- April 12, 2020
- Posted by: CoachShane
- Category: Trading Article
The Butterfly pattern, discovered by Bryce Gilmore, is a reversal chart pattern that consists of four distinct swings in the market.
The rules to identify the Butterfly trading pattern are strict and requires the use of certain Fibonacci ratios that were made public by Scott Carney.
If you use ratios from Fibonacci to identify certain patterns, you are essentially trading a harmonic pattern which the Butterfly pattern is considered as.
In this article, you are going to learn a Butterfly Pattern trading strategy that includes:
- How to identify the Butterfly pattern using the required Fibonacci retracement and extension ratios
- How to calculate your stop loss level
- Where to set your profit target
These types of patterns, harmonic patterns, are not for everyone.
You must buy into Fibonacci as a means of trading and believe there is an edge in doing so.
That said, one important aspect of the Butterfly trading pattern is an A-B=C-D formation and that is something I personally use as a rule of thumb for profit targets and potential turning points. It does not have to be an exact match
How To Identify A Butterfly Harmonic Pattern
The Butterfly pattern is similar to the Gartely as both form a warped “W” or “M” shape. The difference is the Gartley is considered a completed pattern when a Fibonacci retracement ratio and an extension level coincide
The Butterfly is considered to be complete when two Fibonacci extensions coincide.
For the Butterfly pattern to be found, we need four points in the market: X, A, B, C and D, which is considered a Potential Reversal Zone and not a point.
It is this location you would look for a trade position.
Each swing has a relationship to another which are specific Fibonacci numbers and are needed to validate the swings:
- AB leg should equal 78.6% retracement of the XA leg
- BC leg should be between 38.2 and 88.6% retrace of the A-B leg
- C-D swing is 168 to 261.8% extension of A-B swing
- The most important number in this pattern is the 127% extension of the XA leg
- Both bullish butterfly patterns and bearish patterns use the same ratios
This is an example of a Bearish Butterfly Pattern where we would want to short a reversal. The red star is the Potential Reversal Zone and you would look to position in the trade in that zone.
Because the reversal zone can be known ahead of time (1.27% extension of X-A / 1.68-2.618% ext of A-B), you can set an alert for when price enters this zone.
How To Trade The Butterfly Pattern
Tradingview has a superb tool (XABCD pattern) for drawing the Butterfly pattern but it can also be done with the Fibonacci tool.
- This is the X point and is the first place we click with the tool
- This ending forms that XA swing
- We click at this point and we get the AB leg (70% retrace in this example)
- Clicking here gives us the BC leg (C ends at an 87.9% pullback against the AB leg)
- This is the Potential Reversal Zone and completes the CD leg (This forms a 153% extension of XA leg and 235% extension of BC leg
Remember, the Potential Reversal Zone is known in advance.
The following chart shows the same chart using Fibonacci retracements and extensions. After point four ( BC leg) has completed, you can then project upwards to find the zones and mark off the areas of interest.
The red zone is the 1.618 extension of the BC leg and the 1.272 (1.618) extension of the XA leg. This is the minimum zone and you would prefer to have a price closer to the 1.272 end of the zone.
The yellow zone includes the extreme extension level of the BC leg and the minimum 1.272 of the XA leg.
While the hard and fast rule is the AB leg must be a retract 78.6% of XA leg, let’s agree that markets are not exact and close is close enough.
Stop Loss Location + Profit Targets
Every method of trading should have a stop loss and the harmonic Butterfly pattern has a built-in stop-loss location.
Your stop loss on a short reversal trade should go just beyond the trading zone outlined via the Fib ratios. Some traders, if the price has not breached the 1.618 extension of the XA leg, will put their stop loss above that location.
Profit targets can be Fibonacci retracements of the entire CD leg. You can also trail your stop above each high (for a short) each time a new low is made
When considering profits, use the levels as zones and monitor price action. What we don’t want to see is strong momentum against our positions and remember that Fibonacci levels hold no magic in the markets.
Learn to line up the levels with actual support and resistance levels that may affect the direction of price.
Butterfly Pattern – A Twist
The important numbers of the Butterfly are the 78.6% level and the 127% extension level. We can use those two levels to form the bones of a trading strategy.
This is an uptrend and we pull the Fibs from highs to low.
When price meets the 78.6% level, we take a long position with the 127% extension level as our price target.
Note that at the top of the chart where the red X is located, price did not breach the 78.6% level and therefore there is no long trade taken. We then reverse to trading shorts.
Another method that will utilize the same important ratios of the Butterfly pattern allows us to play both sides of the trend.
In this case, we are trading the break of the 78.6% level and taking profits at that 127% level.
The yellow dashes are the break of the 78.6 levels and the yellow splash is the 127 level where you’d take profits and reverse if possible.
We will then look to see a reaction in the opposite direction of our previous trade. We are looking to take advantage of:
- Momentum once price breaks the 78.6% level
- Reversal momentum once price hits the 127% level, reverses, and traps traders that must exit.
The last trade on the right is a current long that just broke the 78.6% level.
As for stop locations, you could use a ratio of 61.8 to tuck your stop behind
Butterfly Pattern Trading Strategy Wrap Up
The Butterfly pattern can be simple to spot when you see a pullback (AB leg) from the initial XA leg. You will then look for a higher low (uptrend) that would form the end of the BC leg.
The stop loss and price targets are built-in which takes much discretion out of the Butterfly strategy.
The biggest issue for a trader is defining swings in the market that can be used to draw the pattern. The rule of thumb is to use a swing that is obvious.
Look around your charts for the pattern and define your trading rules for a Butterfly strategy or for the last two just mentioned.