The Butterfly pattern belongs to a family of Harmonic patterns and indicates a potential reversal. H.M. Gartley developed the pattern, later Scott Carney introduced Fibonacci levels and fined tuned it.
What is the Butterfly pattern?
The Butterfly pattern appears at key market reversals and pinpoints price’s highs and lows. It compromises of five points or legs (X, A, B, C, D) which are connected through Fibonacci ratios.
Scott mentioned in his book, “Harmonic Trader” that the Butterfly requires specific Fib ratios for its formation. To validate its structure, he described that:
- The AB has to retrace up to 78.6% of the XA leg.
- BC needs to retrace between 38.2% to 88.6% of the AB leg.
- CD should show an extension of 1.618% to 2.618% of the AB leg. Also, CD could extend up to 1.272% to 1.618& of the XA leg.
- The point D is where the PRZ (potential reversal zone) begins.
This is how the pattern looks like on the chart:
At point D, a trader takes a long or short position. A trader can set a profit-target at 61.8% of CD and second target at 127.2%.
The Butterfly pattern resembles the Gartley pattern in structure. But, the difference lies in Fib ratios. The D leg of Butterfly extends beyond the leg X.
How to use the Butterfly pattern?
To enter the trading positions, a trader must acquaint himself/herself with the Butterfly variations; bullish and bearish.
a. Bullish Butterfly pattern
The bullish Butterfly emerges in an uptrend and signals a price reversal at point D. Traders take long positions at point D, with stop-losses below it. It looks like M.
The AB leg of the bullish Butterfly retraces up to 62.1% of the XA leg. The BC leg retraces to 65.6% of the AB leg. And, CD leg extends XA leg by 1.40%. It resembles M.
b. Bearish Butterfly pattern
The bearish Butterfly occurs in a downtrend and identifies a price reversal at point D. Traders take short positions at point D with stop-losses above it.
In the bearish version, the AB leg retraces up to 79.9% of the XA leg. The BC leg retraces to 96.9% of the AB leg. CD shows an extension of 1.17% of XA leg.
A keynote to add is that these bullish and bearish patterns may not meet the exact Fibonacci ratios, as described above. When the pivot point forms at D, traders should look for the rise/decline of the price.
Sometimes the Butterfly presents false signals on shorter timeframes. To compensate for the issue, traders could use momentum oscillators to confirm the price reversal. Besides this, a trader could take position after point D.
Butterfly pattern trading strategy
For a trading strategy, traders may look for the Butterfly pattern on any timeframe according to their own individual trading needs.
Butterfly pattern buy strategy
- Locate the pattern in an uptrend.
- Wait for the price bar to go bullish before entering.
- Enter the trade at point D or after it.
- Place a stop-loss near the recent low from point D.
- Exit the trade before the price drops.
Butterfly pattern sell strategy
- Look for the pattern in a downtrend.
- Wait for the price bar to go bearish before entering.
- Enter the trade at point D or after it.
- Place a stop-loss near the recent high from point D.
- Exit the trade before the price rises.
Butterfly pattern conclusion
The Butterfly Pattern is an easy-to-spot Harmonic pattern that can be used on your trading platform charts to help filter potential trading signals as part of an overall trading strategy. Before implementing, traders should consider extensions and retracements of the legs.
I would prefer to use the majority of candlestick patterns such as the Butterfly Pattern on the 1-hour charts and above. I tend to find that these charts contain less market noise than the lower time frames and thus give more reliable signals for my forex trading strategies. This also means that I spend less time staring at charts and can also set alert notifications to let me know when price has reached certain levels, candlestick pattern has been formed or a particular indicator value has been reached.
The Butterfly Pattern is just one method of market analysis amongst thousands. I would not build a trading system alone, but rather combine with other technical indicators such as moving averages, Parabolic SAR, Stochastic Oscillator, RSI, ADX and price action analysis.
Of course, every trading system will generate false signals which is why money management is so important. I would personally be implementing sensible money management and only take traders that give me a favorable risk to reward ratio, ideally of at least 1:3. This means that one losing trade does not wipe out consecutive winners.
The methods of implementing the Butterfly Pattern into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice trading with the Butterfly Pattern, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.