Part 1.  January 28, 2013

Harmonics are a great source of information about the market, but they don’t tell you how or when to trade any more than do MACD crosses or breadth indicators.  So, how do you use them?  This discussion of the basic process might serve as a good starting place for beginners.

Harmonics first burst on the scene with the publication of H.M. Gartley’s Profits in the Stock Market in 1935 — more than a little ironic in terms of market timing.  Many technicians have expanded and refined Gartley’s initial work over the years, and those of us who practice harmonics swear by the results.

In general, harmonic patterns (Gartley, Bat, Butterfly and Crab) signal potential turning points based on prior price movements.  Most practitioners consider them to be successful about 70% of the time, which IMHO is very good odds.

I regard harmonics as trade alerts.  That is, every time we approach an important Fib level, I stop and consider whether the market is likely to react or not, then make a trade decision accordingly [for a discussion of Fibonacci levels, click here.]

There are pages for each specific pattern under the Learn>Harmonics tag on the Home Page.  But, they are quite similar in how they operate.  Let’s walk through a real world example.

SPX has fallen from 1576 to 666 and seems to have bottomed (knowing when a market has bottomed is a good trick, but that’s a topic for another post.)  I draw a Fibonacci Retracement grid on the price range (100% for 1576, 0% for 666) and make sure every important level is showing as on the chart below.

 

ThinkorSwim makes this very easy with a built-in drawing tool, as do many other platforms.  If your platform doesn’t provide it, you might want to think about changing, or at least opening up a TOS account to facilitate your charting (and, no, they don’t pay me to say that.)  You can read about harmonics and study the charts I post, but there’s no substitute for doing your own charting.

Back to our example: because we went long at the very bottom, we set our sights on the higher Fib levels.   All harmonic patterns are marked using the letters X, A, B, C and D.The inception point (high) is X, the low is A.  B is the first reversal, C is the next, and D is the completion. The location of the reversals relative to specific Fib levels tells us what kind of pattern we probably have.

Suppose we’ve watched SPX climb all the way up to 956, where there’s a 9% correction down to 869.  Because this reversal occurred below the .618 Fib level, we might have a Bat Pattern on our hands.  Bat Patterns complete at the .886 (1472) so we’ll make a note of that for future purposes and consider 956 a potential Point B.

We sail right through the .382 and .500 levels, then experience another 9% correction at just above the .500 (1150 to 1044.)  Again, it’s below .618, so it could be signalling a Bat Pattern.  But, it’s a relatively minor reaction, so we treat it as only a potential Point B.

Now we’re approaching the .618 at 1228.74 — the most important of the Fib levels.  Because the two prior reversals were pretty tame, we might suspect more from this one. We begin to contemplate a short position, and look for other signs of a reversal.

Because we’ve been watching closely, we notice a smaller Crab Pattern setting up as we approach the .618 (the purple pattern below.)  It features a Point D at 1215.93 — slightly below our .618 at 1228.74.  So, we feel pretty confident about this being a good trade entry.

Are there other chart patterns such as a rising wedge, channel, fan line, etc. that also hint at a reversal?  In fact, there’s a nice channel that’s formed over the past 9 months, not to mention a broken RSI channel (in red) just shy of the Crab completion.  And, we’re nearing the 1240 target of the Inverted Head & Shoulders pattern completed at the 2009 bottom.

These would all be good reasons to consider a short.  Taken together, they make for a pretty compelling argument.  Where, though?  Other traders are watching the same charts we are, so there’s a chance the reversal will come a little early.  We don’t wait to wait too long and miss the top.  But, of course, every point too early is a point of lost profit.

In the end, timing is a judgement call based on many factors, including liquidity, risk tolerance, the type of instruments we’re trading, other positions in the portfolio, etc. and is worthy of its own article.

Let’s assume we make the decision to open a short position around 1213 on the April 15 — in case SPX doesn’t make it all the way to 1215 or 1228.  We feel pretty good about our decision when SPX is down to 1186 the following day and 1183 the next.  That’s a 2.5% move in two days — not bad.

On the third day, however, our plan is looking iffy.  SPX gaps up on the open and hits 1208.  Three days later, it pops above the Crab target of 1215.93 and tags 1217, seemingly in search of the .618 at 1228.74.

Suddenly, we’re underwater by 15 points or 1.25%.  Is it time to bail?  Again, it depends on the type of investor you are.  Options traders might have closed their puts for large profits already, while swing traders might be happy as long as SPX doesn’t exceed 1230-1235.  Buy and hold types might have used the Fib level as a warning of a potential downturn and hedged or lightened up on their long positions.

Checking our charts, we can see that neither the price nor the RSI channels have been broken to the upside.  In fact, the little red RSI channel which helped convince us of the downside potential shows the latest push higher came with a lower RSI score (negative divergence) and a pretty pathetic back test.  So, we’re inclined to hang in there.

It turns out to be a great decision.  The following day, RSI plunges through the midline of the purple channel.  SPX plunges 38 points from its high, stabilizes for four days, then really starts falling apart.  On May 4, SPX reaches the white channel midline, a possible bounce spot.  We’ve already made 4.5% since shorting at 1213 less than 3 weeks ago.  Time to bolt?

To be continued…