Three Simple Patterns To Improve Your Trading: The Scott Carney Interview

Editor's Note:
The following is an interview done by Dave Goodboy in conjunction with RealWorldTrading.com. After you read the interview, talk about it here.
Brice

This is Dave Goodboy, executive producer at www.realworldtrading.com. Today, I am joined by Scott Carney from Harmonictrader.com. Scott has developed a unique technical analysis method he calls “Harmonic Trading.” It utilizes specific, measured chart patterns to pinpoint high probability trades. I found this discussion to be quite enlightening and educational regarding a seldom talked about technical technique. Let’s get started!

Dave: How are you today, Scott?

Scott: Doing great, Dave

Dave: Let’s start at the beginning. What first got you interested in the market and developing your strategy?

Scott: Well, I have been tracking stocks since I was a young kid. Around 11 years old, I would follow my Dad’s portfolio. I would track stocks that were really starting to move especially in the early stages of the bull market in 1982. From there, I have always followed companies and tracked the markets. I have a degree in accounting, which gives me a pretty solid fundamental background, but as I got into my late teens and started to trade, I realized that I needed some more technical analysis, which really gave me the insight of price movements. Although I like to still have a good understanding of companies, technical analysis is really my forte and has helped me understand price action tremendously

Dave: Do you still use a combination of technical analysis and fundamental research?

Scott: I like to look at good companies and analyze companies from a long-term perspective. When advising a long-term client I will look at the fundamental research. However, most of my short-term trading is geared toward technical analysis. The day trading I do with futures is pretty much all technical analysis based. Even though I do some fundamental work for long term strategy, I use technical analysis to determine when buy and sell points are optimal.

Dave: What exactly is the Harmonic Trading method?

Scott: Harmonic Trading is a combination of a variety of techniques. It borrows somewhat from Elliott Wave Theory, it also incorporates Fibonacci ratio measurement techniques to determine price patterns and looks for price patterns that continually repeat in the markets. I do use a lot of standard technical analysis approaches like trend line indicators, such as stochastics and MACD for strength. Harmonic trading caught my eye when I started looking at Elliot waves and noticed there was credence to the wave counts. I focused on corrective structures, the common M and W type Elliot wave patterns that continually form.

Dave: Lots of traders and analysts do this. What makes Harmonic Trading different?

Scott: When I started to apply Fibonacci ratios to these M and W patterns, I realized that there was extensive differentiation that really refined these techniques. One of the biggest discoveries that I made many years ago, back in 1997, was the qualification of what is now known as the common Gartley pattern. A lot of people prior to that have been studying this pattern, but using it for more of a general approach. When I did my research, I realized that there were common elements to the Gartley pattern that differentiated from other patterns.

Dave: Is the Gartley pattern your creation, or is it from someone else?

Scott: The Gartley pattern was originally outlined in H.M. Gartley’s book Profits in the Stock Market, written in 1935. He outlined a basic Elliott wave type structure of an A-B-C-D. But he did not incorporate any Fibonacci ratios or any percentage ratios within the pattern. He identified a basic structure that was very vague. What I did was realize that this structure had very specific points. It’s actually an M or W type Elliott wave pattern, but I have realized that each point has to have a specific alignment with specific rules to differentiate it from similar M and W type patterns. I took a look at this and came up with a variety of rules that really differentiate it from other M and W structures.

Dave: When you say M and W, an M would be a topping pattern and W would be a bottoming pattern?

Scott: They are specific five-point patterns. An M pattern would be some type of low with a snapback bounce which then has a slight correction coming back down to test that support.

Dave: What’s the exact aspect that differentiates your Gartley pattern technique from the standard?

Scott: The aspect of these patterns is that they are five-point structures that are very specific that can be quantified by Fibonacci ratios. One of the keys that I came up with was that determining that the B point, or the midpoint of this pattern, had to be at .618 which is the golden ratio that people are familiar with when using the Fibonacci.

Dave: Now would that be .618 from the beginning? How are you measuring this?

Scott: From the initial low point to the bounce that snapped backed high, then you have the correction to test that initial point. It is a little difficult to just describe it, but I have a lot of illustrations on my site. This type of M and W analysis, at each specific point there were certain patterns that were forming these structures but would bounce or create alignments at different Fibonacci points.

Dave: OK, let’s get more specific in the definition.

Scott: According to my definition in order for it to be a valid Gartley, it has to have a .618 at the initial corrective B point, and then an eventual reversal point that you would be looking at would be a .786 retracement. Many people are familiar with Elliot wave, or zigzag, or A-B-C-D type patterns. Harmonic trading and the Gartley pattern try to incorporate these Elliot wave general structures, quantified by specific Fibonacci ratios. If you go to my site and take a look at the illustrations, it should be pretty clear.

Dave: Have you found any specific time frames where this pattern works more effectively?

Scott: Well, the Harmonic Trading approach with patterns applies on any time frame. It is determined by what the trader’s time frame is. If they are a short term trader, they can look at 1, 3, or 5-minute charts say for futures or the minis. But if they are looking at longer-term daily or weekly charts, the same structures appear.

Dave: I see, it’s a fractal approach?

Scott: Yes, it is a fractal. The principles apply across the board for each timeframe.

Dave: Do you use logarithmic charts?

Scott: I am looking at arithmetic charts, not log charts. I find that what I am looking for is the price structure, regardless of what the log scale might reveal. The structures are pretty straight forward based on the measurement techniques. You are really looking for specific structure for each based on arithmetic charts.

Dave: I know you have developed several other patterns, are they all based on the Gartley pattern? For example, the Bat Pattern or the Crab Pattern?

Scott: The Bat Pattern was a big advancement off the Gartley. One of the problems that people were having was differentiating between the M and W structures. Once I realized what specifically the Gartley was. It’s what I like to call, a technical entity where each alignment is defined, I realized that other M and W structures were differentiated by that B point, but required different rules. The Bat Pattern is a similar type of M or W structure, but at the reversal point where you would be looking to execute, it incorporates a .886 retracement, which is a Fibonacci .618 derived ratio that myself and my partner Jim Cane of Cane trading came up with the.886 a few years ago. I have released the .886 on my site and other sites. It is an amazing Fibonacci number to use when looking to buy support or sell resistance.

Dave: This all sounds good in theory, but come on Scott, how can a trader actually make these measurements while trading?

Scott: That was a major struggle I had initially, and I have been working with these patterns for almost 10 years. After a few years of tireless effort, I was able to locate a gentleman who developed a software program that luckily does everything automatically. That software is called The Harmonic Analyzer and it can be found at my website. That has enabled us to make substantial gains by understand the nature of these patterns and helping us understand which pattern will be a valid trade and which will not. There are a lot of other techniques that I employ to validate what are the best structures, such as RSI, but from a very general perspective, what I am looking for is the exact alignments of these five point structures.

Dave: Is the software applicable across all timeframes?

Scott: Yes, I am using it for 1, 3, and 5-minute time frames. I also like to cross reference the 15 and 60-minute time frames, but the programs streams in real time and automatically kicks out the patterns. That has facilitated the whole identification process.

Dave: There is a pattern called the Ideal Butterfly Pattern, can you elaborate on that?

Scott: Sure, the Ideal Butterfly Pattern again requires a specific alignment and specific rules of the Fibonacci ratios to validate the structure. Similar to the Gartley dilemma, where a lot of people would identify a similar looking type structure without differentiating it. Many people were looking at this extension pattern and were not sure where this would complete to execute a trade. One of the main things that I did was differentiate the general interpretation from the ideal structure. Again the B point is key and it must be a .786 and a retracement of the initial leg. In my definition on the site I look at that structure. There is only one point where I execute a butterfly, and really call any of them an ideal butterfly and that is only at a 1.27 extension. One of the misnomers of this pattern’s approach was that people were not sure exactly where to make the trade. I was able to classify all of these structure to help people identify where the valid patterns are, and where they aren’t.

Dave: Do you find that these patterns work across all markets or are there particular markets that they work best on?

Scott: I believe some patterns definitely apply to certain markets. For example, I trade the Euro dollar quite intensively, and I see a lot of deep retracement that form bat structures. I am more inclined to be looking at if the Euro is going to retest support or resistance and if it is forming a W or M type structure. Most times it is going to be a bat. I have studied the British pound, I trade the Yen a bit, all against the dollar and I see a lot of .886 retracements. In terms of other markets, I tend to see the gold market is very harmonic. I see a lot of simple and precise A-B-C-D patterns which is where each leg is equivalent. If the market moves down $10, the retracement is $5, and then moves down another $10, that is a simple A-B-C-D.

Dave: Have you applied these techniques to the energy market, oil in particular?

Scott: I have looked at oil and natural gas. There are other patterns that work pretty well on them. A lot of patterns I see on oil are the 1.618 extensions. Oil has been phenomenal lately, but intraday I am noticing a lot of simple 1.618 extensions.

Dave: I know you mentioned the minis earlier, is this applicable to an extremely intraday volatile market like the S&P 500 minis?

Scott: Absolutely. I use these everyday and we post the charts in the chat room. I write a morning report everyday looking at the various patterns that Harmonic Analyzer generates. Then I use those patterns to execute as my approach at price action.

Dave: When trading the YM, the ES, or the NASDAQ minis, is there one of the three that fits better with the harmonic trading method?

Scott: I think the ES because the liquidity is better. I have noticed for the YM there are a lot of Gartleys that complete intraday. But for liquidity, I really feel that the ES is probably the best vehicle to trade and forms the best structural patterns.

Dave: I see you have some writing concerning the Gartley controversy. What is the Gartley controversy?

Scott: That is really what got me into all of this. It is something that I was determined to prove that all these M and W structures need to be differentiated. I have worked with many students that were confused how these patterns developed. The Gartley controversy is that you have a lot of people writing about this pattern and throwing any combination of Fibonacci numbers on the structure. What happens is that when students of mine get into real-time trading to apply these techniques, and they don’t respect the pattern alignments, they will a lot of times be executing at the wrong points. Again the biggest key for a valid Gartley is to have the midpoint at .618. But there are a lot of guys that say the midpoint can be a .382 or a .50, and it really doesn’t matter. But believe me, the differentiation and the exact specification is what makes the difference when you trade. I wrote that as a means to reach out to people to underscore the importance of pattern differentiation based on exact alignments. Also a lot of people don’t understand that Gartley in his book never discuses Fibonacci ratios. I own the book and have read it extensively many times and there is not a single mention of Fibonacci ratios. In fact the Gartley structure, found on page 222 in the book, was a very general interpretation looking for some kind of A-B-C-D corrective move after a critical high or low was established. But there is a wide room for interpretation, and when it comes to real time trading and applying these methods to the markets, you have to be exact. That is my emphasis, and what I urge people who read that. I am not trying to knock anyone else that is writing about the pattern, but I am trying to clarify the patterns origins and underscore the exact specifications.

Dave: Let's say the Gartley pattern indicated to buy or sell, and you execute, how long do you stay in that trade and what tells you how long to stay in it?

Scott: I am looking at the Fibonacci and harmonic calculations to find a specific zone of numbers that converge in to a tight area. That is the area I am looking for to buy or sell. Once I am looking at the market, and the market tests that zone, I am looking for signs of a reversal. I am also looking at indicators like relative strength. If it is a bullish Gartley, and the market is starting to stabilize in those numbers, that will get me to clue in and say that things are turning. Then I will look at my other indicators, and my other basic methods, that converge with the harmonic measurements.

Dave: Yes, that makes sense from a technical perspective. Let’s dig a little deeper into your exact technique.

Scott: After executing a trade, I am looking at one really good continuation, and looking for something to come and test the numbers. Maybe it will be a reversal, a one bar, or three-bar break out if I am looking at a five-minute chart. I am also using the low and the high of the zone as a potential reversal point. If I get a valid reversal off that point, another technique that I have come up with is the .382 trailer, which is a 38.2% trailing stop from the reversal low or high. The thing that I have noticed in these patterns is that once they hit the zones and reverse, they should provide good continuation and should not pull back beyond the .382 retracement from the reversal extreme. That would be a sign to get out, and it tells me that it is not continuing as much as I would like to believe. I might in a day execute three or four trades using different patterns catching these big moves. It is common for them to have a retest before they really start to move from the reversal zone. I am really using steady trend lines looking for steady trend off the reversal zone and using that .382 trailer.

Dave: Do you use volume at all in your analysis?

Scott: I do look at some volume; one of the things that I have noticed is that you will get extreme volume spikes signaling the exhaustion as critical harmonic numbers are tested. I have seen much of this in the ES, where you see a major sell off low coming down into a bullish pattern. The ES will then hit the potential reversal zone with a real clear volume exhaustion spike. If you see that the volume is exhausted and that it can test the numbers and stabilizes after, that usually indicated a bullish pattern that the sellers are out.

Dave: You mentioned RSI. How do you use the relative strength indicator?

Scott: I have noticed that the RSI is probably the best confirmation that goes along with the pattern. There is a very specific and advanced relative strength technique that I use.

Dave: Let’s first define RSI and then explore your specific technique with the RSI.

Scott: RSI is defined in Technical Analysis from A to Z by Stephen B. Achelis. It was first introduced by Welles Wilder in an article in Futures magazine (formally Commodities magazine) in June 1978. The name “Relative Strength” is slightly misleading as the RSI does not compare the relative strength of two securities, but rather the internal strength of a single security. It’s a price following oscillator that ranges between 0 and 100. Tops are usually above 70 and bottoms below 30. The key to RSI is that these tops and bottoms are often formed before the underlying price chart.

Dave: OK, well, how specifically do you use the RSI with your harmonic patterns?

Scott: I use it as a confirmation of the harmonic pattern. Normally, extreme readings in the RSI along with a harmonic pattern substantially increase the ability to interpret price action and to define profitable trading opportunities.

Dave: We are almost out of time. Thanks for joining me today!

Scott: Any time. It’s been a pleasure.