Spotting, charting, and trading the butterfly pattern is an effective strategy for monitoring the prevailing market trend and predicting its future direction.
However, mastering this technique requires thorough practice.
The butterfly pattern is an indication of a potential trend reversal. Accurately spotting this pattern gives you a reliable reference for which price point the market will potentially reverse. This ultimately provides you with profitable entry and exit points.
This article will walk you through the basics of butterfly pattern trading. Here, you’ll learn how it works, the best practices in spotting it, the different types of butterfly patterns, and how it differs from other harmonic price patterns.
What is Butterfly Pattern in Trading?
Let’s address the elephant in the room: butterfly harmonic pattern trading is complicated.
Not only can a trader be confused with double-top and double-bottom patterns but spotting this is also difficult due to its complex and intricate formation.
Additionally, the butterfly pattern is tightly knitted to the Fibonacci ratio – a Mathematical concept adopted in forex trading.
Scot—the author of ‘Harmonic Trade‘— noted that the market must follow a certain Fibo measurement to form a harmonic butterfly pattern.
According to him, three fib ratio-aligned formations must occur to establish the butterfly pattern.
- AB leg must retrace to 78.6% of the XA leg.
- BC leg has to retrace between the AB leg’s 38.2% to 88.6%.
- CD leg has to extend between AB leg’s 1.618% to 2.618% and XA leg’s 1.272% to 1.618.
When the market reaches point D, it indicates the start of the potential reversal zone (PRZ), the line connecting points D and X (XD leg).
Butterfly Harmonic Pattern Is a Reliable Reversal Signal
Behind all the complexities of the butterfly harmonic pattern is the reliability of its predictive power.
Mastering how this pattern works and accurately interpreting its signals are valuable skills to help you profit from the forex market.
Let’s look at the points and legs of the butterfly pattern.
| Points | Legs |
|---|---|
| X | XA |
| A | AB |
| B | BC |
| C | CD |
| D | DX |
How Does Butterfly Pattern Work?
Developed by Larry Pesavento, the butterfly pattern identifies the prevailing price actions. It interprets the current price movement to predict the potential asset price movement.
But what market conditions are you looking at when the price chart forms the butterfly harmonic pattern?
The market trades on a series of retracements and extensions–thus forming a butterfly-looking price action.
The start of each retracement or extension represents the points of the pattern. Meanwhile, legs form when subsequent points are connected.
Retracements and Extensions Must Be Fib Ratio-Aligned
Again, Scot suggested that the formation or placement of each leg (the distance between two points) should align with a certain fibo ratio. If one leg fails to do so, it invalidates the formation of the butterfly pattern.
Read more: TradersUnited – Fibonacci Trading Basics: Beginner Guide to Butterfly Pattern TradingThe key to butterfly pattern trading is identifying the PRZ at leg DX (points D and X).
A market reversal is imminent due to the exhausting prevailing trend when the market forms this leg.
Spotting this pattern gives you a reference for your trade’s entry or exit point.
But should you immediately enter or exit a trade once the formation is completed? No.
You have to know which type of butterfly pattern occurred. Knowing the butterfly pattern type refers to the price direction and your supposed trade position, whether long or short.
Types of Butterfly Patterns
When you trade forex, you profit from the market’s highs and lows. It’s just about effectively identifying the price movement, whether it will be bullish (up) or bearish (down).
The butterfly pattern can tell you just that.
Let’s look at the two different types of butterfly patterns – the bearish pattern and the bullish pattern.
Bearish butterfly pattern
A bearish butterfly chart pattern occurs at the peak of an uptrend. When the market forms this pattern, buying pressure is running its course and selling pressure is about to dominate the market.
Here’s what you should see at the
- DX leg (Points D and X) is established at the peak of an uptrend
- Point B is plotted lower than the DX leg
- Point B is higher than points A and C
- Point A and C are formed at the through of a downtrend
Bullish butterfly pattern
The bullish butterfly harmonic pattern occurs at the end of an extended downtrend. With its bullish reversal signal, the formation of this bullish pattern presents a strong buy signal for traders.
Here’s what happened to the price chart during the formation of this bullish butterfly:
- Leg DX forms at the bottom of a downtrend
- Points A and C represent the peaks of the uptrend
- Point B is plotted at the middle of throughs D and C and peaks A and C
- Point B forms at an area relatively higher than points D and X while lower than A and C.
Butterfly Pattern Structure
At their core, butterfly patterns formed through these three major factors: the legs, pivot points, and the Fibonacci ratios.
- Legs correspond to the specific price movements of the asset. They are the alternate series of bullish and bearish price movements.
- Pivot points (points) are the turning points that represent extension and retracements.
- Fibonacci ratios determine the distance of the points from one another.
How to Identify the Butterfly Chart Pattern
You must be familiar with the Fibonacci retracement to identify and trade a valid butterfly pattern.
The butterfly harmonic reversal pattern is significantly aligned with certain Fibonacci levels. Thus, each leg’s level of retracement and extension should follow a key Fibonacci level.
Point X to Point A
Also known as the XA leg, points X and A are the starting points of any butterfly chart pattern.
Thus, this leg is the first signal you’ll get from the market.
- A potential bearish reversal is signaled when points X and A form at the peak of an uptrend.
- An XA leg at the bottom of an extended downtrend indicates a potential bullish reversal signal.
The market condition in which this pattern occurs is essential in telling the type of butterfly pattern you’re monitoring and whether to lock in your profits from long positions or enter a short position to profit from a potential bearish market movement.
Point A to Point B
Following Leg XA is Leg AB.
To confirm whether this formation is part of a butterfly pattern, check whether this leg is shorter than Leg XA.
If yes, continue monitoring the price action, as it could be a butterfly pattern. If this leg is longer than the previous one, it’s safe to assume you’re not looking at a butterfly pattern.
Leg AB can appreciate to represent a bearish butterfly, while a depreciating Leg AB is part of a bullish butterfly.
Point B to Point C
Leg BC is the most crucial part of the butterfly pattern formation. This is the leg that makes or breaks the pattern formation.
This leg should strictly extend or retrace between 38.2% and 88.6% of the previous leg (AB).
If not, the butterfly pattern is invalid.
Point C to Point D
If the market passes through the Leg BC, the Leg CD completes the pattern formation.
This leg is the decisive or confirming trendline, suggesting whether the price will start a new trend or continue to trade on another specific Fibonacci range.
If the price reverses direction, the market will likely trade according to the pattern’s signal.
Point X to Point D
Leg XD is not a retracement or extension level. Rather, it is the key support and resistance level for this pattern.
After the price traded the leg CD and touches this key S/R level, it’s likely for the market to change in direction; thus, it’s also called the Potential Reversal Zone (PRZ)
Thus, this leg is known as the Potential Reversal Zone (PRZ).
Advantages and Disadvantages of Butterfly Pattern Trading
With its popularity among technical traders, there’s no denying the profitable opportunities when you trade butterfly patterns.
It’s a no-brainer that trading the butterfly pattern has many profitable benefits. If you’re going to think of it, it garnered a worldwide preference for traders.
v
| Advantages | Disadvantages |
| While its intricate formation makes this pattern rare to appear, this makes it a reliable and precise signal. | With its extreme reliance on the Fibonacci retracement ratio, trading the butterfly pattern is known for its additional learning curve, which sometimes requires several losses before spotting correctly. |
| Once the trader surpasses the learning curve, spotting, monitoring, and trading the butterfly pattern becomes easier. | Butterfly pattern trading requires a broader and deeper understanding of technical analysis. A trader should utilize a multi-indicator approach, use different charting tools, and monitor the prevailing trends and news to confirm the signals and entry/exit points. |
Forex Butterfly Pattern Trading Strategy
The good thing about foreign exchange (forex) trading is that you can profit from the market’s ups and downs.
Your profitability only lies in how you position your trade, whether you’re taking a long or short position.
When to enter a trade?
Entering a trade with the butterfly pattern requires patience and precision.
You typically wait for the D point to be fully formed at a specific Fibonacci level—usually an extension of 127.2% to 161.8% of the XA leg.
When the price reaches this D point, it often signals a potential reversal zone. Once confirmed, traders can enter a trade opposite to the current trend, anticipating that the price will reverse from D towards point B or C.
To increase the odds of success, look for confluences of support or resistance levels and use additional indicators like the Relative Strength Index (RSI) to identify overbought or oversold conditions at the D point.
At which stop-loss level?
Like in financial markets, trading forex requires risk management techniques because of the volatility risk.
A common approach is to place the stop-loss slightly beyond the DX leg, usually around 10-20 pips above or below.
- Above Leg XD if the butterfly is bearish
- Below Leg XD if the butterfly is bullish
This placement allows for some price fluctuation while protecting against a trade that doesn’t go as planned.
Alternatively, you can use an ATR (Average True Range) multiple to determine the stop-loss distance to account for the volatility.
At which take-profit level?
The butterfly pattern offers multiple profit targets, which vary based on risk tolerance and trading style:
- First target: Point B is the most conservative take-profit target. It’s usually ideal for traders looking to capture quick gains.
- Second target: Point C is a more moderate profit target, often reached after a partial reversal.
- Third target: The third target could be an extension beyond point C or a Fibonacci extension (such as 261.8%) of the AD leg, which provides a more aggressive profit target for longer trades.
Many traders exit positions at these different levels to lock in their profits at point B, then C, and so forth.
Gartley Pattern vs. Butterfly Pattern
Gartley and butterfly are harmonic patterns that are usually confused with one another.
Why? It’s because they are both;
- Used to identify and interpret the prevailing price action. With this correlation
- Composed of five points and legs with the same names
The main difference here lies in the extension of point D.
- The butterfly pattern’s CD leg extends longer than leg XA
- The Gartley pattern’s CD leg is shorter than leg XA
Some online traders and analysts prefer Gartley over the butterfly pattern.
This is because the butterfly pattern is known to be rare. Thus, traders have more difficulty spotting it than Gartley.
Read more: TradersUnited – Harmonic Price Patterns Basics : Beginner Guide to Butterfly Pattern TradingShould You Start Butterfly Pattern Trading?
The moment you start effectively predicting market direction is when you can maximize the financial markets’ full potential.
However, butterfly pattern trading requires a broad and deeper understanding of financial markets analysis. Traders usually combine the patterns with multiple technical indicators and charting tools to confirm the signals and the exit/entry points.
