The butterfly harmonic pattern is a new approach to technical analysis, which often helps traders earn profits. This article is a complete guide to understanding the concept and how you can profit from it.
The butterfly pattern is one of the harmonic price patterns. So, what is a harmonic price pattern? Harmonic pricing patterns leverage Fibonacci numbers to determine precise turning points, taking geometric price patterns to the next level. Unlike other more typical trading approaches, harmonic trading tries to predict future movements.
Harmonic trading blends patterns and arithmetic to create a precise trading method based on the idea that patterns repeat themselves.
The primary ratio (0.618 or 1.618), or a derivative of it, is at the core of the technique. Some of the complementing ratios include 0.382, 0.50, 1.41, 2.0, 2.24, 2.618, 3.14, and 3.618. Almost all-natural and environmental structures and occurrences contain the primary ratio and manufactured structures. Environments and societies influence assets, so asset prices reflect the ratio because the pattern repeats across nature and within society.
The trader can use Fibonacci ratios to predict future moves by identifying patterns of various lengths and magnitudes. Scott Carney is credited with inventing the trading approach; however, others have contributed or discovered ways and levels that improve performance.
There are many different harmonic patterns, but four seem to be the most frequent: the Gartley, butterfly, bat, and crab patterns.
However, traders frequently employ butterfly patterns since it helps them grasp how patterns work and apply them.
What is a Butterfly Pattern?
The butterfly pattern is a type of reversal chart pattern related to the harmonic pattern classification. It indicates price consolidation and is particularly noticeable after a prolonged price move.
Traders can use the butterfly pattern to predict when a trending advance will stop and when a corrective or new trend phase will begin. In Elliott wave terms, you’ll typically observe this pattern during the last wave of an impulse sequence.
Like all other harmonic patterns, the harmonic butterfly pattern is a reversal trading pattern that traders can trade at any moment. Some traders prefer trading them at longer time intervals.
Bryce Gilmore and Larry Pesavento discovered the pattern near the market’s extreme lows and highs and predicted a reversal.
The Butterfly Formation’s Framework
The four legs of the butterfly pattern are X-A, A-B, B-C, and C-D. They can aid you in determining when a current price move is likely to come to an end. As the price changes direction, you will enter the market.
These four legs form a pattern of the letter M in a downtrend and W in an uptrend on the charts. Be careful, as it is common to confuse butterfly patterns as a Double Top or Double Bottom pattern during the development of the pattern.
An X indicates the beginning of the pattern. The four price swings of the formation are then identified as XA, AB, BC, and CD.
How to Identify the Butterfly Pattern
There are exact Fibonacci levels that must be met to identify the butterfly pattern correctly. But as you might know, Fibonacci relationships are an essential part of harmonic pattern trading, and the butterfly is no exception.
To properly recognize a simple butterfly chart pattern, you must first validate that the formation’s price fluctuations correspond to specific Fibonacci levels.
Let’s dig deeper into the different Fibonacci interactions within the butterfly:
XA: This is the first step that sets that pattern. This movement does not necessitate any special rules.
AB: The butterfly pattern’s most significant level is the B point, which should retrace 78.6 percent of the XA leg.
BC: Either the 38.2 percent or 88.6 percent retracement of the AB move should be used for the BC move.
CD: If BC is 38.2 percent of AB, a CD will likely achieve BC’s 161.8 percent extension. On the other hand, a CD is likely to reach the 261.8 percent extension of BC if BC is 88.6 percent of AB.
AD: The overall AD move, which consists of AB, BC, and CD, should be 127.0 percent or 161.8 percent of XA.
Let’s sketch these harmonic relationships now.
To gain confidence in the anticipated reversal zone, we need to observe a Fibonacci cluster emerge at the forecasted D point.
The Fibonacci phases of the BC and CD moves are represented by two different colors: orange and purple. The orange color levels are related to each other in the same way that the purple color levels are.
As mentioned previously, if BC reaches 38.2 percent of AB, CD should reach 161.8 percent of BC. When BC achieves 88.6 percent of AB, CD should achieve 261.8 percent of BC.
This is a basic guideline that you should be mindful of, not an ironclad rule. However, as previously noted, a B-point retracement of 78.6 percent of XA is required to designate a pattern as a butterfly.
How to Trade Using a Bullish Butterfly Pattern
The bullish butterfly pattern is depicted in the diagram above. Let’s look at the structure once more, this time with the forecast price reaction at the D point.
Take note of how the bullish butterfly’s structure matches that of an “M” type structure. As the blue arrow on the sketch demonstrates, the bullish butterfly is likely to result in bullish price action at the D point.
Let’s break it down step by step:
- Enter your trade – Determine where the pattern will end at point D, at 127 percent of the X-A leg’s extension. Usually, the traders place a long entry.
- Set your stop-loss order – Set your stop-loss immediately below the X-A leg’s 161.8 percent Fibonacci extension.
- Determine your profit target – With this pattern, where you position your profit target is highly variable and relies on your trading objectives and market conditions.
Alternatively, if you prefer a more aggressive profit objective, set it at point A of the pattern. Place it at point B for a more conservative profit target.
How to Trade Using a Bearish Butterfly Pattern
The bullish butterfly’s counterpart is the bearish butterfly. In this respect, the bearish butterfly pattern resembles a “W” type structure. Let’s take a look at a depiction of a bearish butterfly:
As the blue arrow on the diagram indicates, the bearish butterfly is predicted to lead to bearish price action at the D point.
Let’s approach it step by step:
- Enter your trade – Execute your sell order at point D, the 127 percent Fibonacci extension of the X-A leg, to trade a bearish butterfly pattern. Usually, the traders place a short entry.
- Set your stop-loss order – Set your stop-loss immediately above the X-A leg’s 161.8 percent extension.
- Determine your profit target – Position your profit target at point A (aggressive) or point B (conservative).
How is the Butterfly Pattern Different From the Gartley Pattern?
The butterfly and the Gartley pattern are similar in that they both have five points and four legs. However, there are some key differences. The most noteworthy difference is that the Butterfly is an extension pattern rather than a retracement pattern. This means that the pattern’s point D extends beyond the initial point X. D in a Gartley pattern denotes a retracement back to X rather than an extension beyond it.
Furthermore, statistics show that a butterfly design has a better chance of success than a Gartley pattern. Another factor to remember is that reversals, after the butterfly has been completed, are much sharper.
The Benefits of Using Butterfly Patterns
It’s no surprise that butterfly patterns provide particular benefits to traders, given their extensive use. These benefits include:
- Butterfly patterns are simple to recognize and grasp. Butterfly patterns are more approachable and recognizable for new traders than other types of chart patterns, making them a typical go-to pattern early in the development of your trading strategy. Even experienced traders may find the simple pattern design intriguing due to its ease of use.
- When compared to other chart patterns, butterfly patterns can provide powerful indicators. There is no such thing as a flawless chart pattern, and even the most powerful trading indicators can lead traders astray on any particular trade. Similarly, relying on a single chart pattern to guide your trades or entire trading strategy is never a good idea. On the other hand, traders prefer butterfly patterns because they provide more constant trading insights.
- According to empirical examples, the butterfly pattern is one of the most effective techniques to spot profit opportunities. Many seasoned traders recognize that a butterfly pattern has a more substantial predictive value than other alternatives, such as the Gartley pattern.
The Drawbacks of Butterfly Patterns
Traders are still looking for the ideal chart pattern to use as a guide for profitable trading. As a result, even frequently used techniques like butterfly patterns have downsides and drawbacks that traders should understand. These are some of them:
- Harmonic pattern trading necessitates a greater understanding of trading analysis to contextualize forecast patterns. Because of its rigid pattern structure, you should use the butterfly pattern with additional indicators and chart patterns to confirm the setup and suggestions provided by this chart pattern.
- For some traders, the rigid structure can be a source of frustration. Complete butterfly patterns can be uncommon because of the Fibonacci retracement levels’ criteria, and many traders seeking butterfly patterns in development are discouraged by the pattern’s failure to complete. This can lead to a waste of time and effort to monitor possible setups.
- The butterfly pattern is harder to recognize than the Gartley pattern. Traders may find the Gartley pattern more practical than butterfly patterns because it is easier to notice and provides equivalent trading advice based on comparable data points.
Many traders find that using the butterfly pattern successfully takes a lot of trial and error. You should expect some bumps and bruises along the way if you’re just getting started with the butterfly pattern in trading—both in terms of detecting beneficial butterfly patterns and appropriately contextualizing them to make the best trading option.
Whether you’re a newbie trader or a seasoned investor, you should never underestimate the power of chart patterns as trading tools. They’re crucial for determining entry and exit points for a position and suggesting a reversal or continuance of the present trend. Butterfly patterns, in particular, can be eye-opening when it comes to predicting the end of price moves.
Butterfly patterns, when employed correctly, can forecast future price action with a high degree of accuracy, making them a valuable trading tool.