Butterfly pattern is an advanced reversal formation based on Fibonacci ratios. It is a harmonic pattern which develops usually during phases of consolidation.
It can be either a bullish or bearish formation, which may provide us with opportunities in both sides of the market.
In this article, we will explore this powerful reversal pattern, understanding how to spot, draw and trade it in financial markets like forex or crypto.
How to identify a Butterfly Pattern: rules and proportions
Harmonic patterns like Butterfly are usually composed by four legs, corresponding to equivalent impulses or retracements in the market.
As for any kind of reversal pattern, Butterfly pattern sometimes appear at the end of an extended price move, when price starts to show weakness in its action. However, this is not a foolproof condition. Due to its shape (similar to a “W” in an uptrend and a “M” in a downtrend), the Butterfly harmonic pattern usually appear during phases of consolidation, when there is not a clear market direction:
Luckily for us, harmonic chart patterns require specific rules of identification: this means that subjectivity partially does not apply to harmonic trading. For instance, the appearance in a specific market of a Butterfly pattern is clearly seeable by all, while the identification of a Cup & Handle pattern may be trickier and not clear to all the traders involved.
Rules of Identification
The butterfly harmonic pattern is identified starting from 5 relevant points (XABCD). Thus, they are composed by 4 legs:
- XA – Starting impulse of price action;
- AB – B point should be spotted in the range between 61,8% and 78,6% retracement of XA leg;
- BC – C point should be spotted in the range between 38,2% and 88,6% retracement of AB leg;
- CD – D point should be spotted nearby:
- the 161,8% extension of BC leg – if C point is nearby 38,2% of AB;
- the 261,8% extension of BC leg – if C point is nearby 88,6% of AB;
Then, the total movement AD should be comprised between the 127,0% and 161,8% of XA leg.
How to easily draw any kind of harmonic pattern
A simple pro tip for you: thanks to tradingview.com, now you can draw any kind of harmonic pattern in an easy and quick way.
Just go on chart and select the “XABCD pattern” on the left toolbar. Then, click on the XABCD points to plot the pattern on chart, as you can see in the picture below:
Identify the Potential Reversal Zone (PRZ) for a Butterfly Pattern
In the previous paragraph, we’ve seen that in order to identify a Butterfly Pattern, point D should appear:
- at 161,8% extension of BC leg – if C point is at 38,2% of AB;
- at 261,8% extension of BC leg – if C point is at 88,6% of AB;
Once D is identified, Butterfly is complete. BUT this does not mean that you are ready to send your order in the market.
Remember that technical analysis is not a precise science. It deals with probabilities. Thus, D point identify a potential area of reversal (the PRZ) and not a precise point.
Look at the picture below:
The Potential Reversal Zone in harmonic trading is nothing but a support or resistance in the market (depending whether we are talking about a bullish or bearish Butterfly pattern). Thus, before to enter in the market, we should wait for a concrete entry reason, like for example an candlestick pattern (shooting star, hammer, etc.).
The Harmonic Butterfly trading strategy
A good strategy relies on 3 main elements:
- Clear entry reasons – as when have seen in the paragraph above;
- Clear exit reasons (stop loss and take profit);
- A clear money management strategy to increase your profitability.
Harmonic trading responds exactly to all these requirements, thanks to Fibonacci’s levels of retracements and extensions.
Exit techniques for the Butterfly Pattern: Stop Loss and Take Profit
I like harmonic trading because for any kind of pattern, provide us with clear, understandable and precise rules of exit from a trade. Look at the example below:
As you can see, there is no room for subjectivity:
- Take profit 1 for Butterfly Pattern – 38,2% retracement of AD leg;
- Take profit 2 for Butterfly Pattern – 61,8% retracement of AD leg;
- Stop Loss for Butterfly Pattern – 1:1 projection of Target 1 or nearby previous support and resistance zones
Backtests have proven that the overall success rate of Butterfly pattern trading strategy can be attested even around the 80/90% of the total trades.
Nonetheless, it’s crucial to remember that this does not necessarily mean that you will able to achieve a similar success (win rates indeed, depends on your strategy, exit triggers and foremost your emotions).
PRO TIP: protect your profits with multiple targets!
Fibonacci’s levels allow us to set multiple targets while trading harmonic patterns. This give us the possibility to increase the risk-to-reward ratio.
How is this possible? It’s easy.
Once you reach Target 1, close HALF of your position: then, move your Stop Loss equal to the entry point and wait for Target 2 in a completely RISK-FREE trade.
This easy but effective money management technique allows you to maximize potential profits, while reducing overall risks.
Real-life example of Bullish and Bearish Butterfly Pattern in forex and crypto market
As you could imagine, especially for novice harmonic traders is not easy to spot this kind of patterns in markets. Well, I think that the only way to acquire more confidence is to see tons of cases.
Here below, you can see some examples of Butterfly pattern on Forex and Crypto markets:
Conclusions – Key takeaways
In this article, we’ve explored the Butterfly harmonic pattern, a Fibonacci’s based advanced pattern used everyday by traders in forex, crypto and stock markets.
In conclusion, I would like to remark the main takeaways of today’s article:
- Butterfly pattern is and advanced reversal formation based on Fibonacci ratios;
- It can be either Bullish or Bearish;
- Sometimes appear at the end of an extended price move, even if usually appear during phases of consolidation (due to its shape!);
- It requires precise rules of identification;
- The D point, may be found either at the 161,8% of BC or at 261,8% of BC depending on the location of point C;
- D point identify a Potential Zone of Reversal rather than a specific pivot point;
- As for any other harmonic pattern, Butterfly provide clear exit techniques with multiple target, allowing to increase the risk-to-reward ratio;
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