What is the Butterfly Pattern?
A harmonic pattern that is a reversal chart pattern is the butterfly pattern. It demonstrates price consolidation and is typically observed after a lengthy price move.
The butterfly pattern can be used by traders to spot the end of a trending advance and set up positions for the beginning of a corrective or new trend phase. In the final wave in the impulse sequence, or in Elliott wave terms, you will frequently observe this pattern.
The harmonic butterfly pattern is a reversal trading pattern that can be traded constantly, just like all other harmonic patterns. Some traders favor trading them on longer time intervals.
Various shapes and variations of butterfly structures exist. The butterfly has a number of advantages over the Gartley 222 harmonic pattern, but its main advantage is that wave D of the butterfly ends after wave XA’s first wave, allowing traders to buy and sell at new lows or highs.
Bryce Gilmore and Larry Pesavento were the first to recognize the pattern, which frequently appears close to the market’s extreme lows and highs and denotes a reversal.
Letter combinations X-A, A-B, B-C, and C-D stand for the four legs of the butterfly pattern. It helps traders forecast the end of a price movement. The market may be entered by traders as the price fluctuates, according to this.
Butterfly Harmonic Pattern Rules
There are four waves in total XA, AB, BC, and CD. Follow a few easy steps to spot a butterfly pattern in the FX market.
- Wave XA has to be impulsive.
- Wave AB must retrace to the XA level between 0.618 and 0.78.
- The BC wave must retrace to the AB level of 0.38 – 0.88 Fibonacci.
- There are two possibilities for the CD wave Either the CD wave can equal the AB wave or it must retrace to the wave XA’s 1.272 extension level.
A decent butterfly chart pattern can be found by following these four easy steps. Fibonacci can be utilized in a variety of ways to maximize results and create attractive chart patterns.
Wave XA will be a bullish wave in a bullish butterfly formation. Retracement waves are wave AB and wave CD. Bullish waves will also make up the final outcome. A negative trend changing to a bullish trend is shown by the bullish butterfly pattern.
Wave XA will be a bearish wave in a chart pattern that is bearish. In turn, the bearish chart pattern will change the earlier bullish trend into a bearish trend, producing a bearish wave as a result.
Psychology of Butterfly Pattern
Simple psychology behind this chart pattern. Wave XA depicts the beginning of a new trend to entice retail traders, but the price will afterward retrace. The majority of retail traders will attempt to enter trades at the Fibonacci levels of 0.618 or 0.78, but a final CD wave will arrive to pursue stop losses after a minor fake-out (BC wave) to attract additional retail traders. Market makers will keep moving after engaging in stop-loss hunting, and an impulsive wave will develop.
What Does the Butterfly Pattern Tell Traders?
Due to its appearance and the places it occurs, the butterfly is one of the most significant harmonic patterns. The significant highs and lows of a trend are displayed by this pattern, according to Carney and Pesavento. In fact, different butterfly designs frequently appear in different periods near the end of a trend when employing alternative time frame analysis. The pattern, which is an illustration of an extension pattern, typically develops when the passage of the CD wave past X invalidates a Gartley pattern.
This pattern comes in two flavors: bullish, in which case traders are recommended to purchase, and bearish, in which case traders are encouraged to sell. When using the butterfly pattern, accuracy is essential because it enables traders to eliminate mistakes.
How to Trade When you See the Butterfly Harmonic Pattern?
Verify the pattern’s validity using the following checklist before trading the butterfly harmonic pattern. The following essential components should be present:
- AB = 78.6% of the XA leg optimum objective
- Fibonacci retracement of the AB leg: BC, minimum 38.2 percent and maximum 88.6 percent
- A target for the Fibonacci extension of the AB leg, CD= is located between 1.272 and 1.618 of the XA leg.
The pattern’s completion at point D will occur at the 127 percent extension of the X-A leg, therefore locate that location.
Set a stop-loss order just below the X-A leg’s 161.8 percent Fibonacci extension.
Take profit target
With this pattern, where to set a take-profit target is entirely up to you and is determined by both your trading objectives and the market’s circumstances. Put your profit target at point A of the pattern if you want it to be aggressive. Put it at point B for a more conservative profit goal.
Trading a bearish butterfly harmonic pattern
Put a sell order in at point D. (a 127 percent extension of the XA leg). Place the stop-loss just above a 161.8% extension of the XA leg. Additionally, set the profit target for an offensive move at A and for a defensive move at B.
Trading a bullish butterfly harmonic pattern
Find point D, which is an extension of the XA leg by 127%, to be the pattern’s end. Now is the time to place a buy order. A stop-loss can now be set below a Fibonacci extension of 161.8% of the XA leg. Setting a profit target is influenced by the state of the market and your trading objectives.
Comparisons to the Gartley Pattern
The Gartley pattern and the butterfly are similar in that both have five points and four legs as parts of their structure. However, there are several significant distinctions. The butterfly is an extension pattern rather than a retracement pattern, which means that point D of the pattern extends beyond the pattern’s initial starting point X. D for a Gartley pattern denotes a return to X rather than an expansion beyond.
Additionally, data show that a butterfly pattern has a better success rate than a Gartley design. Reversals that occur after the butterfly is finished are also sharper, which is something to keep in mind.
Whether you are a novice trader or a seasoned pro, you should never undervalue the effectiveness of chart patterns as tools for trading analysis. They are essential for identifying entry and departure points as well as suggesting if the current trend will reverse or continue. Butterfly patterns in particular can be useful in predicting when price movements will finish.
When applied appropriately, they can predict price movement in the future with great accuracy. They become crucial trading tools in the majority of markets (forex, stocks, etc.) as a result.