Most traders will be familiar with the Fibonacci tool - and many use Fibonacci retracement and extension levels to define entry and exit points in a trade.
You can find out about the basic use of Fibonacci levels here - LearningMarkets.com - Fibonacci analysis in the forex market
However, this is not the way harmonics traders use Fibonacci ratios.
Harmonics traders look for certain sequences of Fibonacci retracements and extensions to occur in a particular order, a pattern, before they enter a trade.
The key Fibonacci ratios that make up the harmonic patterns are mainly - the golden mean 1.618, its reciprocal 0.618, plus their square roots 1.272, 0.786, and their fourth roots 1.128 and 0.886. Extension ratios such as 2.618, 2.24 and 3.618 are also used for some patterns.
It was discovered that, when a particular sequence of Fibonacci ratios appear in order in a X-A-B-C-D pattern, as in the Gartley pattern below, the probability of forecasting the next move successfully is over 70%.
When that happens, you have an edge, and it's time to trade.
It is these sequences that make the harmonic patterns (Gartley, Butterfly, Bat and Crab).
Trade entry is within the Potential Reversal Zone (PRZ) at the D point.
The chart below shows how the pattern recognition software identifies all Fibonacci numbers over recent price action - the dotted lines linking highs and lows with the associated Fibonacci level.
When a valid pattern occurs (shaded in blue), it means the alignment of Fibonacci ratios is in accordance with one of the 4 Harmonic Patterns (Gartley, Butterfly, Bat, Crab).
The PRZ - Potential Reversal Zone - is the red box, showing the cluster of Fibonacci retracements and/or extensions as yellow and blue lines. The closer together the cluster of Fibonacci levels, the better it is.
The cluster of Fibonacci retracements and extensions occurring around the D point, the Potential Reversal Zone (PRZ), identify an area where price action is likely to reverse. A place to enter the trade with a higher probability and lower risk.
Other pages in this series on Harmonics Basics are:
Learn how Adaptive Position Sizing can grow your account balance - exponentially.
Real-time harmonic alerts to pc and email. Free harmonics education videos and harmonic software. Harmonic traders chat room.
Over 15 hours of educational lessons narrated and presented by the originator of Harmonic Trading, Scott Carney.