How To Trade Butterfly Pattern

What is Butterfly Pattern?

A butterfly pattern is a reversal pattern. Traders use reversal patterns to detect the end of a price movement. This reversal pattern allows traders to know when to enter the market at the end of a price trend. A butterfly pattern consists of four legs named XA, AB, BC, CD. This pattern is similar to the Gartley pattern because they have similar markings XA, AB, BC, CD.

This chart pattern can either be bullish or bearish, and it indicates the stop of a particular price trend and the start of a new trend.

Advantages of Using Butterfly Patterns

• Given the popularity of this chart pattern, it’s no surprise that the butterfly pattern comes with a lot of advantages. These advantages include:
• Butterfly patterns are beginner-friendly. and are easily identified and easily used in trades.  New traders easily detect and understand the butterfly chart patterns as compared to other chart patterns in Forex trading. This is why many traders prefer to use these chart patterns when it comes to Forex trading. Most experienced traders use this chart pattern as well in forming good trading strategies.
• Butterfly patterns offer strong trade signals. However, no chart pattern offers a guarantee on the movement of price, even the most powerful Technical indicators can provide a false price direction in some trades. This is why it is not advisable to base trading signals based on a single chart pattern. It is advisable to base trading strategies based on more than one forex pattern, with the use of Technical indicators. But it has been stated that butterfly patterns have a higher percentage when it comes to indicating accurate price movements.
• Some traders believe that Butterfly patterns are the best way to pinpoint trading opportunities. Professional traders state that has a higher percentage of predicting the movement of price correctly as compared to other Harmonic patterns.

Disadvantages of Using Butterfly Patterns

Most Forex traders, both advanced and beginners, are still in search of a flawless chart pattern, the reason isn’t far-fetched. Traders want the ability to use forex chart patterns that will provide profit opportunities in their trades. However, there are no flawless patterns that present 100% perfect forex price actions. Even the best patterns have their disadvantages and the butterfly pattern isn’t left out.

These disadvantages include:

• Harmonic pattern trading entails a wider knowledge. It is difficult to analyze, and can not be understood by new traders. This is because the structure of the pattern is rigid. It is critical to use the butterfly pattern together with other trade signals and chart patterns. This will help confirm the setup and signals provided by the chart pattern.

• The butterfly’s rigid structure can end up discouraging traders. Patterns can hardly develop due to the excess linking to Fibonacci retracement levels. Most traders end up getting frustrated while waiting for the full rules to take effect. Thus, resulting in a waste of time while surveying potential trade setups.

• Generally, most traders do not apply the butterfly forex chart patterns. Most spot traders prefer to use the Gartley chart pattern rather than the butterfly pattern because the pattern provides identical trading views based on equal data points, traders often use the Gartley Forex chart pattern as opposed to the Butterfly pattern.

Most traders view the use of butterfly patterns as a trial and error process. If you’re a beginner it’s okay if you’re yet to understand how the butterfly patterns, that’s fine you’ll get to understand it with time. Some professional traders are yet to also understand how this pattern works.

Structure of Butterfly Pattern

The butterfly pattern has a shape of “M” and “W” for its bullish and bearish patterns respectively. The pattern has four price swings, and it is often misinterpreted as a Double top or double bottom pattern by traders.

The butterfly pattern starts with an “X”

The four price swings of the pattern are recognized as XA, AB, BC, and CD.

Butterfly Pattern and the Fibonacci Levels

There are certain Fibonacci levels required for adequate predictions of the butterfly pattern. It has already been established that the Fibonacci retracements technical tools are the main tools used by traders in pattern identification.

For proper identification of a pattern, the trader needs to ensure that the trade meets up with the specific Fibonacci levels allocated to the various price swings.

Let’s discuss the several Fibonacci levels present in the butterfly sketch.

XA: This is the first step of the pattern. This first step forms the shape of the pattern and specific requirements for this move.

AB: The B level is the most important level of the pattern, the B point should retrace by 78.6% of the XA point.

BC: the BC price swing retraces by 38.2% or 86.6% of the AB price swing.

CD: if the BC leg retraces 38.2% of AB, the CD should attain the 161.8% extension of BC. However, if BC retraces 88.6% of AB, then the CD will attain the 261.8% extension of BC.

AD: This is the general move that comprises AB, BC, and CD and it is either 127.0% or 161.8% of the point XA.

Now let’s visualize these harmonic relationships.

Take a look at the illustration below:

The above image shows the relationship between Fibonacci and a butterfly pattern.

The rules stated above are not rigid rules that cannot be broken. They are mare procedures that help in the identification of a butterfly pattern. Nevertheless, the B leg retracement 78.6% of XA needs to be followed accordingly to help properly in identifying the pattern.

How to Trade Butterfly Pattern

There are different methods used by traders in trading the butterfly pattern. But in this article, we will focus on the trading method based on utilizing the BC point to find the D point. We will extensively discuss the three vital trade components. The entry point of trade, the stop-loss point of trade, and the take profit point of a trade.

Entry Point

If a trader using the butterfly pattern wants to enter a trade, the trader has to wait for certain conditions to be met at the D point before buying the currency pair.

An entry point is confirmed when

The point CD of the butterfly pattern decreases at 161.81% of the point BC if BC has a drawback of 38.2% of AB. Or in a case where point CD bottoms at 261.8% of BC if BC draws back 88.6% of AB.

For a trader going short on a bearish butterfly, he/she is expected to sell a Forex pair short when the value of the pair reacts to the D point after:

CD sets at an uptrend of 161.8% of BC and BC

Drawback 38.2% of AB.

Or CD sets a resistance at 261/8% of BC if BC decreases by 88/6% of AB.

Stop Loss

A trader trading the bullish butterfly pattern is allowed to place his/her stop-loss order under the swing of the recently formed D low. If trading the bearish butterfly, the trader is allowed to set his/her stop-loss order over the swing of the recently formed D top.

Ensure to set your stop loss at an adequate distance after point D, and also consider the market instability and how it could affect your trade.

Take Profit

There are several methods for closing a trade when trading with the butterfly pattern, an exit trade is preferably set at the 161.8% area of the CD point.

A trader could contemplate exiting a portion of his/her trade before approaching this point. These key swing points are points B, C, and A. Traders can use these points to monitor the price action of their trades. They should also check how the market price of the trade reacts at these key points. This would determine if a trader should maintain the trade position or close the trade.

If there is a breakout in the A point, it indicates a fair confirmation of the price target at point CD would be accomplished.

The above structure indicates the confirmation of a bullish butterfly chart pattern. In the above diagram, it is seen how the price of the trade starts to turn after reacting with the D point. The same applies to a bearish pattern but in an opposite direction.

The above sketch offers a visible presentation of comprehensive objectives during a downward trend butterfly trade. The horizontal line with points B, C, and A are the resistance points moving up to set new highs. It is important to monitor your trades at this point to help you make good trade decisions.

There are permanent rules set for the cycle of a butterfly pattern. It is important to survey your trades for the best exit alternatives. The above procedures also apply to a bearish butterfly trade however, it moves in the opposite direction.

Identifying Butterfly Pattern in an Uptrend

The above sketch explained the movement of price in a bullish butterfly pattern. Let’s discuss the sketch at the common price reaction at the D level.

In the above sketch, the bullish butterfly has the shape of an “M”. The bullish butterfly is predicted to steer the bullish price movement at the D level as illustrated above.

Identifying Butterfly Pattern in a Downtrend

The downturn of a butterfly pattern is the same as a bullish butterfly but in the opposite direction. The bearish pattern has a letter “W” shape.

The bearish butterfly pattern starts its price movement from the D level as indicated in the green arrow on the diagram.

The butterfly pattern is confirmed at the level of point D. When the price of the trade begins to reverse at point D it indicates an entry point.

Butterfly Pattern Confirmation

The image above shows the formation of a butterfly uptrend pattern. The above diagram shows how the price of trade begins to reverse at the level of D. The same applies to butterfly downtrend patterns, but in an opposite direction.

Rules of Trading Butterfly Pattern

Most traders prefer the butterfly patterns a lot, this is because they are popular among most traders.

There are some rules that trades should note when trading the patterns.

A butterfly pattern starts at the XA leg.

The Point AB must not exceed the X level.

The point BC must not exceed the A level.

The point CD must not exceed the level X

The final point of level D in Point CD must be equal to or more than point B.

Traders should note that the butterfly pattern needs to have a pattern where AB is equal to CD.

Conclusion

In Forex trading, it is important to note the importance of a chart pattern irrespective of if you are a new trader or a professional trader. The importance of using good forex tools to determine price movements is the ultimate way of attaining profitable trades. These chart patterns help a trader to know when a price is about to reverse and when a price is maintaining a trend. It also helps in the identification of entry and exit points of a trade. The butterfly pattern is a good Forex trading pattern that helps traders in determining the end of price action.

When a butterfly pattern is used correctly, it helps a trader indicate the potential movement of a price with a high percentage of its occurrence.