The Butterfly Pattern is a harmonic reversal chart pattern, which can be both bullish or bearish. After a number of measured moves in the direction of the underlying trend, a buy or sell signal is generated. The endpoint defines a direct trading signal and indicates the start of a correction or a new trend.
Bullish & Bearish Butterfly Patterns
Just like other harmonic patterns, the Butterfly formation takes shape with the XA leg. As it takes form, each new leg is dependent on the formation of the prior leg.
The structure of this pattern is predicated on Fibonacci retracement and extension lines. It’s important to note that the Butterfly pattern ends outside of its initial XA trending move, unlike some other patterns.
After XA lays the foundation, point B should emerge as 78.6% retracement of the XA leg. In the Gartley pattern, for instance, point B shows up after the reversal at 61.8% and that’s why the Butterfly formation appears less often given that a series of XA retracements ends before the price hits the 78.6% Fibonacci retracement point.
As for point C, it can have two possible destinations. It could appear either at the 38.2% 88.6% retracement of the previous AB leg. Therefore, point D also depends on where the C appears. So if point C is drawn at the 38.2% retracement of AB, the D will appear close to the 161.8% Fibonacci extension. Alternatively, a CD leg usually ends near the 224.2% extension.
In the last instance, point D can be the 127.2% Fibonacci extension, however, keep in mind that there’s a high chance that deviations will occur since point C can appear at different places. Therefore, point D can even take shape at 161.8% of the initial XA leg.
After all of the points appear, the overall structure should look like a butterfly with open wings.
How To Trade The Butterfly Pattern in Forex?
When the point D is finally identified, you need to determine all of the elements of the trading setup. If you’re taking a short position, open it near the recent swing high. The stop-loss order should be placed either above the swing high or north of the 161.8% Fibonacci extension line. This trading setup will let the price action extend further upwards, however, the risk increases as well.
In order to determine your potential profit, use the same approach you’ve used for calculating point D. The horizontal support line you see in the chart above is an optimal area to take profit since this line may keep the price from declining further. Alternatively, you could take profits at one of the Fibonacci retracements – between 38.2% to 61.8%.
In that event, the price retraced to about 50% of the CD leg. Thus, you should place our order where the bearish candle closed. In this case, that’s at $1.2950. The stop-loss is placed at $1.3070, more than 20 pips above the peak of the swing high.
Below, the red support line is sitting at $1.2615, and that’s where the take-profit order is placed. In this case, 120 pips are at risk to generate more than 330 pips. Ultimately, the currency pair retraces to $1.2589, before moving back up. The risk-reward ratio in this trading setup is almost 1:3, which makes it quite appealing.
In conclusion, the Butterfly Pattern is a harmonic chart formation based on Fibonacci retracement levels and extension lines. The most important point of this pattern is the point D, which acts as a sell signal in bearish Butterfly or a buy signal in the bullish Butterfly pattern. This pattern is very easily distinguishable, thus it offers an appealing trading setup.
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