The Butterfly pattern is a harmonic trading reversal pattern that is made of 5 swing points (X,A,B,C and D).
The pattern was discovered by Bryce Gilmore and further defined by Scott Carney.
Due to the fact that the D point is located above X, it isn’t referred to as a point but more as a Price Zone that is defined by Fibonacci extension levels (read more). That allows to define where the stop loss order should be (read more in trading guidelines below).
Butterflies patterns are called Harmonic Extension Patterns and their advantage is that they allow you to enter trades at extreme highs or lows.
Just like all of the harmonic trading patterns, there’s a bullish version of a Butterfly pattern and there’s a bearish one.
Below I’ll describe the pattern’s rules on the bullish version of the Butterfly pattern but these rules can easily be translated to the bearish version as well.
Harmonic patterns are made of consecutive Fibonacci retracement and extensions levels. They differ by the Fibonacci levels that are being used to form the pattern.
The Butterfly is formed by using these rules:
- The B point is at the 78.6 retracement level of the XA (in Gartley its 61.8 and in Bat it is the 50).
- D point presents a 1.27 Fib extension level of XA.
- In most cases C points is a 50 or 61.8 retracement of the AB leg (although it can be also 38.2 or 78.6)
- The AB and CD legs will form an AB=CD pattern (read more)
Here’s a real example of a Butterfly pattern:
As you can see in this bearish example (USDCAD):
- B point reached the 78.6 level (even slightly above it)
- C point reached the 50 Fib correction level of AB
- D point reached exactly to the 1.27 extension level of XA
This daily Butterfly pattern generated a move of almost 400 pips in USDCAD!! (still didn’t reach its final target zone).
The Potential Reversal Zone
As mentioned above, in Butterfly pattern the PRZ (Potential Reversal Zone) is defined differently than in Gartley and Bat patterns.
In Gartley and Bat patterns the PRZ is limited by X.
The rule for stop loss orders is that they should be above (for bearish patterns) or below (for bullish pattern) X.
Still, we need to have a defined risk. That’s one of the biggest advantages of harmonic patterns – Defined trading rules and defined risk.
The PRZ in Butterfly patterns is created by using Fibonacci extension and inversion levels:
The picture above shows a successful bullish Butterfly on AUDCAD.
As you can see, the price spiked below the D point and rallied straight up to hit both target zones of the Butterfly pattern (read more about setting targets below).
The PRZ is the Price Zone found between the 1.618,2 Fib confluence zone near 0.997 and the 2,2.618 confluence zone near 0.992.
The R/R for this bullish setup is shown below:
The Target Zone for Butterfly patterns are the 38.2, 50 and 61.8 Fibonacci level of the A to D leg:
If we will pull the Fibonacci tool on UK100, from A (3500) to D (7600) we will get these
- Target 1 – 6000
- Target 2 – 5500 (I would focus on the 200 months MA line)
- Target 3 – 5000
This Butterfly pattern is a monthly pattern that I mentioned in my Weekly Markets Analysis newsletter (subscribe now).
Obviously, since we are talking about a monthly pattern, it can take months and maybe even years till the price will reach one of these targets.
But, if this pattern will remain valid and the price will remain inside the PRZ, we are talking about risking about 5% to gain from a potential 20% correction wave of a stretched market:
The same target setting principles can be used on any time frame that you are trading.
*Notice that Target 3 is below the strong support zone of the 200 months MA line. I would pass it as potential target zone for this setup and focus only on Target 1 and 2.
Butterfly patterns tend to create very strong reversal moves.
As mentioned the PRZ is located at extreme price levels and allow you to trade underlines that are usually highly overbought or oversold.
However, you need to realize that Butterfly patterns are counter trend patterns that rely on a temporary shift in trend. That makes them also risky patterns.
For example, the UK100 chart above shows that the UK FTSE recently made new All Times High. The buyers clearly dominate the markets these days and there’s no guarantee that the buying spree will end soon.
As in all technical patterns, and especially in harmonic extension patterns, it is highly important to manage risks and properly manage your trades.
Remember, you do not know what the market is about to do, you can only speculate and trust your trading edge to deliver its results over time. It is up to you to stay in the game long enough for your edge to work and deliver.
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