The beauty of the ABCD pattern in Market analysis

Keywords: Technical analysis, Fibonacci, Harmonic patterns, ABCD, Trading, Currencies, Financial markets.

Scott Carney wrote several terrific books[1] about harmonic patterns and has made significant advancement in this amazingly beautiful type of analysis. To have a full view on harmonic patterns, one will need two things:

• An eagle’s eyesight. Not literally but it’s a very important skill to develop. The ZigZag indicator might help detect some wave formations.
• Know the Fibonacci retracements that are relevant to trading or at least have a software that features them.

What are harmonic patterns?

They are a combination of simple and complex formations of certain ratios and their reciprocals through candlesticks that might indicate a reversal or at the very least a correction zone at certain levels. As any other type of analysis, it is better to use them in conjunction with other methods and indicators. The most common harmonic pattern is the ABCD. The name refers to 4 points in time and two legs, the AB leg which then retraces to the C point, then from the newly formed BC leg, we calculate the projection to the D leg that is going to be the tradable point. The main retracements and their reciprocals as outlined in Carney's book are:

So, ABCD patterns refer to two legs defined by two impulse and correction waves. The ratios go hand in hand with ABCD patterns and just like in the previous chart, 0.618 is followed by 1.618 and 0.786 is followed by 1.272. Below is a simple example on the EURGBP pair of two successive ABCD patterns that have succeeded in providing adequate signals:

The white letters refer to the first ABCD pattern that is characterized by a 0.618-1.618 (the first blue triangle and the first pink triangle) and the orange letters refer to the second ABCD pattern that is characterized by a 0.786-1.272 (the second blue triangle and the second pink triangle). At point white-D and point yellow-D, the trades could have been initiated. The optimal way was to combine them with any support or resistance level, otherwise acting solely on the patterns may entail some unnecessary risk. Another example of an ABCD pattern on the NZDUSD pair:

The ABCD framework is therefore:

• Detecting all relevant waves and their corrections as well as noting the retracements of the corrections’ levels. It is also a good idea to color the areas of waves and corrections.
• Start visualizing the patterns in your head and cross-check them with what you see. The ABCD pattern can be found by searching the patterns that look like double waves.
• Double-check the retracements and make sure the levels are mirrored (i.e. 0.618 vs 1.618 and 0.786 vs 1.272).
• The ZigZag indicator can help with finding some waves.

Issues with the ABCD

As with any strategy, perfection is a very far goal. With ABCD patterns (and respectively harmonic patterns), the main problems can arise due to:

1. Subjectivity of ratio interpretation: In some cases, the shadow of a candle that needs to be matched with the Fibonacci level can be too long that it crosses many levels, therefore, the user must choose which level to take into account. Considering that sometimes the distance between the retracements is quite big, it can be challenging to act on the ABCD. In the below example, point C has a long shadow that crosses the 0.500, 0.618 and 0.707 which entails a zone between 1.410 - 2.000 and that can be problematic to risk management strategies. The distance between the below range was around 200 pips, and that can be seen as a too-wide zone of support. A trade-off between wanting to get in early on the trade and being too careful has to be made. The way to remedy for this problem is not to trade such patterns with long shadows that confuse the calculation.

2. Simple failures: Markets are extremely unpredictable and no one strategy will be able to explain everything. Sometimes, the trend is too strong for a correction or a reversal, which is why failure can be an option too. It can also be a way of confirming the trend. Below is a failed ABCD pattern that predicted a reversal at the level 2.24. Sure, the trend has stalled, however, for most traders, this might not be what they have hoped for. There is also the lack of scientific and intuitive backing for technical trading as a whole.

3. Fundamental coincidences and shocks: On 24/06/2016 and following the Brexit announcement, a coincidence of 0.618-1.618 has been presented that resulted in a purely coincidental success of the pattern. This should not be interpreted as a success of the harmonic figure as per the rule of thumb: "Technical analysis does not work in economic and political surprises/events".

Conclusion

Depending on the experience of the user and the ability not to fall into the traps, volatility, and too much reliance on the patterns, this technique can be profitable and helpful, albeit lying in the field of the highly subjective technical analysis that has yet to confirm its scientific backing.

Other examples

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[1] Source: Scott Carney on Harmonic Trading, Volume 1 & 2.