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Butterfly Patterns: Breaking Down One of the Most Common Forex Strategies

   

butterfly pattern blog

When you choose to trade forex, the key to finding success is often reading patterns. When patterns are discussed, you are going to hear one name mentioned pretty consistently: H.M. Gartley. His harmonic patterns have been famously linked with chart reading and carry as much use today as in 1935 when they were first detailed in his book, Profits in the Stock Market.

Although there are several harmonic patterns of note—see bat, crab, shark, and Gartley patterns, among others—butterfly patterns remain the most prominent. A complete breakdown follows to help you get a full grasp on what they are, how they work, and how to make use of them.

What Are Butterfly Patterns?

The butterfly pattern is, simply put, a reversal pattern with four legs. It’s similar to the Gartley pattern in the sense that it’s marked XA, AB, BC, and CD. The butterfly pattern helps you identify the ending of a price movement, meaning that you can enter the market during the reversal of the price. 

There are two versions: bullish, in which you buy, and bearish, in which you sell. General precision is paramount when it comes to using butterfly patterns because precision allows a trader to eliminate mistakes.

Here’s an example of a bearish butterfly pattern developing on the GBP/USD chart. Note the relative strength index meter below, which affirms the bearish trend by indicating highly overbought levels, indicative of a price drop:

Screen Shot 2019-12-18 at 2.05.57 PM

The actual pattern structure has a variety of interpretations that can be applied to forex trading, largely because the butterfly pattern gives traders the ability to enter long or short at new lows or highs, unlike the Gartley pattern that it’s commonly discussed alongside. 

This is because wave D of the butterfly pattern reaches beyond the starting position of wave XA, and the butterfly pattern depends on the B point. The B point defines the pattern’s structure and sets up the other measurements that determine trade opportunities within the pattern.

Comparisons to the Gartley Pattern

The similarities of the Gartley and the butterfly pattern lie in their construction: five points and four legs. However, there are a few important differences. Outside of what was briefly touched on above, the most notable difference is that the butterfly is an extension pattern, not a retracement pattern, meaning that point D of the butterfly extends beyond starting point X. 

In the EUR/JPY chart below, notice how point D represents only a retracement back toward X rather than an extension beyond. This is the key characteristic of a Gartley pattern rather than a butterfly pattern.

Screen Shot 2019-12-18 at 2.08.59 PM

 

A butterfly pattern, in addition, offers a higher probability of a successful trade, according to statistics, than a Gartley pattern. Another factor of note is that reversals after the completion of the butterfly tend to be sharper as well.

Advantages of Using Butterfly Patterns

Given their widespread use, it’s no surprise that butterfly patterns offer distinct benefits to forex traders. These advantages include:

  • Butterfly patterns are easy to identify and understand. For novice traders, butterfly patterns are more accessible and identifiable than other types of chart patterns, which can make them a popular go-to pattern early on when developing your trading strategy. Even for experienced traders, the simplistic pattern design can be appealing for its ease of use.
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  • Compared to other chart patterns, butterfly patterns can offer strong indications. No chart pattern is foolproof, and even the strongest forex indicators can lead traders astray on any given trade. Similarly, it’s never recommended to base your trades and/or overall trading strategy on a single chart pattern. That said, butterfly patterns are favored in large part because they’re a more consistent source of accurate forex insights.
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  • Anecdotal evidence suggests the butterfly pattern is one of the best ways to identify profit opportunities. Many seasoned traders believe that the predictive value of a butterfly pattern is higher than that of other approaches, including the Gartley pattern.
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Disadvantages of Using Butterfly Patterns

Forex traders are still searching for the perfect chart pattern to inform trades that turn a profit every single time. As a result, even widely used tools such as butterfly patterns have certain drawbacks and disadvantages that traders should be mindful of. These include:

  • Harmonic pattern trading requires a broader knowledge of forex analysis to contextualize predictive patterns. Because of its rigid pattern structure, it’s important to combine the butterfly pattern with other indicators and chart patterns to validate the setup and indications offered by this chart pattern.
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  • The rigid structure can be a point of frustration for some traders. Because of its rules around Fibonacci retracement levels, it’s uncommon for butterfly patterns to develop, and many traders looking for butterfly patterns in development end up being frustrated by the failed fulfillment of the full pattern. This can lead to wasted energy in monitoring potential setups.
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  • In general, the butterfly pattern is less frequently identified than the Gartley. Because the Gartley pattern is more common to spot and offers similar trading insights based on comparable data points, traders may find it more practical than butterfly patterns.

For many traders, the successful use of the butterfly pattern requires a process of trial and error. If you’re just starting to use the butterfly pattern in trading, you can expect some bumps and bruises along the way—both in terms of spotting useful butterfly patterns and in properly contextualizing them to make the strongest trading decision.

Ways to Spot a Butterfly Pattern

We’ve said it before, and we’ll say it again: Butterfly patterns share more than just a passing resemblance to Gartley patterns. On a price chart, both will take the form of a heavily skewed “W” or “M” in appearance. 

The key to spotting a butterfly pattern and differentiating it from a Gartley pattern is that a butterfly pattern finishes at the coming together of two different Fibonacci extension levels, but the Gartley pattern is completed at the coming together of a Fibonacci retracement and extension. The beauty of butterfly patterns comes about through their symmetry, which occurs between the two triangles that connect at point B. As with other geometric patterns, a sell or buy signal occurs as the pattern is finalized at point D.

Naturally, traders are eager to identify these patterns as they’re developing in hopes of maximizing their potential earnings. Given that the butterfly pattern is a five-point pattern, it can take time for it to develop, and anyone watching charts for butterflies in progress will likely identify many false starts.

That said, some data points can help indicate the potential for a butterfly pattern. One is the retracement level of AB; the ideal retracement for this leg is 0.786. If you see this develop, you’re three-fifths of the way toward a butterfly. Similarly, the retracement from points A to C should be close to 0.527 to show a continued progression of the trend. And watch for point D to rise above X for an official extension—until that happens, you don’t technically have a butterfly pattern.

Uses of Butterfly Patterns to Identify Bullish and Bearish Patterns

One of the simplest features of butterfly patterns is how their orientation easily indicates bullish and bearish setups. When the X and D points are situated lower than the A and C points on the chart, for example, this indicates a bullish setup. The butterfly pattern indicates that a price increase is likely after the D point reaches full retracement.

On the other hand, a bearish pattern is identified when the X and D points are placed above the A and C points, creating an inverted butterfly pattern from a bullish setup. The bearish trading strategy is also a mirror of the bullish setup. When the CD line reaches its full Fibonacci extension, the butterfly pattern anticipates a subsequent price decline.

Because butterfly patterns are so uncommon as a trading strategy, they’re usually the first indicator or chart pattern used to evaluate a trade. Rather than turning to butterfly patterns to corroborate bullish or bearish indications from other aspects of your trading strategy, you’re much more likely to kick off trade analysis by identifying a butterfly pattern and then using other indicators and/or chart patterns to validate the bearish or bullish indication—and to then open a position as a result.

These butterfly patterns can also help you set a stop-loss above or below the D point to minimize your losses if your prediction is wrong. Other indicators, such as volume indicators, can help you determine how long to hold a position before closing out and taking a profit on the price increase or decrease.

Butterfly Pattern Trading Rules

You are likely to hear butterfly patterns routinely discussed within trading circles, which tells you plenty about how common they are. Here are the most basic rules with regard to butterfly patterns:

The starting point is the XA leg, which is the basis for the pattern and everything that follows the leg.

  • The AB leg can’t surpass point X.
  • The BC leg can’t surpass point A.
  • The CD leg must surpass point X (unlike with the Gartley pattern discussed above).
  • The ending point of D in CD must be equivalent to or surpass point B.

It’s also important to note that the butterfly pattern must have an “AB equals CD“ pattern, which is a minimal requirement.

 

Conclusion

It doesn’t matter whether you’re a novice trader or an experienced investor—you shouldn’t ever underestimate the effectiveness of chart patterns as trading tools. They are pivotal when it comes to signaling a reversal or continuation of the current trend and identifying entry and exit points for a position. Butterfly patterns, specifically, can be an eye-opener in determining the end of price movements. 


When used effectively, butterfly patterns can predict future price action with a high probability, making them an indispensable tool among traders in the forex market.

forex-signals

Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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