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 fine tuned it. Harmonic patterns are chart patterns that form part of a trading strategy – and they can help traders to spot pricing trends by predicting future market movements. They create geometric price patterns by using Fibonacci numbers to identify potential price changes or trend reversals.
What is the Butterfly pattern?
Like the Gartley pattern, the Butterfly pattern uses Fibonacci measurements to define each point that arises after the initial impulse wave XA. Additionally, the last point in the structure, point D, is not a point, but instead, a zone called a potential reversal zone (PRZ). The main difference between the Gartley pattern and the Butterfly pattern is the Fibonacci retracements and Fibonacci extension that are used to define each point or zone.
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?
Butterfly is a Fibonacci pattern defined by five points X, A, B, C, and D, of which: For a bearish Butterfly, X, B, D are tops of the price plot, and A and С are bottoms. For a bullish Butterfly, X, B, and D are bottoms of the price plot, and A and С are tops.
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
The Bullish and Bearish Butterfly patterns are 5-point patterns. Each of a basic ABC pattern that is preceded by an impulse wave XA. Butterfly patterns are geared to picking highs and lows. After the setup is created, a potential reversal zone (PRZ), point D is generated as a target range that can be a buying point and a selling point.
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, simply put, a reversal pattern with four legs. It’s similar to the Gartley pattern in the sense that it’s marked XA, AB, BC, and CD. The butterfly pattern helps you identify the ending of a price movement, meaning that you can enter the market during the reversal of the price.
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.
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