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Butterfly pattern

Author: Consultant Finmaxfx

The Butterfly pattern is a variation of XABCD or harmonic patterns used in the graphical analysis to calculate possible retracement depth during strong trends, define reversal points attractive to enter the market, implementing the buy-dips or sell-highs trading strategies. The formation is based on Fibonacci retracement levels reflecting ratios between the legs of the pattern. Those ratios help forex traders to predict support and resistance ranges where the price reversal is likely.

Butterfly patterns can be also used with additional technical indicators to increase the overall efficiency of a trading system.

What is a Butterfly pattern?

Butterfly pattern is a five-points formation on a price chart with certain relations between the pentagon’s faces. This XABCD formation is almost symmetrical and reminds a butterfly. In most cases, the pattern continues the previous trend, reflecting two waves of a technical retracement. This is why it is important to make sure that the initial leg (XA) comes in line with the general long-term trend on the price chart.

Point X is the starting point of the formation and wave XA has to correspond with the general trends direction. Point B shows the first local bottom of the initial rebound following the peak of the price action at point A. Point C reflects by-the-trend wave and it is lower than point A. Wave CD is the second correction wave larger than the first one as point D appears to be lower than both point B and point X. Despite the overall shape reminding a reversal formation, the Butterfly pattern is used to apply trading strategies based on following trends.

Butterfly pattern conditions

  1. The price moves to point A from point X, while wave XA goes in the same direction as the general previous trend;
  2. Retracement AB has a 0.786 distance of leg XA;
  3. Leg BC relates to AB in a range from 0.382 to 0.886;
  4. CD is a 1.618 to 2.24 extension of the XA wave;
  5. Point D shows a potentially attractive price range for entries in the same direction as the previous trend with targets for take-profit orders at point C, point A and 1.618 extensions of the wave XA.

Butterfly pattern versus Gartley pattern

Although both patterns are continuation formations, reflecting the end of the technical retracement during strong trends, there are several crucial distinctions in geometry. First of all, the ranges of ratios between waves are different, and the Butterfly pattern has a wider shape because both retracement legs are longer compared to Gartley pattern. Second, point D is higher than point X is the Gartley pattern, which is a crucial condition to open by-the-trend positions, while stop-loss orders are hidden below point X. In the case of Butterfly pattern Forex trading, it is allowed for point D to be lower/higher than point X, which leaves room for the price to come back below/above the starting point of the formation, while the level of stop-loss order has to be calculated depending on a particular currency pair but not a fixed point. The rest of the trading rules are the same for both variations of harmonic patterns, the key factor is to keep the required conditions and ratios.

If you like this strategy, you might also be interested in this Cypher Pattern Trading Strategy

How to draw Butterfly patterns?

Traders should connect all of the points of the XABCD pattern consequently, paying attention to ratios between legs shown by the graphical analysis tools automatically. It is important to remember that ratios mentioned in the pattern conditions do not necessarily have to be equal to Fibonacci levels. Even if the figures appeared on the graphical instrument are in the acceptable percentage ranges and the overall shape of the pattern is not shifted in either side, the Butterfly pattern might signal the previous trend continuation. Therefore, the main practical usage of the pattern is to predict possible price ranges where the end of the counter-trend price action is likely and when the trend could resume in the same direction as previously. Another powerful advantage of the Butterfly chart pattern is that it helps Forex traders to plan stop-loss and take-profit orders, maintaining an efficient profit/loss ratio.

How to trade Butterfly pattern?

Main trading approach is to follow a long-term trend. What the Butterfly pattern shows to Forex traders is a visual representation of harmonic relations between several correction waves of the price action. Although the pattern looks like a double-top reversal formation, it continues the previous trend thanks to harmonic ratios between waves based on Fibonacci retracement levels. Double and triple tops and bottoms do not have such a relation between legs when forming peaks and bottoms, respectively. Therefore, the main goal of the graphical analysis using Butterfly patterns is to make sure that the formation meets all of the conditions in terms of the shape, geometry and ratios. If that is confirmed, then a trader can conclude that a reversal is not completed, and the trading activity has to come in line with the previous trend (long positions for bullish and shorts for bearish patterns).

There are two possible methods to use the Butterfly pattern in Forex trading. The first one is to wait for the price to complete the pattern, making sure that all of the conditions are met. Besides, it would be also useful to see the initial movement in the right direction. For example, when the price reached point D and showed at least preliminary reversal signs reflected on additional technical indicators, then traders could enter the market, executing trading rules described below. This is a more conservative way of trading as it suggests waiting for the pattern to be completed. Although risks are lower in this case, profits can be limited.

Another approach is to apply a preliminary analysis and calculate price ranges where the reversal is possible without waiting for the Butterfly pattern to be completed on the graph. For example, a trader spotted that the price action could form the Butterfly pattern at the beginning of the wave CD. So the formation has four points and all of the preliminary ratios correspond with the requirements of Fibonacci levels, but the last point D is not formed yet. Thus, a trader could calculate the possible depth of the leg CD using the ratio and already known distances XA, AB and BC. As a result, s/he would get a price range to place a postponed buy or sell order together with if-done orders, which will act as stop-loss and take-profit in case if the trading position will be triggered. Nevertheless, the trading rules of the patterns are the same for both cases.

Trading rules

  1. Point D is the entry point for long positions if the Butterfly pattern is bullish and shorts when the Butterfly pattern is bearish;
  2. Stop-loss order should be placed at a certain distance below/above point D. The number of pips should not exceed a 2.24 extension of the wave XA;
  3. If the price action goes in the correct direction and the deal is getting into the profitable zone, it is important to monitor the market momentum at point X. If the rate breaches that resistance/support, then traders should remove the stop-loss order to non-risk mode;
  4. Initial target for the take-profit order is placed at point B. If the price bounces from it, failing to break it through with the first attempt, then traders should consider taking profits manually;
  5. Next target for the trading position is placed at point C and point A in extension. Long-term traders might consider holding the position until the price reached a 1.618 extension of the wave XA. Intraday trading strategies suggest taking profits at point A as the final destination of the Butterfly pattern.

Bullish Butterfly pattern

An example of a bullish Butterfly pattern is shown on the screenshot below:

bullish butterfly pattern

Bullish Butterfly pattern

The chart below shows an example of a bearish Butterfly pattern:

bullish butterfly pattern

Examples of profitable trades using

EUR/GBP cross rate started an initial bullish swing at point X, peaking at point A. After that, the bullish momentum was exhausted and the pair retraced to point B, keeping the required ratio between legs AB and XA (78.6%). The next wave was going in the same direction as the overall trend, while the second top was formed at point C, lower than point A. Despite the general look of the formation like a double-top reversal pattern, ratios between its legs were in line with harmonic patterns, which was confirmed by the wave CD. That helped a trader to determine the Butterfly pattern and open long positions at point D. The initial target at the level of point B was reached quite quickly, while the final destination of the pattern at point A gave a nice profit of 85 pips in 24 hours.

Examples of profitable trades using

Conclusion

Butterfly pattern is one of the harmonic patterns widely used in the graphical analysis to find periods when the recent trend is going to continue after two waves of correction. The pattern is an effective tool to differ continuation formations from such reversal patterns as double and triple tops and bottoms. The mathematical background is based on Fibonacci retracement levels reflecting ratios between the legs of the pattern. Forex traders can open deals after the pattern is completed, confirming the previous trend continuation, as well as determine price ranges where the retracement could come to the end and place postponed orders to enter the market once the price reached a certain depth of the retracement. The key advantage of the Butterfly pattern forex trading is that it is based on the approach to follow strong trends, maximising possible profits. It is also can be used together with additional technical instruments and indicators to increase the overall efficiency of a trading system.

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