern Completion Interval and Potential Continuation Zone, for harmonic

pattern trading. In the first few chapters of this book, we will illustrate the

concept and the operating mechanism behind these new techniques. After

that, we will focus on how to manage your order and risk with Harmonic

pattern. We will illustrate how to apply this precision concept for both market

order and pending order setup for your practical trading. At the end of the

book, we describe the rolling ball effect and we show how it can affect your

turning point strategy. In the final chapter, we introduce Mutual Pattern

Turning Point Strategy for your practical trading. Then we show you three

essential but powerful steps to trade with turning point strategy. Please note

that we use our own custom ratio sets for harmonic patterns presented in this

book because our backtesting and forward testing results indicates that they

perform better than the original patterns. The studies presented in this book

are the results after the intensive computerized research using Harmonic

Patterns. If you want to dig deeper on rolling ball effect and other mutual

patterns for turning point prediction, you can also read our book: Scientific

Guide to Price Action and Pattern Trading.

Download Peak Trough Analysis Tool

In the book, we provide some exercise on manual pattern detection. For

manual detection of patterns, you need to use Peak Trough Analysis tool. We

provide Peak Trough Analysis Tool for free of charge for this book. Here is

the download link for the free version of Peak Trough Analysis. Please

download Peak Trough Analysis before reading this book. In addition, we

provide the practical MetaTrader tutorial with Peak Trough Analysis at the

end of this book (Chapter 13).

1) MetaTrader 4 Version of Peak Trough Analysis

www.mql5.com/en/market/product/23797

2) MetaTrader 5 Version of Peak Trough Analysis

www.mql5.com/en/market/product/22420

3) Peak Trough Analysis from Algotrading-Investment.com

www.algotrading-investment.com/portfolio-item/peak-trough-analysis-tool

In addition, Optimum Chart provides its own Peak Trough Analysis tool.

Hence, you do not need to download Peak Trough Analysis if you are the

Optimum Chart User. We also provide the Excel and VBA version of Peak

Trough Analysis for free. Please check the Chapter: Algorithm and Prediction

for Artificial Intelligence, Time Series Forecasting, and Technical Analysis

for the download link for this free tool. Even non-MetaTrader users can

practice Peak Trough Analysis.

Table of Contents

1. Introduction to Harmonic Pattern

2. The Concept behind the Pattern Completion Interval (PCI)

3. Pattern Completion Interval for Harmonic Pattern

4. Trading Setup with Pattern Completion Interval

5. Potential Reversal Zone (PRZ) and Potential Continuation Zone (PCZ)

6. Managing Reward/Risk Ratio with Real Time Market Data

7. Insignificant Turning Point, Local Turning Point and Global Turning Point

8. Market Order and Risk Management

9. Pending Order and Risk Management

10. Practical Trading Management

10.1 Various Risks in Trading and Investment

10.2 Position Sizing Techniques

10.3 Reward/Risk Ratio in your trading

10.4 Breakeven Success Rate

10.5 Know your profit goal before your trading

10.6 Compounding Profits

10.7 Trading Performance and Cost Metrics

11. Rolling Ball Effect and Harmonic Pattern Trading

12. Young’s Mutual Pattern Turning Point Strategy

13. Tutorial with Peak Trough Analysis

13.1 Loading Peak Trough Analysis indicator to Your Chart

13.2 Working with Fibonacci Retracement in Your Chart

13.3 Working with Fibonacci Expansion in Your Chart

14. Special Chapter: Algorithm and Prediction for Artificial Intelligence, Time Series Forecasting, and

Technical Analysis

15. References

1. Introduction to Harmonic Pattern

The concept of trading with patterns has been around the financial market

over 80 years even before R. N. Elliott pointed out the Elliott Wave patterns

from US Stock market in 1940s. Since then, various patterns have been

utilized by Forex and Stock market traders including Japanese candlestick

patterns, Harmonic patterns, Breakout patterns, Elliott Wave patterns, etc. In

this book, we mainly focus on the Harmonic patterns due to its wide usage in

the financial market. The main idea behind the Harmonic pattern is that price

movement is based on the structured relationship defined by Fibonacci ratios.

The typical Harmonic patterns are constructed from 4 to 5 price points in

your chart. The main application of Harmonic pattern is to identify the

potential key turning point in the financial market (Figure 1-1). Harmonic

patterns are typically accomplished by reversal traders. Due to the non-

lagging advantage over the technical indicators, Harmonic Patterns are used

by many professional traders in forex, future, and stock markets.

Figure 1-1: Bullish turning point example with Harmonic pattern in

EURUSD H1 timeframe.

The history of the harmonic pattern goes back to the Gartley’s book “Profits

in the Stock Market” in 1935. At that time, Gartley described the trend

reversal pattern on page 222 of his book. The pattern become popular in the

late 1990s (Pesavento and Shapiro, 1997). Carney (1998) identified the

structure of the several popular harmonic patterns in his work. Since then,

many traders developed the common interest in looking for the repeating

patterns in the financial markets. The harmonic patterns were refined many

times in several decades. Harmonic trader emphasizes that the patterns are

not only repeating in history but they also follow natural orders. Although

few different references exist about the meaning of the natural orders, the

natural orders mostly means the periods of the neighbouring waves in the

Fibonacci relationship (Pesavento and Shapiro, 1997). Fibonacci ratio

derived from Fibonacci numbers are the core relationship used in harmonic

pattern identification. To have a feel about the Fibonacci ratios, here is the 21

Fibonacci numbers derived from the relationship: Fn = Fn-1 + Fn-2. Many

traders uses these Fibonacci number sequences to derive some important

Fibonacci ratio.

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,144, 233, 377, 610, 987, 1597, 2584,

4181, 6765, …………………

As the Fibonacci number become large, the constant relationship is

established between neighbouring numbers. For example, every time, when

we divide the former number by latter: Fn-1/Fn, we will get nearly 0.618 ratio.

Likewise, when we divide the latter number by former: Fn/Fn-1, we will get

nearly 1.618. These two Fibonacci ratio 0.618 and 1.618 are the very

important basis for the harmonic pattern. These two ratios are even used by

many Elliott Wave practitioner too. In addition, harmonic pattern traders like

to use 0.786 and 1.272 ratio. The ratio 0.786 and 1.272 are derived from the

square root of 0.618 and 1.618 respectively. Likewise, one can derive the

secondary ratio 0.382 and 2.618 by squaring 0.618 and 1.618. Many more

secondary ratios can be derived using mathematical operations like square

rooting, squaring, inversing, adding and subtracting the primary ratio 0.618

and 1.618. In addition, primary Fibonacci numbers like 2, 3, 5 and 13, which

have no positive divisor other than one and itself, can be used to further

generate the secondary ratios. In Table 1-1, we list some commonly used

Fibonacci ratios and their calculation generally used by trader.

Type Ratio Calculation

Primary 0.618 Fn-1/Fn of Fibonacci numbers

Primary 1.618 Fn/Fn-1 of Fibonacci numbers

Primary 0.786

Primary 1.272 0.382=0.618*0.618

Secondary 0.382 2.618=1.618*1.618

Secondary 2.618 4.236=1.618*1.618*1.618

Secondary 4.236 6.854=1.618*1.618*1.618*1.618

Secondary 6.854 11.089=1.618*1.618*1.618*1.618*1.618

Secondary 11.089 0.500=1.000/2.000

Secondary 0.500 Unity

Secondary 1.000 Fibonacci Prime Number

Secondary 2.000 Fibonacci Prime Number

Secondary 3.000 Fibonacci Prime Number

Secondary 5.000 Fibonacci Prime Number

Secondary 13.000

Secondary 1.414 3.142 = Pi = circumference /diameter of the circle

Secondary 1.732

Secondary 2.236

Secondary 3.610

Secondary 3.142

Table 1-1: Fibonacci ratios and corresponding calculations to derive each

ratio.

Two main elements of Harmonic pattern trading are the pattern recognition

and the market timing. Between those two elements, the pattern recognition is

the prior task before the market timing. Mostly harmonic patterns consist of

five points except few patterns. The five points are denoted as XABCD

conventionally (Figure 1-2). Harmonic Pattern trading is the typical mean

reversion trading strategy. It assumes that the market will change direction,

for example, from buy to sell or from sell to buy. In fact, the harmonic

pattern detection is equivalent to detecting the turning point. Although the

accuracy of the turning point prediction is subject to the probabilistic nature,

harmonic pattern trading is popular among traders. In this book, we first

introduce the new concept, the Pattern Completion Interval, for harmonic

pattern trading. The Pattern Completion Interval was created by analogizing

harmonic pattern with other contemporary scientific methods like multiple

regression. The precise nature of Pattern Completion Interval can help

harmonic pattern traders in many ways. In the first few chapters, we illustrate

the operating principle of Pattern Completion Interval. After that, we will

demonstrate how to apply Pattern Completion Interval for the practical order

and risk management for your harmonic pattern trading in details.

Figure 1-2: Gartley Pattern detected by automatic pattern scanner in Hourly

EURUSD chart.

Figure 1-3: Small ABCD pattern (H1 timeframe) inside greater ABCD

pattern (D1 timeframe) in EURUSD. Both patterns were detected by

automatic pattern scanner.

2. The Concept behind the Pattern Completion Interval (PCI)

Pattern Completion Interval is the emerging concept first introduced from this

book. The concept was born after the extensive computerized research in

tradable patterns in the financial market conducted by myself. Therefore, not

many traders are aware of its existence yet. As you read this book, you will

find out that it is extremely useful concept for your harmonic pattern trading.

At the same time, the concept is not a rocket science. The concept is simple

enough for any average trader for their practical trading. To understand the

concept of the Pattern Completion Interval, we shall understand the term

approximation first. Of course, everyone know the literal meaning of

approximation. However, technically speaking, approximation make quite

big influence every day in our life, but many people will not notice its impact

unless you are the math geek crunching numbers all day in your job.

Whether you agree or not, approximation arises naturally every day in our

life. There can be plenty of examples but we shall start with most intuitive

one. Let us use the sprint record of Usain Bolt to learn about approximation.

The record-breaking sprint of Usain Bolt was the popular coverage in many

Newspapers during the 2016 Olympics since he was winning his third gold

medal in 100 meter sprint. Here is simple but interesting three numbers about

Usain Bolt, the fastest man in the world.

Height: 1.96 meters (6 foot 5 inches)

Distance: 100 meters

Time: 9.58 seconds

These three numbers can be true but maybe not. I am not suspecting about

legitimacy of Usain Bolt’s record like the drug test results in the Olympics. I

am pointing out that the measuring instrument, whoever measured, can only

approximately measure these numbers up to certain degree. It is not because

the measuring person did his job poorly but just because the instrument have

own limitation to measure these numbers. For example, the sprint time might

be 9.5823 seconds instead of 9.58 seconds. Maybe expressing it into 9582.3

milliseconds, we can be slightly more precise. However, still we are not dead

accurate. To be dead accurate, we need infinite number of decimals to

describe these numbers. This is impossible. Most of time, we will always

approximate regardless of what measurement unit we are using. Likewise,

the height of Usain Bolt is only the approximation too. Precisely speaking it

is impossible to tell if he is 1.963 meter tall or 1.962 meter tall. Besides the

height and time approximation, you can probably find many other

approximation examples in our daily life like weight, speed, calories, etc.

Here is another example. From your High School, you will probably

remember pi, the ratio of a circle’s circumference to its diameter up to 2

decimal places as 3.14. Once again, this is only approximation. Some

scientists remember it up to five decimal places as 3.14159 if they work

frequently with pi. In fact, even if we use 50 decimal places to describe it as:

pi = 3.14159265358979323846264338327950288419716939937510,

we are only approximating it. By now, you should realize that countless

approximation influence in and out of your life. One negative example might

be that my classmate in my old university in the United Kingdom, failed to

achieve the First Class honor since his overall score was only 69.4. In British

degree system, First Class honor is granted to the students achieving the

overall score over 70. First class honor is the highest grade they can achieve

under the British degree system. At the same time, the other mate scored 69.6

earned First Class honor. Apparently, the academic satisfaction for these two

friends were very different. Even after graduate, when they find jobs or when

they get married, when they do business, these Second Class and First Class

label will definitely stick with them. Now you can probably imagine that our

world is not as pretty and square as you think. Well the same thing goes to

scanning of Harmonic Patterns from your chart too.

Pattern Completion interval build its concept over the approximation but

nothing else. It is in fact based on the assumption that the measured ratio in

the harmonic patterns are only an approximation. Ideally, the popular Gartley

Pattern should consist of the ratios shown in Figure 2-1. It is because we

assume that harmonic pattern should have the exact Fibonacci ratio in theory.

However, when the Gartley pattern is detected by the pattern scanner, most of

time the pattern will possess the approximated ratios, which closely match to

the ideal Gartley pattern but not dead accurate. Well, one day you can be very

lucky to find the perfect Gartly pattern with perfect ratio in your chart. This is

very rare event. Even in this very rare event, the chance that your pattern will

be truly perfect is very thin because the pattern scanner might round up the

ratio AB/XA for 0.618 instead of 0.6181 or CD/BC for 1.272 instead of

1.2723. Approximation error is always there in our pattern detection task. We

will never be able to get rid of them since we have only limited memories

inside both human brains and computers.

Figure 2-1: Structure of Gartley Pattern for Bullish and Bearish Pattern.

Since this approximation exists every time in detecting harmonic pattern, we

know that, we are less accurate every time when our pattern scanner measure

the ratio 0.618 or 0.382 or other Fibonacci ratio from our chart. Well, this is

very common facts in the scientific world. On the other hands, as this is so

common, the scientist already gave a lot of thought in overcoming this

approximation error rather than using infinite number of decimals to describe

the measurement.

So how can we be overcome this approximation error? Typically, in practical

application like engineering and statistics, people use tolerance as one

possible way of describing the measurement. In technical term, tolerance is

the total amount by which a specific dimension is permitted to vary. The

tolerance is the difference between the maximum and minimum limits. Going

back to our Usain Bolt’s sprint record. Instead of writing 9.58 seconds, we

can write 9.58 seconds 0.005. This means that Usain Bolt’s record will

not be greater than 9.585 seconds and it will not be smaller than 9.575

seconds. His record will fall somewhere in between 9.585 and 9.575. By

assigning maximum and minimum tolerance limit, we can be more precise in

recording his records. We can also avoid using the infinite decimal places to

describe his record. Using infinite decimal places is impractical. Likewise,

we can describe his height as 1.96 0.005. This means that his height will

fall in between 1.965 and 1.955 meters.

How this tolerance can be related to the Pattern Completion Interval in our

Harmonic Pattern trading? Well, Pattern Completion Interval is in fact no

more than just the tolerance limit described above. It is indeed the upper and

lower limit permitted to vary in detecting Harmonic Pattern. Since detecting

Harmonic Pattern is quit visual task, it might be a good idea to show the

pattern completion interval using a box like in Figure 2-2. In the AB=CD

Bearish reversal Pattern in Figure 2-2, the upper limit is the maximum price

level permitted for this pattern to be qualified as AB=CD Harmonic Pattern.

If EURUSD goes beyond this Upper Limit, then the Pattern can not be

qualified as the AB=CD pattern since the pattern is breaching the tolerance

limit for the given Fibonacci ratio.

In general, the tolerance limit in many practical applications are specified in

symmetric manner like 1.96 meters 0.005. Technically, we can assign

symmetric Upper and Lower Limit for Pattern Completion Interval too.

However, either one limit between Lower Limit and Upper Limit is relevant

for our trading depending our trading direction. For example, for Bearish

Reversal Pattern, we only need to concern about Upper Limit since we want

to know when the Harmonic Pattern will fail to form from the price moving

too high. Likewise, for Bullish Reversal Pattern, we only need to concern

about Lower Limit.

Figure 2-2: Bearish AB=CD Pattern for EURUSD.

Another peculiar thing to discuss is that unlike our height and time example

from Usain Bolt’s sprint, our pattern detection task involves several ratios

and not just single ratio. For the Bearish AB=CD pattern in Figure 2-2, we

will measure the ratio BC/AB and CD/BC together to check if these ratio are

held near 0.618 and 1.271 respectively. Alternatively we can also check if the

ratio is held near 0.786 and 1.618 respectively. Since we are checking two

ratios, in fact we are concerning about 4 points for our pattern detection in

our case of AB=CD pattern detection. Although the most important tolerance

limit will be based on the final point D, one can still have the tolerance limits

at the point A, B and C too. However, the tolerance limits at the point A, B

and C are much less useful for our trading. In our operational definition, the

Pattern Completion Interval is the tolerance limit at the final point D.

Pattern Completion interval and tolerance concept should clear up the most

commonly asked questions from junior traders like:

Why detected Harmonic Patterns have the ratios different from the

ideal one?

I am seeing the wrong patterns in my chart. Can I only see the ideal

patterns in my chart?

My pattern is dead accurate. If I trade with this pattern, can I have

success rate of 96%?

Although we use the analogy of tolerance to illustrate the concept of the

Pattern Completion Interval. In the course of our research, the concept of

pattern completion interval was actually drawn from the concept of the

prediction interval and confidence interval from statistics. For simple

example, consider the simple regression with prediction interval and

confidence interval shown in Figure 2-3. The fitted line on the constructed

regression equation is the point prediction for the given x values. If we are

using this regression equation to predict future y values according to the

given x values, you can see that the point prediction from the given fitted line

will not accurately predict the future outcome from Figure 2-3. In fact, most

of time, prediction from regression equation will offer us some reference

points to consider but they will be quite far out from actual future outcome.

Instead of relying on this point prediction, statistician use prediction interval

to illustrate worst and best case of your prediction in probabilistic sense. For

example, 95% prediction interval means that future outcome will fall within

this interval 95% of time. With the prediction interval, it is much easier to

assess your risk of making wrong prediction than just using the point

prediction alone. Likewise, the confidence interval is the similar concept to

prediction interval. Instead of concerning the point prediction, Confidence

interval concern our choice of parameters in our mathematical model. Since

we can only estimate our parameters based on our sampled data, confidence

interval help us to assess our risk associated with our choice of parameters.

As before, 95% confidence interval means that the true population parameters

will fall within this interval 95% of time. For both prediction interval and

confidence interval, 90%, 95% and 99% are the common intervals to use.

However, some industries use some other intervals like 80%.

We found that our Pattern Completion Interval shares many common ideas

with prediction Interval and confidence interval. However, it is difficult to

tell which one is closer to Pattern Completion Interval. The Pattern

Completion Interval helps us to assess the risk associated with the Harmonic

Pattern formation. If we view the harmonic pattern detection task as the

prediction of turning point, then the Pattern Completion Interval offer the

similar functionality to prediction interval to users. However, the Pattern

Completion Interval does not offer us any probabilistic information like

prediction and confidence interval do. Since we assume the Fibonacci ratio as

an absolute measure for the Harmonic Pattern formation, the typical concern

rising over the choice of parameters, which is necessary for many other

practical applications, fade away. Since this book focus on the practical side,

it make more sense to concern about the functionality of Pattern Completion

Interval for traders.

Figure 2-3: Illustration of simple Regression equation with confidence

interval and prediction interval.

3. Pattern Completion Interval for Harmonic Pattern

In previous chapter, we have covered the concept behind the Pattern

Completion Interval. In this chapter, we will show you how the Pattern

Completion Interval works for Harmonic Pattern. Harmonic Patterns are

detected measuring the ratios between retracements. The ratio can be

expressed like this:

where retracement 2 comes after retracement 1.

Since the building block of Harmonic Patterns are the Fibonacci

Retracement, it might be easier to illustrate this ratio using Fibonacci

Retracement. In Figure 3-1, the ratio AB/XA is nearly 0.382 (38.2%). After

the price moved from X to A, some retracement made from A to B. Most of

the 5 points Harmonic Pattern start like this. Initially they make AB/XA in

significant Fibonacci ratio like 0.382 or 0.618 or some other Fibonacci ratio.

For 4 point patterns like AB=CD, they will make AB/BC in significant

Fibonacci ratio to start with. To form a good harmonic pattern, the price must

continue to move in Fibonacci ratio in next successive points.

In our example in Figure 3-1, we have nearly 0.382 retracement since this

ideal case was chosen for the textbook example. In real trading, you might

meet a lot of premature Fibonacci Retracement reverting at 0.370 or 0.367

instead of 0.382. Even you will observe the late reversal at the ratios like

0.390 or 0.400. Here again, we can not escape from the approximation error.

Many traders are looking at different chart through different platforms. Each

trading or charting platform consistently round up their numbers up to six

decimal places or less. Different brokers uses different data feed and their bid

and ask prices are varying from one company to the other. In addition, the

financial market often shows the total random fluctuations, which can not be

explained by any of the above reasons. All these add little bit up on making

our market much less ideal system than how junior traders might think. Now

we are facing one ugly truth about the Financial Market.

To make our ratio less vulnerable from approximation error, technically, we

can set the tolerance limit on our first ratio AB/XA as shown in Figure 3-1.

On the other hands, our tolerance limit can serve as our criteria to trigger our

trading. You could trigger your trading based on this tolerance limit if you

want to trade with 3 points reversal, called Harmonic Triangle by some

traders. For example, you might set 0.382 1% [0.386, 0.378] as your

upper and lower limit. You will trade if the retracement falls within this

permitted range. Practically speaking, 1% tolerance limit is normally quite

tight. You will not meet such a case quite frequently in real world trading.

Instead, you can set generous tolerance limit like 0.382 5% [0.400,

0.360]. You will have more trading opportunities with 5% tolerance than 1%.

Since our focus is how to trade with Harmonic Patterns rather than Harmonic

Triangle, we shall extend the Harmonic Triangle with next harmonic triangle.

Typically, you can assume that Harmonic Patterns are made from several

Harmonic Triangles like this.

Figure 3-1: Harmonic Triangle made from 3 points. The ratio AB/XA is

nearly 0.382.

Since this is the chosen textbook example, we already know that the price

will follow good path through point C and D. After point B, the price further

continues to retrace making the ratio CD/BC is nearly 2.00 (200 %). This

successive retracement in Fibonacci ratio will lead to second Harmonic

Triangle. In fact, these two Harmonic Triangle forms the cypher pattern in

our example.

Figure 3-2: Two successive Harmonic Triangles made from XABCD 5

points.

Note that we have shown the tolerance limit for the final point D in Figure 3-

2. As we have mentioned, the Pattern Completion Interval is the tolerance

limit at the final point D for the detected Harmonic Pattern. For any

Harmonic Pattern, the Pattern Completion Interval can be calculated

including Gartley, Butterfly, Shark, Cypher, AB=CD, etc. As we have lightly

exposed you with the role of tolerance limit in the case of Harmonic Triangle

earlier, you can probably understand how important having Pattern

Completion Interval is for your trading. Later we will expose you on the

detailed trading strategy with Pattern Completion Interval.

Tolerance limit calculation for Harmonic Triangle is straightforward. It is

little bit more complicated with the case of Harmonic Patterns. Since

Harmonic Patterns are made from several Harmonic Triangles, there are

some knock on effect from all 5 points. Since this book is meant to be for

traders, we will not discuss the calculation part for the Pattern Completion

Interval in this book. However, we should know that the size of the Pattern

Completion Interval is affected by several factors. Firstly, Pattern Completion

Interval size will depend on the size of patterns. In general, we will have

bigger Pattern Completion Interval for larger patterns. For example, when we

set our tolerance limit to 0.382 5% [0.400, 0.360] for the ratio AB/XA.

The range for the retracement AB can differ quite dramatically from 360 to

400 pips when our XA retracement spans over 1000 pips. If XA spans over

100 pips only, then the permitted range for retracement AB can be from 36

pips to 40 pips. Secondly, Pattern Completion Interval size will be depending

on the location of previous 4 points. From our example, if we have B and C

with huge errors from ideal ratios, then we are likely to have bigger Pattern

Completion Interval for Point D too. In general, if the pattern looks closer to

ideal pattern, then the pattern completion interval can be smaller too for the

same pattern. The first factor normally have greater influence on the size of

Pattern Completion Interval than second factor.

The chance for the price to touch the ideal level at all five points XABCD for

Harmonic Patterns are very low. The chance is even thinner than the

Harmonic Triangle case with 3 points. Statistically speaking, for more points

in your patterns, there is less chance that you will have the perfect ideal

looking patterns in your chart. Therefore, when you set the tolerance limit for

the Pattern Completion Interval, we need to use some generous margin to get

some trading opportunities. Otherwise, you may never get any trading

opportunities. After all, the great thing about using the ratio for pattern

detection task is that it is unit-less. Therefore, the same methodology can

work for many financial market applications. Forex, Stock, Future and

Commodity market are very good candidate market for you to test your

Harmonic Pattern Trading. From my experience, the success rate of each

market are very different. Even among the same market, it is important to

note that the success rate of Harmonic Pattern are different for different

instrument. It is mostly wise to apply harmonic pattern trading to most

popular instrument. In addition, I often heard from many traders in my

network that the harmonic pattern does work well in the emerging stock

market like Indian, Brazilian, Turkish, etc. Since Harmonic Pattern are based

on Fibonacci Retracement, if the instrument works well with Fibonacci

Retracement, then there is high chance for the harmonic pattern trading to

work for that instrument too.

Figure 3-3: The structure of bullish and bearish cypher pattern.

Figure 3-4: Bullish cypher pattern in EURUSD with Pattern Completion

Interval.

4. Trading Setup with Pattern Completion Interval

We covered sufficient details about Pattern Completion Interval in the

previous chapters. In short, it is the tolerance limit at the final point D. Figure

4-1 illustrates Pattern Completion Interval visually in the chart. In Figure 4-1

below, if the price at pattern detection candle went below the lower tolerance

limit 1.30173, then the pattern would be not qualified as a valid Harmonic

Pattern. Since the price stayed within the Pattern Completion Interval, the

pattern formation was successful and so it was for your trading too if you

trade with this pattern. We are currently using our Tolerance Limit 5%.

This gave us 19 pips range between upper and lower limit. You can see that

the low at pattern detection candle just touched 1.30173 and in fact the low

can touch anywhere inside our Pattern Completion Interval as long as they do

not move below 1.30173. Now let us do some experiment with tolerance

limit 10%.

Figure 4-1: Pattern Completion Interval for EURUSD with tolerance limit

5% (Box Range = 19 pips).

You will expect that the increase in tolerance limit will widen the range

between upper and lower limit. With tolerance limit 10%, the range

become doubled to 38 pips. In Figure 4-2, we can see that low at pattern

detection candle is in fact pretty inside our Pattern Completion Interval.

Figure 4-2: Pattern Completion Interval with tolerance limit 10% (Box

Range = 38 pips).

At this point, you might wonder what the good tolerance limit is for Pattern

Completion Interval. Since the Pattern Completion Interval is a new concept,

google search is not that useful. We will not find any useful literature for this

from our public library either. The best approach is probably to seek some

reference from some other industries. Many industries including engineering,

finance, business like to use 90%, 95% and 99% or 1%, 5% and 10% criteria.

For example, in statistics, 1%, 5% and 10% are the common probability limit

to reject the null hypothesis over some statement. This might be good

reference point to start with. Since we need our tolerance limit to reject the

ugly patterns, whose ratios does not match the ideal Fibonacci ratio well,

statistical tolerance limit have some close proximity to our application.

However, these statistical probabilities assume the normal probability

distribution of data. In our pattern matching exercise, it is difficult to assume

any normality for our tolerance limit. Since we are traders, we will not drill

down much of these theories. However, it is still good to know that other

industry make good use of tolerance limit in their application.

Figure 4-3: Tolerance limit example in statistical application.

Another good reference point we can count about tolerance limit is the

mechanical engineering industry. In the mechanical engineering industry,

tolerance limit is heavily used for design and engineering purpose. Often

tolerance means that the physical tolerance limit for the dimension of the

object. The main purpose of this type of tolerance limit is that the object must

fit precisely to another object. For example, gear must fit precisely to shaft so

they can function properly for engine. Otherwise, the design fails and waste

the materials. The safety cannot be guaranteed for your car. Most of time, the

tolerance limit in the mechanical engineering industry is measured in meters,

centimeters and millimeters. Since we are using ratio instead of dimension

unit, our mechanical engineering example is not the perfect match for our

application either.

Figure 4-4: Tolerance limit example in mechanical engineering industry.

Since our pattern scanning is unique task, we can only use above references,

from statistical and mechanical engineering industry, as the rough guideline.

However, it is much better to have something than not. Since we are dealing

with many Fibonacci ratios, expressing our tolerance limit with percent is

more convenient than expressing them with decimal numbers. To give you

some ideas, using 1% or 5% tolerance limit make much more sense and much

more applicable across the entire Fibonacci ratios, 0.618, 0.382, 1.27, 0.786,

1.27, etc. If you are using 0.001 or 0.002 decimal numbers, then soon you

will find that your tolerance limit is not equally sized for different Fibonacci

numbers. Let us avoid the problem by choosing percent.

Although we cannot claim it with beautiful normal distribution, we can still

make use of some good percentage numbers 1%, 5% and 10% from our old

school as our tolerance limit for our pattern completion interval. Since we

want to pick up reasonably good-looking patterns matching to the ideal

pattern, our choice for 1%, 5% and 10% are not bad. If the final point D of

the pattern is out over 10%, then the flawed pattern will be quite notable

visually too. We can use some complicated statistical approaches for the

pattern identification task. However, there is absolutely no need to

overcomplicate things for traders. We will explain why our percent tolerance

limit is sufficient for us in next couple of paragraphs.

Our tolerance limit for Pattern Completion Interval is two-sided symmetric

tolerance. In fact, 1%, 5% and 10% will correspond to 0.5%, 2.5%

and 5% respectively. You will find that you will get too few patterns

qualified with 0.5% and 2.5% tolerance limit. 5% might be good

choice. Since some industries use tolerance limit of 20%, 10% can be

usable tolerance limit. Normally it is not great idea to use tolerance limit over

10%. With tolerance limit over 10%, qualified patterns will not pass

your visual inspection since their final point D is deviated too much from the

ideal level. From our experience, tolerance limit in between 5% and

10% are quite acceptable.

As we discussed before, we need the Pattern Completion Interval to deal with

approximation error. At the same time, it can serves as our criteria to qualify

the detected patterns. Since we are traders, we are more interested in the

second point. Indeed our Pattern Completion Interval can serve as your first

consideration for your stop loss. For example, the lower limit 1.30077 in

Figure 4-2 can be considered as your stop loss for your buy position since the

pattern formation will fail if the price goes below 1.30077 level. In fact, it is

not logical to hold your position after the pattern is failed to form although

you can still do that. You can still hold your position even after the failure of

the pattern formation. In that case, you have to increase the size of stop loss

at the same time reducing your Reward/Risk ratio. In general, it is not

sensible idea to hold you position this way.

Since we are using Pattern Completion Interval as our stop loss, we could

make use of our Pattern Completion Interval for our take profit too. The

sensible way of putting it together is to use the Pattern Completion Interval as

the building block of take profit and stop loss. For example, we can use

multiple of Pattern Completion Interval Range to express our Stop Loss and

Take Profit as shown in Figure 4-5. In the example in Figure 4-5, we use stop

loss and take profit in 1 times Pattern Completion Interval Range. Therefore,

the size of stop loss and take profit are 38 pips since we are using 10%

tolerance limit. Since take Profit and stop loss are equal, our Reward/Risk is

one. In real trading, Reward/Risk will be little less than one since you have to

pay commission. The great news is that our stop loss is quite affordable.

Since this is based on 10% tolerance limit, we will have even smaller

stop loss size if you choose 5% tolerance limit. Well, of course, the

advantage comes from the fact that we have measured precisely the tolerance

limit for our pattern formation. Therefore, in our stop loss, there is not too

much excessive assumption to eat up our Reward/Risk ratio.

Figure 4-5: Stop loss and take profit expressed in Pattern Completion Interval

10% (i.e. Reward/Risk=1).

Since we prefer higher Reward/Risk, you can in fact use greater take profit

like 2 or 3 times Pattern Completion Interval Range. Figure 4-6 shows take

profit with 3 times Pattern Completion Interval Range with tolerance limit

5%. We can see that our take profit level is well below 61.8 %

retracement of CD leg in Figure 4-6. The most important take away here is

that we have formulated our stop loss level in a way that we do not need a lot

of momentum after the turning point. It is very difficult to predict how much

momentum we will have after the turning point. If your stop loss is too wide,

then you can not win without having a good momentum in your trading

direction. With our stop loss formula, your concern about having good

momentum can be dramatically reduced. This means that you can be

profitable even if you have small retracement after the appearance of our final

point D. So far, we have covered the risk formulation using Pattern

Completion Interval for your trading. We have not covered about the median

open price yet. In the next part, we will discuss how to apply this risk

formulation in real world trading for the favourable outcome for traders. We

will also explain the concept over the median open price as well as order

execution mode in details.

Figure 4-6: Stop loss and take profit expressed in Pattern Completion Interval

5% (i.e. Reward/Risk=3).

5. Potential Reversal Zone (PRZ) and Potential Continuation

Zone (PCZ)

In previous chapter, we have described the Pattern Completion Interval in

details. Now many harmonic pattern trader can be curious how the Pattern

Completion Interval (PCI) is different from the Potential Reversal Zone

(PRZ) introduced by Carney (1998). In first place, as the PCI and PRZ are

derived from different process, they are two different tools to trader. Having

said that, the deriving process for PCI and PRZ might be complicated causing

some traders to confuse the concept from each other. For this reason, we will

clarify the difference by comparing PCI and PRZ here. Let us look at the

Potential Reversal Zone since we have covered PCI in details. So what is

Potential Reversal Zone? Simply speaking potential Reversal zone is the area

where three or four Fibonacci levels are converging together. Potential

Reversal Zone can be used to detect the final Point D of the Harmonic Pattern

by projecting several Fibonacci retracements respectively from the point X,

A, B and C. The area of the Potential Reversal Zone can be defined by the

top and the bottom projected levels in the all projected levels as shown in

Figure 5-1.

Figure 5-1: Illustration of Potential Reversal Zone forming non-symmetrical

trading zone around Ideal Point D for XABCD Harmonic Pattern.

Figure 5-2: Potential Reversal Zone formed the Non Symmetrical Trading

Zone around Ideal Point D of Bullish Gartley Pattern.

The main difference between PCI and PRZ is that Pattern Completion

Interval forms the strict symmetrical trading zone around the ideal Point D

(Figure 5-3 and Figure 5-4). The Potential Reversal Zone (PRZ) does not

form the symmetrical zone. However, the PRZ area formation is dependent

on the location of each Fibonacci level projections as shown in Figure 5-1

and Figure 5-2. Sometime PRZ area can form the symmetrical trading zone

but it is only by chance. Most of time, Potential Reversal Zone will not form

the symmetrical trading zone. On the other hands, Pattern Completion

Interval will strictly form the symmetrical trading zone for every Harmonic

Pattern. Due to this symmetrical property of the Pattern Completion Interval,

trader can use many different trading strategies around the symmetrical

trading zone beyond the classic Harmonic Pattern trading setup. With Pattern

completion Interval, you can expand your classic trend reversal entry to

hedging and breakout trading by setting identical but opposite trading. For

example, for bullish Harmonic Pattern formation, you are able to setup the

buy and sell hedging positions or straddle breakout setup around the Pattern

Completion Interval. This is possible because the Pattern Completion Interval

provide the median open price, which can be mirrored around the Ideal Point

D.

In addition, Pattern Completion Interval provides you the direct numerical

description corresponding to the size of the Harmonic Pattern like 5%, 10%

and 15%. This means that the height of Pattern Completion Interval is

approximately proportional to the height of the Harmonic Pattern. However,

the height of Potential Reversal Zone and the height of Harmonic Pattern are

not directly related to each other. Sometimes the height of PRZ can be too

narrow whereas the height of Harmonic Pattern is too large. For this reason,

the heights of symmetrical trading zone around the Pattern Completion

Interval is a readily scalable measurement for your stop loss and take profit

for each Harmonic Pattern. Especially, once you have mastered the Pattern

Completion Interval for your trading, you can gauge your Reward/Risk Ratio

with real time market data without the need of any other additional tools. You

can expand this knowledge with limit and stop order for better managing

your order and risk.

Another advantage of pattern completion interval is that you need very little

concern about analysing candlestick patterns after the formation of Harmonic

Pattern. For example, the typical Harmonic Pattern Trader uses an additional

step to define entry price analysing the terminal bar or other candlestick

patterns. This judgemental task of entry price analysis might be difficult for

starters and junior traders. With the Pattern Completion Interval, your entry is

predefined with the formation of the Harmonic Pattern. Therefore, your

trading can become much simpler and efficient. In spite of this convenient

feature, you will see how sophisticated trading plan you can build with

pattern completion interval in next few chapters.

Overall, Pattern Completion Interval can provide you precise and fast

decision-making process for your Harmonic Pattern Trading. For your

information, the concept of Pattern Completion Interval is not only applicable

to Harmonic Pattern Trading but you can also applies for any other tradable

patterns. Therefore, the Pattern Completion Interval is a very general trading

framework for the financial market. In next chapter, we will continue to show

you how the symmetrical trading zone of Pattern Completion Interval works

to manage your order and risk in details.

Figure 5-3: Illustration of Symmetrical Trading Zone detected around Ideal

Point D for XABCD Harmonic Pattern.

Figure 5-4: Pattern Completion Interval formed the Symmetrical Trading

Zone around Ideal Point D of Bullish Gartley Pattern.

Another important concept we found from our Research is Potential

Continuation Zone. Potential Continuation Zone was not covered by any

other harmonic pattern trader before. The definition of Potential Continuation

Zone was first introduced in my other Book: Scientific Guide to Price Action

and Pattern Trading. Potential Continuation Zone is the paired concept to

Potential Reversal Zone. It is similar. Hence, Potential Continuation Zone is

also the area where three or four Fibonacci levels are converging together.

However, the important difference is that Potential Continuation Zone is

constructed after the final point D is formed. Since we confirmed all five

points X, A, B, C and D, we can use all four legs XA, AB, BC and CD to

construct Potential Continuation Zone (Figure 5-5). For this reason, the

algorithm to construct Potential Continuation Zone is different from Potential

Reversal Zone marginally. Potential Continuation Zone also serves different

purpose to Potential Reversal Zone. Potential Reversal Zone is there to

predict the Point D of harmonic pattern. However, the main purpose of

Potential Continuation Zone is to predict future price movement after

harmonic pattern and Point D is confirmed. Just as if its name indicates, price

needs to penetrate these Potential Continuation Zone if we have the valid

turning point at Point D. Another difference comes from that we can have

multiple of Potential Continuation Zone after Point D. These Potential

Continuation Zone can be used to gauge further reversal or breakout

movement for your harmonic pattern. For example, in Figure 5-6, we can tell

that the turning point at Point D does not lead us to continuous bullish action.

The price made another turning before Potential Continuation Zone. This

type of Harmonic pattern is not necessarily failed but they just do not provide

us sufficient range for profit. On the other hands, in Figure 5-7, price made a

clean breakout through Potential Continuation Zone. As a result, the pattern

provided greater profit range for our trading. As we have mentioned before,

unlike Potential Reversal Zone, we can have multiple of Potential

Continuation Zone. In Figure 5-8, we had five Potential Continuation Zone

on GBPUSD. Each potential reversal zone helped us to predict six dead

accurate turning point after Point D was confirmed.

Figure 5-5: Illustration of Potential Continuation Zone.

Figure 5-6: Potential Reversal Zone and Potential Continuation Zone for

Bullish Harmonic Pattern.

Figure 5-7: Potential Reversal Zone and Potential Continuation Zone for

Bearish Harmonic Pattern.

Figure 5-8: Potential Continuation Zone for Bullish Harmonic Pattern for

GBPUSD H4 timeframe.

So far, we have introduced the concept of Pattern Completion Interval,

Potential Reversal Zone, and Potential Continuation Zone. For the practical

application, you will need to blend these three concepts into your trading

strategy. If Potential Reversal Zone and Pattern completion interval is

concerning your entry, you can use Potential Continuation Zone for your exit.

On the other hands, you can even create a trading strategy exclusively using

Potential Continuation Zone as an entry and exit too. In this case, the way

you trade is not so different from typical support and resistance trading. In

terms of prediction power, Potential Continuation Zone will provide much

higher accuracy to any other known support resistance lines.

If we compare Potential Reversal Zone (Carney, 1998) and my Potential

Continuation Zone, I can tell that this is like Yin and Yang in the ancient

philosophy. Like female-male, dark-light and old-young, Potential Reversal