There are various chart trading patterns that can help you make better trades. However, some of the most reliable and forward-looking trading patters include the Gartley, the Butterfly and the AB=CD, also mentioned as harmonic patterns.
A market either moves in a trend whereas it expands or moves sideways or consolidates whereas it contracts. Usually for contraction the most commonly used ratios are .618 and .50, whereas for expansion the most commonly used ratios are 1.618 and 1.27.
I want to emphasize the advantage of these patterns over other patterns in that they offer trading opportunities with predefined reward to risk ratios and predefined profit take targets and stop loss.
Trading these patterns can feel like following a flight plan. No guessing involved after you have familiarized yourself!
Let’s go through….
1. Simple, but important – The AB=CD pattern.
The AB=CD pattern is based on the repetitive nature of price swings in the markets in all time frames. As you will further see it’s also a critical component of Gartley and Butterfly patterns that we are going to see next.
First leg AB is the basis – The pattern starts with the leg AB which is the benchmark for the next retracement leg BC. BC usually retraces leg AB by a Fibonacci ratio (.382, .50, .061, .786) depending on the strength of the trend. In strong trends it will usually retrace leg AB by .382 or 0.50, whereas in weak trend it could retrace AB by as much as .786.
Third leg CD completes the setup – The third leg CD follows the completion of BC and moves in the same direction as the first leg AB. Usually leg CD is a 1.27% or 1.618% extension of leg AB. Once the CD leg starts to form and passes point B, then we start to anticipate the CD leg’s completion based on it’s the time, number of bars, angle and key Fibonacci ratios mentioned above.
These 2 Rules Are No Go:
- BC retracement cannot retrace more than 100% first leg AB. This invalidates the pattern.
- Final leg CD cannot end before exceeding point B. It can end right on the level B for a 100% extension of leg AB, but no less.
The Trade – Trading the pattern is easy. Once the pattern completes within an applicable Fibonacci ratio the trader puts a short or long trade in the opposite direction with a stop loss slightly above or below the reversal candlestick’s highest or lowest point accordingly.
Profit Target – The most likely take profit targets are the .618 and .786 retracement levels of the move from A to D. In many cases the market will continue further with strong momentum, but these targets have been the most consistent and recommended.
Be Aware – However, there are cases that the market will continue moving in the same direction and hit the stop loss. That’s why it is important that we set a stop loss order according to our risk tolerance.
Take the Profits – In addition, it is always best to take some profits as the market moves in our favor and trail the stop loss with our remaining lots.
2. Consistent since 1930 – The Gartley Pattern.
There isn’t a more classic retracement pattern than Gartley ‘’222’’. The pattern has been around since 1930 and some claim it has a consistency of 70% under certain conditions.
Gartley’s many main advantage is the fact of allowing a trader to enter a potentially lucrative reversal trade with a minimum and quantifiable risk.
AB=CD pattern inside Gartley – The modern version of the Gartley patterns utilizes certain Fibonacci ratios to improve consistency and is built on the AB=CD pattern with an additional leg, the XA leg. Basically, Gartley is an XAB=CD pattern and also appears in all markets and time frames making it a valuable tool to a trader’s trading tools.
These 3 Conditions Are No Game:
- Point D cannot exceed the starting point X.
- Point A must always exceed or at least be equal to C in rare cases.
- Point B can never exceed point X.
The Trade – The way to trade the pattern is to enter at .786 of XA leg’s retracement with a stop loss just below point X for safety.
Profit Target – The most likely take profit targets are the AD leg’s .618 and .786 retracement levels.
Money Management – I recommend using at least two equal trading lots in order to be able to capture partial profits with the first half and leave upside potential with the second while minimizing risk by trailing the stop.
3. The Wonderful Butterfly Pattern.
Handpicking the Tops and Bottoms – The Butterfly pattern is as close as it gets to capturing market tops and bottoms and while common wisdom says never try to go against the prevailing trend, the Butterfly patterns is probably your best bet in doing just that.
While the Gartley pattern is considered a retracement pattern, the Butterfly pattern is considered an extension pattern. It looks like a failed Gartley pattern whereas the completion of the pattern at point D exceeds the level of point X (remember in Gartley that D can never exceed X or at least reach the same level).
The Butterfly pattern usually completes in 1.27, 1.618 and 2.00 Fibonacci extension. Higher extensions are ignored as the pattern is considered failed at higher ratios.
Beware of these 5 Points:
- In order for the pattern to be valid, it needs to contain an AB=CD pattern.
- If leg CD exceed by more than 2.618 of leg XA then the pattern is likely invalid.
- B point can never exceed the starting point X of the pattern.
- Point C can never exceed point A
- If D does not extend beyond starting point X then we are not dealing with a valid Butterfly pattern.
The Trade – The way to trade the pattern is to enter at a 1.27 or 1.618 extension of leg XA leg with a stop loss above these points that would allow some room.
Profit Target – The most likely take profit targets are the AD leg’s .618 and 1.27 retracement levels.
Money Management – I recommend using at least two equal trading lots in order to be able to capture partial profits with the first lot and leave upside potential with the second while minimizing risk by trailing the stop.
Important Note: You will find many times that patterns on various time frames complete at the same time. That happens, and it is a very good confluence with higher probabilities of success and better reward to risk ratio. You can exploit this confluence by placing your stop loss based on the smaller time frame pattern and placing your exit orders at the exit targets of the larger time frame pattern.
Warning – I have to warn you though, that you always have to have in place proper risk management and stop loss orders to protect your capital, as if the pattern does not complete on the expected ratios, the market can move very quickly against you.
It might sound cliche at this point but, I it couldn’t be less important to have a solid money management and risk management in place for these patterns to work.
Many traders cannot accept draw downs and quickly change to other systems that could have worked and saved them from a specific draw down. It’s a fact though, that all systems have draw down periods and the most critical element in trading is to allow for such periods in order for a trading system to play out its edge over a much-needed large number of trades.