We will discuss today what the Butterfly pattern is and how you can make profits from the forex market using this trading tool.
The Butterfly pattern is a harmonic pattern trading strategy that has years of proven track record of providing profitable trades. Furthermore, many professional and institutional traders use this chart pattern, which indicates the strategy’s effectiveness.
What is the Harmonic Pattern in Forex Trading?
Harmonic patterns are the geometric pattern of a forex chart that combines with the price and Fibonacci retracement and extension.
Harmonic patterns work as a profitable forex trading strategy. We can distinguish it in two classification- internal pattern and external pattern.
Among the external patterns, the butterfly figure is very profitable, and many professional and institutional traders use it.
However, what is the butterfly pattern?
In the following section, we will cover everything you need to know regarding the butterfly pattern.
Butterfly Harmonic Pattern
The butterfly is a reversal pattern, which is almost similar to the ABCD Pattern. It works as a counter-trend indicator and seen in the top or bottom of a price swing.
We all know, the price of a currency pair consolidates before changing a trend. During the consolidation, a trader should know how and when the consolidation phase would end and the counter-trend will start.
As a part of the swing-trading, harmonic butterfly pattern allows traders to take a counter- trade from a swing high or swing low.
Let’s have a look at the structure of the Butterfly pattern:
In the image above, the straight line between XA, AB, BC, and CD represents the price movement.
XA is the primary correction of the price. Then the point B is the correction of XA leg, and point C is the correction of the AB leg. Point D is the potential buying point from where an impulse wave is expected.
Furthermore, there are some Fibonacci calculations in an ideal Butterfly harmonic pattern.
Let’s have a look at how the Fibonacci calculation is implemented in the butterfly figure:
- XA= it is the first leg. It will appear after a bullish or bearish trend.
- AB= should be at 0.786 or 78.6% Fibonacci retracement of XA leg.
- BC= BC retraces 38.2% and maximum 88.6% Fibonacci retracement of AB leg.
- CD= should be at 161.8% to 261.8% Fibonacci extension of BC.
As we have seen earlier, there are bullish and bearish butterfly patterns, it would be easy to see a glimpse of these before proceeding to forex strategies using this pattern.
Bullish Butterfly Pattern
The bullish butterfly pattern appears after a bearish trend, and it indicates that the price is willing to move higher.
Let’s have a look at an example!
The image above represents a bullish Butterfly figure where point X is the starting point, and point D is the entry point.
However, the position of point B is essential for the butterfly pattern as it is related to the retracement point of AX leg and the extension point of the CD leg.
The ideal position of point B is the 78.6% retracement of AX leg. However, it might differ from 4-7% considering the different prices in brokers.
Point D is the entry-level that you should determine by using 161.8% or 261.8% Fibonacci level of BC Leg.
Bearish Butterfly Pattern
Bearish butterfly pattern has the same concept that we have seen in the Bullish butterfly pattern but in a reverse formation.
The bearish butterfly figure appears after a bullish trend, and it indicates a counter-trend movement towards the downside.
Here is an example of a Bearish harmonic Butterfly Pattern:
After a bullish trend, the price will correct lower from point X to point A then continue the bullish trend to the 78.6% retracement of the XA leg to point B. Point B is also crucial in this pattern as it is related to the starting point and trade entry point. Later on, point D is the entry point, which is 161.8% or 261.8% Fibonacci extension level of BC Leg.
Some other trading rules of Butterfly pattern are mentioned below:
- The CD leg should be at least the equivalence of the AB leg.
- Point C should be at 88.6% retracements of point XA. If point C goes below or above point A, the pattern will be invalid.
- The probability of trade will be increased if the price follows the Fibonacci levels accurately.
The Fibonacci drawing tools are free in most of the trading platforms, including Mt4, Mt5, and cTrader. Furthermore, butterfly-drawing tools are also available in the tradingview platform, which is very easy to use.
How to Trade Butterfly Pattern
Some traders use a butterfly figure to understand the market context, but we can use this pattern as an individual trading strategy.
The following section will see a butterfly chart pattern trading strategy in both bullish and bearish market structure.
Bullish Butterfly Trading Strategy
The bullish butterfly will appear in the chart after a bearish trend. Therefore, a trader should wait for the price that moved through a bearish trend. Later on, observe price movement following the Fibonacci levels and identify the point D.
Read the price carefully and match Fibonacci levels.
The above image represents the EURJPY H4 chart, where point B retraces 88.6% of the XA leg. Later on, the entry point D comes at the 161.8% extension level of BC leg.
Therefore, point D is the buy point. To take an entry, make sure to have a bearish rejection candle like a pin bar, two bar, and engulfing bar and enter the trade as soon as the candle closes.
Stop-loss should be below the rejection candle at point D. Remember, the price of your chart might differ from the price in another broker’s chart.
Furthermore, there is a possibility of a false move or price manipulation. Therefore, make sure to put your stop loss with some buffer.
In a reasonable market condition, the buffer would be around 10-15 pips while in a volatile market, it would be at 20 pips maximum.
The standard take profit target for the butterfly pattern is the 161.8% extension level of CD leg.
However, it is better to observe the market rather than using a set and forget rules. As we know, in the forex market we trade only probabilities.
Therefore, if the price starts to move from the point D with an impulsive bullish pressure, it is likely to create a new high at the 161.8% extension level.
However, the price can reverse from point B or point C if the market becomes volatile. Therefore, you can take some profits at points B and C if volatility rises and hold the rest of the position for full gain.
It is the hardest part, and most of the traders struggle to follow these steps.
You may become greedy when you see your profit is running in the chart, and you may close your trade before hitting the desired take profit level.
On the other hand, you may close your profitable trades with a loss if you failed to put your stop loss at breakeven. So after taking a trade, please follow these steps:
- If the price rejects Point B after entering the trade, you can book your profit or make a partial closing.
- If price closes above point B, you can move your stop loss at breakeven to make the trade risk free.
- If the price moves above point C, move your stop loss to point B to ensure some profit in the market reversal.
- Furthermore, you can close your full trade at 161.8% extension level of CD leg. However, intense bullish pressure above point C would indicate the possibility of the price to reach a 261.8% extension level of the CD leg.
Bearish Butterfly Trading Strategy
The bearish butterfly will appear in the chart after a bullish trend. Therefore, a trader should wait for the price that moved through a bullish trend. Later on, observe price movement following the Fibonacci ratios and identify point D.
Read the price carefully and match the Fibonacci level.
The above image represents the EURJPY H4 chart, where point B retraces 88.6% of the XA leg. Later on, the entry point D moves to the 161.8% extension level of the BC leg.
Therefore, point D is the selling point. To take the selling entry, make sure to have a bullish rejection candle like a pin bar, two bar, or engulfing bar and enter the trade as soon as the candle closes.
Stop-loss should be above the rejection candle at point D with a buffer of 10-15 pips or 20 pips (in case of high volatility).
The standard take profit target for the butterfly figure is the 161.8% extension level of CD leg. If the price starts to move from the point D with an impulsive bearish pressure, it may create a new lower low with the 161.8% extension level. Furthermore, the price can reverse from point B or point C in case of high volatility. Therefore, you can take some profit at points B and C if volatility rises.
Like bullish butterfly pattern, follow the below-mentioned steps to manage your trade:
- If the price rejects Point B after entering the trade, you can book your profit or make a partial closing.
- If price closes below point B, you can move your stop loss at breakeven to make the trade risk free.
- If the price moves below point C, move your stop loss to point B to ensure some profit in the market reversal.
- Furthermore, you can close your full trade at 161.8% extension level of CD leg. However, intense bearish pressure below may extend the price to reach a 261.8% extension level of the CD leg.
People Also Ask
How Do You Draw a Butterfly Harmonic Pattern?
Drawing a butterfly pattern needs trendline and Fibonacci levels. In Fibonacci levels, there are retracement levels, and extension levels both are straightforward and easy to draw.
If you pull the Fibonacci level from the starting point to the ending point, it will automatically show the different retracement levels, like 50%, 61.8%, 38.2%, 161.8%, or 261.8%.
What is the ABCD Pattern?
ABCD is a harmonic pattern that has three legs- AB, BC, and CD. AB and CD are the first impulsive leg, and BC is the correction of AB and CD.
The ABCD pattern is similar to Gartley or Butterfly patterns. However, traders use the ABCD pattern as a trend continuation pattern where Butterfly Pattern is a market reversal pattern.
Which Harmonic Pattern is the Best?
Traders can use harmonic patterns as an indication of market reversal and market continuation.
Therefore, if you want to trade continuation, you can use the ABCD pattern after an impulsive movement. On the other hand, in a market reversal condition, Gartley and Butterfly patterns are best to use.
For reversal trading, it is essential to identify the top and bottom of the price to provide the best trading ideas.
How do you make a harmonic pattern?
There is two way to make a harmonic pattern- using trendline and Fibonacci tools or using a Harmonic pattern drawing tools.
In Mt4 and Mt5 platforms, it is straightforward to draw harmonic patterns as trendlines and Fibonacci levels are free. On the other hand, you can draw using harmonic pattern drawing tools from tradingview platform, which is also casual to use.
How Do You Know What Harmonic Pattern to Use?
It depends on the market condition. If the market moves top or bottom of the price and creates a divergence with an oscillator, it will provide a primary indication of market reversal.
Still, it would be best if you waited until it forms a Butterfly or Gartley pattern before entering the trade.
On the other hand, if the market breaks any significant level, it is not likely to reverse.
Therefore, you should use the ABCD pattern to find an appropriate correction level to enter the continuation trade.
If we summarize the whole concept of the Butterfly pattern trading strategy, we can identify these below-mentioned points:
- The butterfly pattern is an internal harmonic pattern.
- Traders use this pattern as a potential price reversal zone in both bullish and bearish market scenarios.
- XA= it is the primary leg, and AB leg is 78.6% of XA leg
- BC can retrace from 38.2% to 88.6% of AB leg, and CD would be at 161.8% to 261.8% of AB leg.
- After taking a trade, it is essential to monitor the price with good trading psychology.
As we know, the forex market is decentralized, and most of the market participants here are prominent institutes. Therefore, it is usual to see your trades to hit stop loss.
Besides using a technical analysis tool, make sure to use an appropriate lot size in every trade to minimize the overall risk.