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SUBJECT SUMMARY
Patterns by themselves do not necessarily lead to consistent outcomes. The development of chart patterns alerts the trader that a range of outcomes is more likely than at other times. As price moves towards a well established resistance level, the trader pays more attention to the stock, ready to place a buy order if prices move a few ticks above the level. He cannot buy until others have bought because he wants to follow the action, not create it. When prices retreat into the body of the support and resistance band, or other chart pattern, the trader shifts his attention elsewhere. Chart patterns signal the probability of action.
The Gartley pattern is a continuation pattern, which was made popular by trading veteran Larry Pesavento who added the Fibonacci ratios to this pattern. Larry had stated that the Gartley is “one of the best patterns I ever found,” and it certainly is an extremely accurate pattern.
It is a pattern with low risk and a very high success ratio, which gives it an excellent risk-to-reward ratio. It follows the Fibonacci ratios quite accurately and that is the pattern’s main advantage, as we can anticipate the reversal point and the target where price should ultimately go.
The key to trading this pattern, is successfully identifying it, and waiting for it to complete to enter a trade.
Now since price keeps moving in waves, and we always have retracements, reversals within the larger pattern, it does become difficult to correctly identify a Gartley pattern. So what we want to do in these notes is to find that particular key element which tells us that a Gartley pattern is forming, and then set our targets accurately to manage the trade. As we can see in the chart below, I have marked out the bullish Gartley pattern with red lines. This is also called a "Bat pattern", since the overall appearance is similar to a Bat. The basic concept of this pattern is that in an ongoing uptrend, price forms certain retracement patterns, which then leads to a continuation of the trend.
Now let us first understand the formation of this pattern.
In an ongoing uptrend, we have a retracement of price towards the down side, from where we start to look for this pattern.
We first identify a swing high and swing low (the points marked ‘X’ and ‘A’), which form the boundary of this pattern. - ‘X’ will be the lowest low in this pattern, and if price falls beneath ‘X’, the pattern is negated. - Similarly, ‘A’ will be the highest high of this pattern, and if price rallies above ‘A’ before the completion of the pattern, then the pattern is negated.
Once this swing high/low boundary has been established, price will move down to a low, which should be a retracement of a maximum of 61.8% of ‘XA’. This swing low is classified as point ‘B’.
Price will then again rally high, which should be a retracement of a maximum of 78.6% of swing ‘AB’. This swing high is classified as point ‘C’. The requirement here is that ‘C’ should not exceed ‘A’.
Once ‘C’ is established, price again reverses to the downside. Price must now trade below the swing low ‘B’, and it should go to a maximum of 161.8% of swing ‘BC’. Once this condition is met, we have our reversal point ‘D’, from where we can expect price to resume its uptrend with renewed momentum.
Now this may sound complicated and confusing, but it is not once you identify some patterns. I have found studying this pattern and waiting for the conditions to form is well worth it. The expected target is also calculated with Fibonacci ratios, but before that we will put in two more conditions for the formation of this pattern. This will make it easier for us to correctly identify, whether a Gartley pattern is forming. In fact, these 2 conditions will ascertain whether we can consider a Gartley trade or not.
The first key element to identifying a Gartley pattern is that the point ‘C’ should retrace to 78.6% to 88.6% of swing ‘AB’. This is the defining element of this pattern, and if this condition is not met, we should not look further for the pattern to develop. For example, if point ‘C’ should retrace only to 38.2% or 50% of the swing ‘AB’, then more often than not, this pattern will not form.
The second key element is that the last leg of the pattern, the reversal point ‘D’, should be at a retracement level of 78.6% of ‘XA’, our established boundary for this pattern. Even if all the other swing points form at their given Fibonacci levels, should ‘D’ not satisfy this condition, then the pattern is negated. Needless to say, that ‘D’ should not fall below ‘X’, but it should not have a shallow retracement also, say about 50% of ‘XA.’
So now we use two additional filters, which make it easier for us to identify the pattern. The first is in the beginning of the formation, and the other at the end of the formation.
Now we will get to the trading of the pattern.
Once all these conditions have been met, there is now a very high probability that prices will reverse off the point ‘D’.
Our entry for the trade should be above the high of the bar which formed at point ‘D’.
We calculate the targets using the Fibonacci ratios again. - Our first target should be 121% of swing ‘CD’ added to the reversal point ‘D’ - The second target should be 121% of swing ‘AD’, added to ‘D’.
Since we are quite confident of the trade, we will place our stop just below ‘X’.
This had a risk-to-reward ratio of almost 1: 3, and this was for two reasons.
Firstly, we could afford to keep our stop quite close to our entry level.
Secondly, we were confident of price reaching our targets.
Both we attribute to the fact that this is a pattern with a high rate of success.
This is the power of the Gartley pattern.
Article as published in the Guppytraders.com weekly newsletter, January 14th, 2006 edition.