The butterfly pattern is one of the technical analysis chart patterns that provides useful reversal signals for traders. So, how can you apply butterfly pattern trading strategies and plan your orders to catch market trends? Let’s explore all the details with FMCPAY in this article!
1. Overview of Butterfly Pattern Trading
Traders may be familiar with well-known technical analysis patterns like the triangle, flat, or wedge. However, chart patterns can vary greatly in complexity, ranging from simple to highly intricate formations. Among the complex ones, “Harmonic Patterns” stand out due to their unique geometric shapes and precise alignment with Fibonacci ratios.
Harmonic Patterns were first introduced by H.M. Gartley in 1935, and later gradually refined by Bryce Gilmore, Larry Pesavento, and Scott Carney. Harmonic patterns including the Butterfly Pattern, Bat Pattern, Shark Pattern, Crab Pattern,Gartley Pattern, Three Drives Pattern, Five Drives Pattern, and A-B = C-D patterns.
These provide traders with a significant edge by enabling them to anticipate future market movements, potentially leading to more profitable trades with proper preparation and strategy.
Now, let’s talk about the Harmonic Butterfly Pattern.
1.1. What is Butterfly Pattern in Trading?
The Butterfly Pattern trading involves 5 points labeled X, A, B, C and D. When you connect these points, it shows four price movement waves (or legs) with drawn lines that resemble a butterfly’s wings.
The very first movement in the butterfly pattern trading is the XA leg, which is created by connecting the starting point X to point A. Following this, the segments AB, BC, and CD develop sequentially along the volatility wave.
Only two main legs represent the primary market trend (the XA and BC legs). The other two legs serve merely as corrective waves. Once the pattern is completed, the price typically reverses sharply and continues to follow the main trend (as shown by the green line in the ablove screenshot).
1.2. Bullish & Bearish Butterfly Patterns
As with most technical analysis patterns, the Harmonic Butterfly trading pattern has both a bullish and bearish variation.
- Bullish butterfly pattern forms at the end of a downtrend and looks similar to a double top. This pattern provides a buy signal, indicating a potential reversal to the upside.
- Bearish butterfly pattern is identified at the end of an uptrend and resembling a double bottom. This pattern offers a sell signal, suggesting a possible reversal to the downside.
Both the bullish butterfly pattern trading and bearish butterfly pattern trading offer traders strategic entry points based on anticipated market reversals.
1.3. Butterfly Pattern’s Characteristics
To avoid mistakes when identifying the butterfly pattern with other patterns, make sure you thoroughly understand its characteristics before applying. Some key features of the butterfly pattern are as follows:
- XA: This is where the Butterfly Pattern begins. The XA leg does not follow any specific Fibonacci ratio rules like the other legs.
- AB: The price reverses from the XA leg, retracing to the 78.6% Fibonacci Retracement level. This retracement is key to identifying this pattern distinctly from other patterns.
- BC: This is a corrective phase, with Fibonacci Retracement ranging around 38.2% or 88.6% of the AB leg.
- CD: If BC is at 38.2%, CD leg will extend to a 161.8% Fibonacci Extension of BC. If BC is at 88.6%, then CD leg will extend to a 261.8% Fibonacci Extension of BC.
- XD: This represents the overall trend formed by AB, BC, and CD and forms a Fibonacci Extension around 127% or 161.8% of the XA leg.
2. Examples of Butterfly Pattern Trading
Real examples are essential for grasping butterfly pattern trading. Here, we illustrate how butterfly patterns play out in actual trading scenarios, helping traders understand their practical applications.
2.1. Bullish Butterfly Pattern Trading Example
The initial signal in the Butterfly Pattern is the XA leg, which represents the final impulse of a downtrend. This leg should be found after a series of consistently directed price swings, indicating an increase in buying pressure as the trend is about to reverse.
Following this, the AB leg develops in the opposite direction of XA. The B point should be around 78.6% of XA according to the Fibonacci grid on the chart. If the error margin is small (about 10%), it indicates that the ratio of AB to XA aligns with the conditions, confirming a valid structure for Butterfly Pattern trading.
The next component of the pattern is the BC leg, which should retrace 88.6% of AB. With this second condition also met, the CD leg then extends, with the CD to BC ratio ideally being 1.68.
Now, let’s verify the final condition for forming a complete butterfly pattern: the ratio of point D to XA. Using the Fibonacci grid, we observe that AD slightly falls short of 127% of XA. As with the AB to XA ratio, minor deviations are acceptable. However, larger deviations reduce the likelihood of reaching the price target following point D.
Despite some minor deviations, all five conditions for the Butterfly Pattern are met, confirming its validity. However, as seen in the chart above, the price movement after point D does not reach the anticipated high of the pattern, requiring traders to adjust their target levels accordingly.
2.2. Bearish Butterfly Pattern Trading Example
In butterfly pattern trading, identifying a bearish setup begins with detecting the XA leg, which now represents the bearish movement after an uptrend. Using the Fibonacci retracement tool, we observe that the AB leg retraces to about the 78.6% level of the XA leg, which is typical for this pattern.
Next, we look at the BC leg, which extends to 88.6% of the AB length. The following phase expands further, resulting in the final segment, CD, exceeding the BC leg. The Fibonacci extension between these legs is approximately 261.8%, which aligns with the characteristics of butterfly pattern trading.
Based on these observations, we can identify this setup as a valid Bearish Butterfly Pattern. It’s important to remind that the Fibonacci ratios for all legs are rarely perfect. A deviation of around 10% is generally acceptable for most traders.
Once the Bearish Butterfly pattern is confirmed, a price reversal is expected at point D. The market is likely to move downward from this point. Traders should enter the trade right after the formation of point D, specifically when the first candlestick closes beyond it, as shown by the blue line in the below chart.
To manage risk effectively, a stop-loss should be placed slightly above the high created at point D, indicated by the red line on the chart. The most conservative target for profit in Bearish Butterfly Pattern trading usually lies between the lows of points C and A, which are common exit points for such trades.
As you can see in this scenario, the price movement then aligns perfectly with the expected levels.
3. How to use the Butterfly Pattern?
Timing is crucial in butterfly pattern trading. This section provides a step-by-step guide on how to effectively use the butterfly pattern in trading.
3.1. When Enter Position
Before placing a buy or sell order in butterfly pattern trading, we need to ensure that the pattern meets the key conditions for a valid Butterfly setup.
The entry point for butterfly pattern trading is at D, which appears at the final phase of the pattern. After point D forms, the price reverses, ending the sideways trend and starting a new trend opposite to the CD leg.
When making an initial investment in butterfly pattern trading, there is no need to wait for two or three consecutive candles in the same direction; the closing of the first candle is usually sufficient if it forms around the 161.8% or 224% Fibonacci level.
In the chart above, the blue line marks the entry point after the bearish Butterfly pattern is completed. Here, the trader waited for a long red candlestick to close before entering the trade. You can also use indicators for additional confirmation. Consider three criteria:
- The D point reaches the 161.8% or 224% Fibonacci level of the XA leg.
- A candlestick in the opposite direction of CD closes.
- The market shows overbought (for bearish pattern) or oversold (for bullish pattern) conditions, as indicated by the histogram.
Experienced traders might set an entry order at the level of point C in the Butterfly pattern, which acts as support or resistance. Based on technical analysis, if the price rebounds from this level, the trend is likely to continue.
Following this pattern, after breaking through point C, you can add up to your initial position to increasing the potential profit.
3.2. When Place Stop-loss
In butterfly pattern trading, if a reversal occurs near the 161.8% Fibonacci extension level of the AX segment, an abnormal stop loss can be set at the 141% level of the same move. In this case, the Butterfly Pattern should complete around 127% of AX. If the price moves beyond the 141% level, it often signals a longer CD wave.
If the CD leg extends as shown in the screenshot above, use the standard method to set a stop loss. Similar to the red line on the chart, place the stop loss a certain distance away from the D point (above it if it’s a high point, or below it if it’s a low point)
Alternatively, a trailing stop can be set at 38.2% of CD if the price moves past point C and you’re unsure if it will reach the 161.8% level.
3.3. When Take Profit
One key advantage of butterfly pattern trading is the ability to set precise profit targets. As the price moves, the take-profit can be adjusted to more distant levels.
The first and most conservative profit target after a pattern reversal is point C, marked with a green band on the chart. Pullbacks following harmonic patterns often reach point C, making it an ideal target for options trading. Be sure to calculate the expiration time so the price can reach this level.
If the profit target in the AC zone is hit and the price keeps moving in the same direction, the take-profit can be extended further to the 127% and 161.8% levels of XA.
Another method for managing profit is using trendlines. You can consider exiting the trade if the price breaks a trendline, or continue to hold until it consolidates beyond it or reaches a target level.
4. Key tips for Butterfly Pattern Trading
Here, we will provide the key tips to help you successfully implement Butterfly Pattern trading, ensuring you make well-informed decisions and optimize your trading performance.
Identifying the Pattern
Detecting the Butterfly pattern can be challenging and typically requires experience. Beginners should use specialized indicators to identify patterns but must manually verify the proportions and trading levels before executing a trade.
Checking Proportions
When assessing the Butterfly Harmonic waves, review the relationship between the XA segment and the total lengths of the AB, BC, and CD segments. Errors between adjacent waves can significantly alter the pattern’s appearance. Remember that for Butterfly Pattern trading, the ratio between XA and AD should be 127% or 161.8% if the CD leg is extended.
Stop Loss Placement
For patterns with an extended price move on the last wave, place a stop loss at 141% of AX when it reaches 224% of the BC leg. If the CD segment is close to the optimal ratio for a Butterfly pattern, position the stop loss just beyond point D.
Combining with Other Tools
Despite the effectiveness of Butterfly patterns, using them alone is not sufficient for optimal trading. Incorporate oscillators to confirm entry points, use trading volume indicators to gauge market sentiment, and apply other technical analysis tools to enhance your strategy.
Considering Option Expiration
When trading options with Harmonic Patterns, calculate the expiration date carefully. Typically, it takes 5-7 candlesticks to reach the nearest targets for the Butterfly Pattern, so ensure you have enough time before the contract expires.
Directional Effectiveness
Initially, analysts believed Butterfly patterns could be used effectively in any market direction. However, it has since been found that these patterns work best when aligned with the global market trend. Therefore, Butterfly patterns can be considered high-level trend continuation patterns.
Conclusion
The Butterfly Pattern is a specialized technical analysis tool that, despite its niche, offers valuable predictive accuracy. Experience plays a crucial role in Butterfly Pattern trading, so trader better make some practice to build proficiency before implying the pattern.
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