Learn the Fundamentals of Butterfly Pattern Trading

Although the stock market conditions are unpredictable, there are times when patterns may be profitably traded. And in fact, pattern trading is possible even during volatile situations. This charting pattern is the result of volatility, and it responds to significant market swings. It’s called a butterfly because it looks like two converging triangles – or, to put it another way, a butterfly.

For skilled traders, this technical pattern and its associated reversal trading pattern technique are for you. But, of course, it’s one thing to recognize a butterfly pattern depends; it’s another thing to know the ratios needed to take action. So, it’s critical to comprehend what you’re seeing when a butterfly pattern appears on a stock graph.

What Is a Butterfly Pattern?

Butterflies are reversal chart patterns that have four distinct entry and exit points. They’re also defined by Fibonacci ratios, making them other harmonic patterns. This makes trading butterflies so tricky; unless you’re familiar with specific Fibonacci ratios and harmonics.

Like all technical analysis patterns, the butterfly pattern resembles ABCD roots and an X beginning point. Concerning X, AB=CD in the case of butterflies, with a proportionate relationship. This is when Fibonacci ratios come in handy. Butterfly patterns have tight specifications and needs:

• The target for the XA goal is 78.6%.
• The 38.2 percent retracement of AB is at $0.0033, and the 88.6 percent retracement is at $0.018.
• Between 1.272 percent and 1.618 percent of XA is a 0.965-1.618% extension of AB, while between 1.218% and 2.618% of XAI

In reality, these ratios help to create the butterfly pattern and entry thresholds. For example, the Potential Reversal Zone is located at Point D in the pattern, where traders may confidently enter a short or long position using the Fibonacci ratios. For example, these stop-loss levels are set just beyond the 1.618 percent extension pattern of the XA leg.

Why Are Butterfly Patterns Important?

Butterflies are significant since they signal a change in direction. And because these patterns are harmonic, traders may use Fib ratios to determine the reversal’s proportionality – as long as they’re skilled with Fib ratios. Many traders employ these methods to signal the end of a trend phase and provide experienced traders with an opportunity.

The second reason why butterfly patterns are so vital is that they’re pretty predictable. They’re simple to trade since the Fibonacci ratio generates stop-loss and price objectives as it does. If you have the technical indicators and know-how to define a butterfly properly, you can feel safe within the Potential Reversal Zones.

How to identify the Butterfly pattern

Like the bat and Gartley patterns, the butterfly price chart has four separate legs labeled X-A, A-B, B-C, and C-D. In addition, the pattern instructs traders on when to sell after the pattern has ended.

X-A:

The bearish butterfly pattern approach begins with the price plummeting from X to A in the first stage.

A-B:

The A-B leg recognizes the price direction change and retraces 78.6 percent of the X-A axis’s distance traveled.

B-C:

The price reverses direction for a second time in the B-C leg, retracing 38.2 to 88.6 percent of the distance covered by the A-B leg.

C-D:

The C-D axis is, in fact, the final and most important aspect of this pattern. To complete the butterfly pattern, like with the Bat and Gartley patterns, you’ll need an AB=CD structure, but the C-D leg extends to create a 127 or 161.8 percent extension of the A-B leg. Traders would want to get into position D of the pattern.

Traders look to place their trade entry order at the point where the C-D leg has reached a 127 percent Fibonacci extension of the XA leg, which is a significant difference between the butterfly pattern and Bat or Gartley patterns. In addition, it is the pattern’s most extended price leg. On average, the extension of the B-C leg should be 161.8 to 261.8 percent of D-D length.

The pattern has four price fluctuations, and its appearance on the chart resembles the letter M in downtrends and W in uptrends. Therefore, it can be mistaken for a double bottom or top pattern during its formation.

Structure of the Butterfly Formation

One of the essential aspects of butterfly patterns is how their orientation swiftly reveals bearish and bullish situations. When the X and D points are below the A and C points on the chart, this indicates a bullish setup. A two-bar candlestick pattern is a sort of reversal pattern signal. The butterfly suggests that a price rise is likely after the D point reaches full retracement.

A bearish pattern is formed when the X and D points are placed above the A and C points, including an inverted butterfly pattern from a bullish setup. The bearish version trading approach is a copy of the bullish form. The butterfly pattern predicts a subsequent price drop when the CD line reaches its full Fibonacci extension.

Butterflies are one of the most popular chart patterns, as they’re so uncommon as a trading strategy. In addition, they’re generally the first indicator or a reversal chart pattern to evaluate a trade. As a result, you’re much more inclined to start trade analysis by identifying a butterfly pattern and then using other indicators and chart patterns to validate the bearish trend or bullish butterfly pattern indication and open a position.

The shape of a butterfly is commonly used to predict the direction of price movement. This knowledge can be used with other indicators, such as volume indicators, to determine how long to keep a position open before closing it out and taking a profit.

Butterfly Pattern Trading Rules

Butterfly patterns are frequently discussed in the trading world, indicating their popularity. Here are the fundamental principles of butterfly patterns:

The XA leg is the first step in the pattern, which serves as the foundation for everything that follows.

• AB leg can’t surpass point X.
• BC leg can’t reach point A.
• The CD leg must beat point X (in contrast to the Gartley pattern described above).
• The endpoint of D in CD must be comparable to or exceed point B.

It’s also critical to remember that the butterfly pattern must have an “AB equals CD” structure, which is not always required.

Advantages of Using Butterfly Patterns

Because of their popularity, butterfly patterns have several advantages for forex traders. The following are some of the benefits:

• Butterfly designs are simple to recognize and comprehend. For novices, butterfly patterns are more approachable and identifiable than other butterfly chart pattern types, making them a popular choice early in developing your trading strategy. The basic pattern design might be attractive to even seasoned traders due to its simplicity.
• Compared to other chart patterns, butterfly patterns are more likely to indicate. Even the most reliable forex trading indicators can mislead traders on any particular trade, and no chart pattern is impenetrable. Similarly, it’s never a good idea to base your trading decisions or overall trading strategy on a single chart pattern. On the other hand, butterfly patterns are popular primarily because they offer more consistent forex insights.
• Anecdotal evidence suggests that the butterfly pattern is one of the most effective methods for recognizing aggressive profit target possibilities. Some seasoned traders think that the predictive value of a butterfly pattern is greater than that of other techniques, such as the Gartley pattern.

Disadvantages of Using Butterfly Patterns

Traders on Forex are still looking for the ideal chart pattern that will alert profitable trades every time. However, even well-known tools such as butterfly patterns have certain disadvantages and benefits that traders should be aware of. These are some of the drawbacks and disadvantages associated with them:

• To make sense of predictive patterns, you must have a deeper understanding of forex analysis. The butterfly pattern requires a combination of other indicators and chart patterns to validate the setup and indications given by this chart pattern.
• For some traders, the rigid structure may be irritating. It’s hard to develop a butterfly pattern regarding Fibonacci retracement levels because they are so tightly regulated. Many traders searching to create butterfly patterns become disappointed by the failure of the entire pattern due to its strict rules on Fibonacci retracement levels. This can lead to unnecessary effort in tracking possible setups.
• In general, the butterfly pattern is less common than the Gartley. Traders may find the Gartley pattern more readily identifiable and easier to interpret based on comparable data points than butterfly patterns, which is why it’s more popular.
• For many traders, the butterfly pattern’s successful trade application necessitates a trial-and-error approach. So if you’re just getting started with the butterfly pattern in trading, be prepared for some bumps and bruises—both in terms of finding helpful butterfly patterns and properly contextualizing them to make the best trade decision.

Common Mistakes

Keeping an eye on the Fib ratios in a butterfly pattern is critical to ensure you’re not charting a bat or crab formation. The harmonic trading ratios are the same, but the proportions differ. The harmonics in this example have different vital ratios. Changing your levels can be difficult if you’re unaware of which butterfly harmonic pattern balance to use.

Along these lines, the pattern’s development is critical. Until the design is finished, a butterfly trading technique won’t crystallize. Because the Fibonacci sequence is a mathematical calculation, it’s essential to figure out the critical legs so you can evaluate whether they fit the pattern.

Closing Thoughts

Chart patterns should never be underestimated as trading tools, even if you’re a novice trader or an experienced investor. They’re significant when signaling the continuation or reversal of a new trend phase. Likewise, butterflies are beneficial in determining when price movements will end.

The butterfly pattern is difficult to understand, much less trade, for even skilled technical traders—and all harmonics are no exception. However, if you’re familiar with Fibonacci ratios and have prior experience charting patterns, the butterfly may be a very dependable pattern to trade. Finding price swings in the market volatile enough to follow a butterfly pattern is the most challenging part. Fortunately, pronounced fluctuations and volatility tend to create butterflies. This price instability may help you make money by recognizing and tracking them.

FAQs

What Does a Harmonic Butterfly Look Like?

The harmonic butterfly appears in both bullish and bearish situations. For example, the upside-down butterfly formed during a stock’s ascent that ends in a new high (bullish butterfly patterns) resembles a butterfly pattern.

The formation that results in a bearish drop (bearish butterfly) resembles an upright butterfly. Because financial markets are fractal, this pattern may be observed in any market or at any time. The patterns you see on smaller time-frame charts are, in many cases, smaller versions of the same ones you discover on more significant time-frame charts.

Is the Harmonic Butterfly Pattern Reliable?

On the other hand, the butterfly pattern is an easy-to-trade harmonic pattern with a very high trade probability. The risk/reward of a butterfly pattern can vary greatly depending on how far the CD leg extends, so traders should only trade butterflies with a lower danger and more conservative profit target potential.

How to Trade the Harmonic Butterfly Pattern?

Setting up a trade opportunity after discovering a potential butterfly pattern is quite simple. First, we can identify the prospective reversal zone of this formation ahead of time due to its harmonic price patterns wave nature. Then, if the price approaches that zone, we may look for indications of a change in trend.

Ether (ETH) appears to form a bullish harmonic butterfly pattern from late August through September 2021. The form’s geometric price patterns are in line with expected values.

For example, B point retraces 99.8% of the XA extended price move. This is a little more than we’d like to see. On the other hand, that significant point retracement pattern is quickly followed by buyers, and prices go higher, leaving behind a long downside wick. Ether (ETH) continues to attempt to sink further, back towards the 78.6 percent retracement level over the next few days but is swiftly met with buyers. Even though this pattern has a more significant first drop of 78.6%, you can see how the market’s geometry attempts to carve it out.

The rally from point B to point C retraces 67 percent of the AB trend, which is typical. This establishes a possible bullish trade reversal zone for wave D at $2,718.05. The price then dips and corrects just below the 127% objective area, where it had been investing.

Placing a Long Entry Position

When Ether hit the target zone, it created a substantial downside wick. This is proof of investors rushing to support the market’s price, suggesting that ETH is a good value.

The most straightforward approach to set up a long entry is to utilize a breakout trade. This might be done by establishing a downward sloping resistance trend line that, when broken, serves as the entry signal. Alternatively, you can look for horizontal resistances and wait for the price to break above before entering long.

Typically, a trader will choose one of these resistance levels as a trading point, but I’m showing you both so you may see how the two look. In other words, once the price rises and breaches the resistance level, it indicates an extended position.

Managing Your Trade

The stop loss should be set at D, the swing low, just below where the price action has been declining for some time. If prices continue to fall, we can exit the trade with a good portion of our account’s capital intact.

Exit Strategy

We can then set a profit target once the position has been entered and the stop loss has been determined. On many occasions, a successful harmonic butterfly goal is located well beyond point A. This is the first step on the road to success. This level may be regarded as a starting point. If this price level is exceeded, the trader might want to close a portion of the position and leave the remainder to float. This method allows the trader to capture much more profit if the trend becomes extremely powerful by trailing the stop loss and taking profits at greater levels.