What is Butterfly pattern and How to Use It in Trading | LiteFinance (2024)

Gartley harmonic patterns provide more accurate signals of future price action than chart patterns. Therefore, harmonic patterns gain popularity with more and more traders.

This overview deals with the harmonic Butterfly pattern, one of the most popular Gartley patterns that predicts the trend reversal in advance and helps to define the beginning of the new trend phase. The Butterfly is also successfully used to define the potential reversal zone by applying the Fibonacci retracements.

Major takeaways

What is the Butterfly pattern and how does it work?

Unlike more popular chart patterns, the Gartley patterns are built according to strict Fibonacci ratios. One of the most common patterns is the harmonic Butterfly pattern. The butterfly is a part of the harmonic family of patterns, which include other formations such as Gartley, bat, crab, and AB CD. This is a five-point reversal chart pattern used in technical analysis by traders to help identify turning points in the market. It is a trading pattern with a specific shape and distances between each leg of the pattern.

Bearish Gartley Butterfly

The pattern chart drawing consists of four movements that resembleElliot waves and form the pattern. Pivot points and price impulses are usually marked with letters. The very first is the X leg, it is formed from the starting point X and ends with point A, the highest or the lowest point of the entire formation. Then segments AB, BC, and CD appear successively on the wave of volatility.

On the one hand, the Butterfly harmonic pattern is a reversal trading pattern. After its completion, the price reverses sharply and forms a directional impulse (the blue line in the screenshot above). But if you look more globally, the local reversal pattern often signals the beginning of a larger trend.

Butterfly harmonic pattern history

The history of harmonic trading begins in 1935. A famous market expert and technical analyst, Harold McKinley Gartley, has developed price action patterns that he has lectured about and discussed in private consultations. He later described the Gartley pattern trading technique in detail in his book Profits in the Stock Market, which is considered a classic textbook on harmonic patterns.

The five-point price movement, later called the Gartley Butterfly pattern, was discovered by Bryce Gilmore. However, fame did not come to the new technique immediately. Harmonic trading became commonplace in technical analysis at the end of the 20th century. By that time, Gartley's work had been finalized and revised by his followers, Scott M. Carney and Larry Pesavento. The latter introduced the Fibonacci ratios, which enable one to more accurately determine and classify price movements. A Butterfly with perfect Fibonacci proportions is called the Pesavento Butterfly.

As there appear new types of Gartley patterns, the methods of their identification also modify. Traders no longer look for extension templates manually but use technical indicators in MetaTrader and other platforms.

How to identify the Butterfly pattern chart pattern

Let's find out how you can spot a Butterfly harmonic pattern in the chart. As I already wrote, this pattern is composed of four waves. All of them are related to each other according to construction rules. When you analyse a potential Gartley pattern, add one point for meeting each condition. If the formation scores five points, you can be sure that this Gartley pattern is a Butterfly and enter trades according to this formation.

X-A

X leg is any price activity on the chart. There are no special requirements for this segment of the Gartley Butterfly patterns. The only criterion is the directional price movement: the harmonic Butterfly occurs during a period of temporary or final exhausting of the trend. If this condition is met and you determine the pattern in a long trend, then feel free to add one point (so, the pattern meets one condition and scores one point of five).

In a bullish Gartley Butterfly, XA goes up, and in the bearish butterfly, this leg goes down. The impulse length could be any. It is important that the next point retracement should follow a particular ratio.

A-B

AB leg moves in the opposite direction relative to XA. In length, it should be approximately 78.6% of the X leg. Thus, if the XA move is bearish, then the AB move should be up. And the B point should reach the 78.6% Fibonacci retracement of XA. If this condition is met, then you can safely add up another point.

B-C

The BC leg goes in the opposite direction of AB. The BC length is from 38.2% to 88.6% of the distance covered by the previous leg (BC). If this condition is met, add one more point to the total score.

Please note: BC in the Gartley pattern is a retracement of 88.6% of AB. This is a fairly new price extension, which was first proposed by J. Kane. Like the more common 78.6% potential reversal zones, the 88.6% present in the butterfly retracement pattern is a derivative of the Fibonacci extensions.

C-D

CD goes in the opposite direction to the previous leg. The CD length in the Butterfly pattern is 161.8% or 224%. If this condition is met, add one more point.

X-D

There is one more rule for the Gartley Butterfly, for the meeting of which the pattern receives the fifth point. When the C D leg finishes, measure the segment and compare it with XA. In a true butterfly, AD deviates from the X point by 127% or 161.8% of XA.

Also, the ratio is useful for placing pending orders. When the chart approaches the critical number of Fibonacci, there is a high probability that a reversal will occur. In the forecast zone, you can open an option in advance or set pending orders and stops if this is allowed for your risk management strategy.

If the pattern you analyse scores 5 points, at the reversal D point, the price should start moving to the level of the C point or A. Also, the impulse, following a harmonic pattern, could break through the pattern’s highs or lows.

Let me remind you once again: in all Fibonacci ratios, errors of no more than 10% of the ideal value are allowed.

How to check Butterfly authenticity?

Let us see how you can check a Butterfly pattern authenticity on the example of the GBPUSD price chart.

The first is the X leg. This is the final impulse of the downtrend. Look for this wave following continuously directed price swings. Here, buying pressure is increasing.

Next, the AB leg is developing in the opposite direction. The B point is around 78.6% of AX, based on the Fibonacci grid built in the chart. The error is small, which means that the ratio of AB to XA of the Gartley pattern will be considered correct.

The next element of the Gartley Butterfly pattern is the BC leg. BC is 88.6% of the AB, the second condition is also met. And, finally, the CD to BC ratio is 1.68.

Let's check the last condition for constructing the pattern - the ratio of the top D to XA. Having built the Fibonacci grid, we see that the AD is slightly short of 127% of XA. Like in the case of the ratio of AB to XA, this error can be ignored. However, the greater the error, the less likely to be reached is the target of the price impulse following the D point.

Given the errors, all five conditions are met, so the Butterfly pattern is true, but you must make an adjustment for the targets. As you can see in the chart above, the growth does not reach the level of the pattern high.

Butterfly pattern example on the Forex market

Let us see how the reversal Butterfly pattern works in the Forex market.

You see a formation that looks like a Gartley pattern in the above chart. It is composed of four legs, XA, AB, BC, and CD. To determine the pattern type and predict further price action, we use the classic reading patterns mode, i.e., the calculation of the ratios between the segments.

With the help of the Fibonacci retracement, we see that the AB wave is near the 78.6% retracement level.

The BC projection is 88.6% of the AB length. And the next expansion of the phase leads to the fact that the last segment, CD, exceeds the BC. The Fibonacci ratio between them is about 261.8%.

We can conclude that this is a classic Butterfly. It is important to note that the ratios for almost all four legs are not ideal. This is normal, most traders allow a 10% error in specific Fibonacci ratios.

Having identified a bearish Butterfly harmonic pattern, we could anticipate that the market will reverse at the D point. Following the D top, the trend should turn down. The trade is entered once the D point has formed. For example, the entry point is marked by the blue line in the above chart; the position is opened immediately after the first candlestick closes.

Based on the risk management rules, a stop loss is set a little higher than the high made by the D point (marked by the red line in the chart). The conservative target profit is the most common for Gartley patterns; it is the lows made by points C and A.

In our case, the target profit for a trade, entered based on the bear Butterfly, is between the A and C tops. You can see that later, the price movement exhausts exactly.

Advantages and disadvantages of Butterfly pattern

The Gartley Butterfly patterns have their advantages and disadvantages compared to other technical analysis tools. I covered the major benefits and drawbacks in the table below.

What does the Butterfly pattern tell traders?

Gartley butterfly pattern trading requires thorough analysis. When you apply it in real trading using different trading strategies, there can be some problems. One of the problems is that patterns with ideal ratios are rather seldom. However, the signals suggested by a Butterfly pattern are always unambiguous.

The butterfly is a reversal pattern if you judge by the direction of the final wave. Even Harold Gartley himself said that the Butterfly’s right wing shows the entry point and the price movement direction with an accuracy of 7 out of 10. Nowadays, the price chart analysis confirms Gartley’s words. FxGroundworks research confirms that the trend reverses after the Butterfly completed in 80%-90% of cases. However, otherharmonic patterns, such as Bat to Shark, are also pretty efficient.

So, the Gartley Butterfly pattern is a reversal pattern in trading. At the same time, due to extension patterns, a trader with a high degree of probability can predict where the correction will end, that is, point D will form. The X leg correlates with the last CD wave with a ratio of 1.27. Also, point D is easily calculated, using the B leg; CD is from 161.8% to 224% of the BC length.

In addition to the accuracy of the predicted trend starting point, Gartley patterns allow you to project with a high degree of probability the level from which the price will rebound. A conservative target profit is usually set in the area between points A and С. Following the Harmonic Butterfly pattern, a strong support or resistance zone is formed between the levels of these two points. That is why a reversal price impulse often reaches this area of the butterfly pattern and is exhausting in the zone.

An aggressive target for the potential profit is set a bit further. For example, a target is often set at a 127% Fibonacci retracement level. The corrections, following the Butterfly pattern, reach this level in 30% of cases.

How to trade the Butterfly pattern

Now, you know what a common Butterfly harmonic pattern looks like. Let's look at the features of trading the Butterfly.

When to enter the trade

Before you enter a buy or sell trade, you should check if the pattern meets five conditions for the Butterfly.

The entry point is D. It emerges at the final trend phase of the pattern construction. Following the D point, the price movement reverses; the sideways trend finishes, and the trend, opposite to the CD wave, starts.

Just like with the B point and C, the D point in a harmonic pattern is easy to predict. So, the common conditions for the reversal could be eased a bit. For example, in order to make an initial investment when trading the Butterfly pattern, you do not need to wait for two or three unidirectional candles, the closing of the first candle is enough, provided that it forms around the 161.8% or 224% level.

On theEURJPY daily chart, the blue line marks the market entry point after the end of the bearish Butterfly harmonic. To enter a trade, one waited for the completion of a long red candlestick.

Additionally, you can use indicator data. For example, to enter the market after the completion of the Butterfly pattern, use three criteria:

• The supposed D point of the Butterfly reaches 161.8% or 224%;

• The candlestick, opposite to the CD direction, closes.

• The market is overbought for a bearish pattern or oversold for a bullish one, which is shown by the indicator histogram.

For experienced traders, the trade entry order is often placed at the level of the C point of the Gartley Butterfly. This level forms support or resistance, depending on the trend direction. Based on technical analysis, if the price rebounds from a key level, the trend is likely to continue.

Therefore, guided by the pattern of the butterfly chart, after breaking through the level of point C, you can add up to the initial position and increase the potential profit quite well.

How to place your stop loss

If the reversal occurs at the level of 161.8% of the Butterfly AX segment, then another technique can be used. Measure the 141% level from the AX movement and set a stop loss on it.

In this case, the Butterfly pattern should end at 127% of AX. If we see a continuation of the movement, and the price crosses the 141% level, then there is a high probability that the Butterfly harmonic pattern will have an extended CD wave.

If the CD leg is elongated, as in the screenshot above, then you should use the standard technique to set a stop loss. By analogy with the red line on the chart, the order is placed at some distance from the level of the D point of the pattern (above the point if it is the high of the pattern or below it, if the point is the low).

One can also set a trailing stop at the rollback, following the Butterfly, at a distance of 38.2% of CD. This is relevant if the price goes beyond the C point and you are not sure whether the price reaches level 161.8%.

Take profit target

One of the benefits of the Gartley Butterfly, and harmonic patterns in general, is the ability to accurately predict profit targets. At the same time, the take-profit can be gradually transferred to more distant targets as the price moves.

The first, more conservative profit target and most achievable goal of a rollback after the Gartley Butterfly pattern is point C. If in other harmonic patterns it is customary to single out two targets - C and A, then in the Butterfly pattern, these levels, due to their proximity to each other, can be combined into one target zone. In the chart above, it is marked with a green band.

Pullbacks after harmonic patterns almost always reach the level of point C, so it is very convenient to use it for options trading. But you need to calculate the expiration time so that the price has time to reach the specified level.

If the conservative profit target in the AC zone is reached, and the price continues moving in the same direction, the take profit is shifted further. A more aggressive profit target will be at levels127% and 161.8% of XA.

Another way to control the profit is the trendlines. When the price breaks a trendline, you can exit a trade. When trading based on Harmonic patterns, I recommend using a complex method. Use the trendline to control the size of the harmonic pattern pullback, and close the position only when the price consolidates beyond the trendline or breaks through one of the target levels.

Butterfly Harmonic Pattern Trading Strategy

Market analysts have developed several trading strategies using the Butterfly pattern. With their help, I will explain how to effectively apply the harmonic pattern to enter the market and get the maximum profit with acceptable risks. But first, you need to consider the types of the Gartley pattern. There are special cases of the Butterfly pattern, the bullish pattern, and the bearish Butterfly pattern, as well as their “ideal” varieties.

Bullish Butterfly

A bullish butterfly pattern starts with the XA leg after a downtrend finishes. The X A leg is always longer than the next two legs. Based on this feature, a butterfly is easy to distinguish from other harmonic patterns.

AB is the next leg. AB should be 78.6% of the XA length in a bullish butterfly. The next segment, BC, could be much shorter than the A B leg. In different versions of this pattern, the ratio of these two patterns can be from 38.2% to 88.6%.

In a bullish Butterfly, the length of CD in relation to the previous wave can vary from 161.8% to 224%. An important criterion is the Fibonacci proportions, within the specified limits. For example, the ratio of BC to AB in a Bullish Butterfly pattern could be 50% or 61.8%. That is matched to the Fibonacci extension, built on segment AB. Similar requirements apply to the CD wave.

The last criterion of the bullish Butterfly pattern is the ratio of wave AD to XA. Valid limits are from 127% to 161.8%. Traders often use it to determine the pivot point D. After the D point appears, we can talk about the completion of the Bullish Butterfly pattern.

The next impulse goes up. The first target is the level of point C, and the second profit target is the level of point A.

Bearish Butterfly pattern

The Bearish Butterfly is an inverted Bullish Butterfly pattern. It is built on the same principles:

Wave XA in the bearish butterfly chart pattern is longer than the next two segments. The ratio of XA to segment AD, consisting of three subsequent price swings, ranges from 127% to 161.8%.

The AB segment of the bearish Butterfly is 78.6% of the XA length. Also, in the bearish version of the pattern, the same ratios for BC (38.2% - 88.6% of the AB length) and CD (161.8% - 224% of the BC length) work as for the bullish one.

The Bearish butterfly chart pattern finished at the pivot point D. Next, a descending impulse starts, which usually reaches the pattern lows. So, the first target for the price impulse after the Butterfly will be the level of the C point, and the next downside target is at the level of the A point.

Bullish Ideal Butterfly pattern

The ideal bullish butterfly resembles the common harmonic butterfly. The main difference between the ideal Butterfly from the common one is in the wave ratios:

• BC is from 50% to 88.6% of AB;

• CD is precisely 161.8% of BC.

Bearish Ideal Butterfly pattern

An ideal bearish butterfly pattern is formed according to the same proportions as the bullish ideal butterfly. When a bearish ideal pattern completes, a downtrend starts. The difference between “ideal” and “non-ideal” patterns is rather arbitrary. It is believed that an ideal formation suggests that the rice impulse, following it, has more chances to reach target levels. However, no one will give a 100% guarantee even in this case.

Conservative Butterfly trading strategy

This strategy means trading based on the Butterfly pattern with minimum risks.

• Spot the butterfly pattern in the price chart and check the ratios of waves AB and BC.

• Based on the proportions of the harmonic pattern, calculate the potential location of the pivot point D.

• At the expected pivot point, spot the candlestick developing opposite to the CD wave. When this candlestick closes, enter a trade. If there is a bullish Butterfly in the chart (looks like M), enter a long trade at the D point (the lowest point). If there is a bearish butterfly (looks like W), enter a short trade at the D point (the highest point of the pattern).

• Stop Loss is set either at a small distance from point D or, according to the technique discussed above, at the level of 141% of the AX wave of the Butterfly harmonic pattern.

• Using the butterfly pattern ratios, mark the level of point C and set there the firsttake profit with closing 50% of the position.

• The second take profit is set at the level of point A and closes the rest of the position when it is reached.

The chart above shows an example of trading the Butterfly pattern using the suggested strategy. The bearish Butterfly has formed in the market, so the position is opened at the close of the red candlestick (blue line). Please note, candles with large bodies should be taken into account, which reflects the impulse movement of the chart in the right direction. The previous two candlesticks reflect price fluctuations, that is, market uncertainty, they cannot be taken as confirmation of a reversal.

The CD wave length of the Butterfly pattern under consideration is in tight limits, so it is logical to place a stop loss just above the expected reversal point. Thus, we will avoid losses in case of pattern cancellation.

The initial target is marked on the chart with a green line T1 and corresponds to the level of point C. Here we fix 50% of the position and move the stop loss to the level of the trade opening. The price breaks through level C, and the next take profit will be at the level of point A of the harmonic pattern, the green line T2. The price reached this level on the next candlestick, and the trading terminal closed the short position with a profit.

High-risk Butterfly trading strategy

The main differences of this trading strategy from the previous one are in the features of entering the market and setting targets.

• Identify the Butterfly pattern in the chart and check for matching the requirements.

• After the D point is formed, enter a trade when the first candlestick with a long body, opposite the CD direction, closes

• Stop Loss is set either at a small distance from point D, or at the level of 141% of AX (red line in the chart).

• If the price movement breaks out level of the C point, add up to the position once the price consolidates below this level (S2 line in the chart).

• The take profit is set at the level of the A point, also at the levels of 127% and 161.8% of XA.

An example of trading this strategy is shown in the dailyAUDJPY chart. Blue lines mark the initial entry point, S1, and the level, where the position is added up, S2. At the moment of averaging, the stop loss is shifted to the breakeven, considering the profit from the trade S1. One could also set a trailing stop at a distance of 30%-50% of XA.

Green lines mark target profit. Take the profit by equal shares or in the proportion that will allow you to keep the profit in case of a sharp price reversal.

How to identify and trade the Butterfly pattern using ZUP indicator

ZUP is the most powerful and convenient indicator to identify harmonic patterns. The tools can spot more than 40 formations based on Gartley Harmonic patterns. The list of supported patterns includes both classic patterns, such as the Butterfly pattern, and rare formations that only experts in harmonic trading know about.

Not all versions of the indicator work stably. Experienced traders prefer to use two versions of it for MT4 with a minimum of bugs:

• ZUP 123;

• ZUP 150.

There are also analogues of the classic indicator for MT5, however, all of them are paid and cost, on average, from 100 to 300 dollars.

Installing the indicator is standard. Unpack the archive and place its contents in the Indicators folder. I described in more detail the procedure for installing indicators for MT4 in the articleBollinger Bands Indicator in Forex Strategies.

The indicator contains more than 300 settings, it is simply impossible to list them all. With the help of various parameters, you can change literally every pattern or remove unnecessary ones and leave only those that you use in trading.

The indicator itself looks like this in the chart above. At first, its display may seem a bit complicated, but over time, you will be able to easily identify Butterfly patterns and other harmonic patterns. The visual display also includes the proportions between the waves, which simplifies the calculation.

Comparisons to the Gartley Pattern

Inexperienced traders often confuse the Butterfly with the Gartley pattern and do not see any difference between these two formations. Both patterns have similar structures, four impulses, and five points. However, the Harmonic Butterfly differs from the Gartley pattern both in its geometry and in the subsequent behavior of the market.

As you can see in the screenshot above, the Butterfly pattern (left) has a much longer wave D compared to the Gartley pattern (right). In the process of analyzing the formation, it is easiest to distinguish by the intersection of point D with the level of point X: in Gartley, point D represents only a rollback towards X, and in the Butterfly pattern, it is an extension pattern beyond this point.

As for the subsequent market behavior, after the completion of the Butterfly pattern, there is a sharper reversal followed by a strong momentum compared to the Gartley. According to statistics, the Butterfly works out more often, so trading on it is more efficient.

Key tips about Butterfly pattern

• Place a stop loss at a distance of 141% of AX only for patterns with an extended price move on the last wave, when it reaches 224% of the B C leg. If segment CD is close to the optimal ratio in a Butterfly, then the stop-loss should be placed at a small distance from point D.

• The main problem of working with a pattern is that it is difficult to detect. Only experienced traders can quickly and accurately identify harmonic patterns. Therefore, I recommend that beginners use special indicators to search for models, for example, the ZUP indicator described above. At the same time, it is important to manually recheck the proportions and trading levels before entering a trade.

• When determining the proportions of the Butterfly harmonic waves, do not forget to check the relationship between the XA segment and the total length of the AB, BC, and CD segments - the errors between adjacent waves in the aggregate can give a completely different picture. Let me remind you that for the Butterfly, the ratio between XA and AD is 127% or 161.8% in the case of an extended CD leg.

• Despite the high efficiency of the Butterfly patterns, it is not enough to use harmonics alone for really effective trading. Incorporate oscillators into your trading strategy to confirm entry points, a trading volume indicator to gauge market sentiment, and other technical analysis tools.

• When trading options using harmonic patterns, you should consider the expiration period. On average, it takes 5-7 candlesticks to achieve the nearest targets for the Butterfly pattern. Thus, you need to have a time buffer before the contract expires.

• In the early days of harmonic trading, analysts believed that harmonics could be used equally effectively in any direction, no matter which type of Butterfly, bullish or bearish, the pattern is. However, later it turned out that the pattern is the most effective in the direction of the global trend in the market. Taking this into account, the Butterfly patterns can be called high-level trend continuation patterns.

Conclusion

The Butterfly Pattern is a specific technical analysis tool. The pattern is quite rare. However, taking into account the accuracy of forecasts based on this harmonic pattern, it is definitely worth adding to your trading toolkit.

Experience is of great importance when trading with the Butterfly patterns. That is why I recommend you to spend some time and practice trading with the harmonic Butterfly pattern on theLiteFinance demo account. If, after reading this overview, you have any questions about the Butterfly harmonic pattern, defining the pivot points and target profits, write in the comments. I will do my best to give all the necessary answers and explanations!

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.