L-3 Communications Offers a Primer in Harmonics

The theory behind Harmonic Trading is that price action is triggered by behavior and that is beautiful and flowing like in nature. It uses the Fibonacci sequence and ratio to review natural flow patterns in price action and attempt to describe ongoing scenarios. One such pattern, the Butterfly, is playing out in L-3 Communications, $LLL, now and offers a great introduction to the method.

The Set Up
Harmonic Patterns are based on an ABCD sequence. Each Pattern uses these but with varying ratios for retracements on the legs. They also signal a reversal after the Pattern completes at D. This often offers 2 trades, one to the completion of D and the second the Reversal. In the Butterfly below, the critical factors are B being a 78.6% retracement of the XA move, and the BC retracement of the AB move being between 50% and 88.6%. This gives rise to a Perfect Butterfly with a Potential Reversal Zone (PRZ) between 80.06 (161.8% extension of the BC leg) and 80.70 (127% extension of the XA leg). These targets can be built when the stock bounces off the C point and traded more confidently when the price passes the B point in the CD leg. It is a Bearish Butterfly because it looks for a reversal lower upon completion at D. This chart shows $LLL moving through the PRZ to top at 81.60 setting the situation for a reversal. The Terminal Price Bar, one that moves back through the entire PRZ triggers the short trade. From there a 38.2% retracement of the entire pattern, or to 78.60, becomes the Initial Price Objective (PO), with a second PO at the 61.8% retracement at 76.74 and a 3rd at a full retracement at 73.74.

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I find these patterns work best when they coincide with other techniques that produce similar results, like Measured Moves, and Triangle Breaks, for example. But there are plenty of traders that do nothing but trade Harmonics. For more look for Harmonic Trading by Scott Carney or his website http://www.harmonictrader.com/

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