The butterfly harmonic pattern is a reversal chart pattern that appears at the end of a trend move. It is known as one of the most advanced and complicated harmonic patterns used by forex traders to identify trend reversals.
At the same time, it is also among the most reliable and accurate chart patterns in trading, if used correctly. Here, we are going to show you how to identify, and trade the butterfly patterns in the forex market.
What is the Harmonic Butterfly Pattern?
The butterfly chart pattern is part of the harmonic patterns group and works on the same principle of the double bottom and double top-charting patterns. In simple terms, this technical analysis charting pattern, which has a butterfly shape, helps traders find a potential reversal zone following a price consolidation and two descending or ascending peaks.
Much like the double top and double bottom chart patterns, the butterfly chart pattern is composed of four legs with two peaks and two lows or highs (bullish or bearish).
However, unlike double tops and bottoms, the butterfly pattern starts the trend reversal throughout the development of the pattern and is considered a more accurate indication than many other harmonic patterns.
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How to Identify and Use the Butterfly Pattern in Forex Trading?
To be honest, finding and identifying the butterfly pattern is certainly not an easy task. It requires trading experience and knowledge of other techniques and technical indicators, particularly the Fibonacci retracement levels.
Further, the butterfly pattern resembles in structure and formation the Gartley pattern as well as the Bat pattern, which makes it a complicated reversal trading pattern to identify and use.
In terms of the structure, the butterfly harmonic has four price movements or price swings – XA, AB, BC, and CD, and five points – X, A, B, C, and D.
These levels help traders identify when a trend reversal is likely to occur. The CD leg and point D serve as a confirmation parameter if indeed the price begins a new trend phase.
Let’s take a look at the price chart to see how the butterfly harmonic pattern is formed.
As you can see in the USD/JPY 15-min chart above, we found a butterfly bullish reversal pattern with two descending peaks and two descending lows. Once the price reaches the D level (which is also the 50% Fibonacci level) – the pattern then offers a good buy position signal.
Taking the above in mind, there are several steps you need to take in order to identify and trade the butterfly harmonic reversal pattern in forex trading.
- Find a chart pattern with two descending highs or two ascending lows (bullish or bearish pattern)
- Draw Fibonacci retracement levels from low to high (the A level)
- Wait for a trend reversal once the CD line exceeds the X level
- Enter a long or short sell position and set the profit target at the B, C levels (or higher)
- Place a stop-loss order at the X level or slightly above/below (depending on the trading strategy – bullish or bearish butterfly pattern)
How to Trade Forex Using the Butterfly Pattern – Strategies and Examples
To trade the butterfly extension pattern – we mention, once again, the combination of the butterfly pattern and Fibonacci retracement levels as the main trading strategy and tool for using this pattern. Without Fibonacci levels, identifying entry levels is a hard task and can be challenging even for the most experienced forex traders.
And, like many other technical analysis indicators and chart patterns, the butterfly chart pattern works in both directions – meaning bullish and bearish.
Bullish Butterfly Pattern
In the example below, we can see how the bullish butterfly pattern is formed on the USD/JPY 15 min chart. As previously mentioned, the best way to find entry levels is by using Fibonacci retracement levels.
In this chart, we can see that the CD line is longer than the XA line, and there are two descending highs. Finally, when the price consolidates around point D, it bounces back and the bullish mini-trend begins.
Bearish Butterfly Pattern
The bearish butterfly chart pattern is exactly the same as the bullish one, but obviously, in the other direction.
In the example below, we can see how the bearish butterfly pattern is formed at the end of a bullish trend. The price retests at the B and finally at the D levels confirm the bearish trend that indeed occurs.
Once again, we used the Fibonacci retracement levels at the XA line, which is the first bearish line of the butterfly pattern. As you can see, the D level stops at 61.8% level, and from that point, there’s a clear bearish trend reversal.
The Harmonic Butterfly Pattern – Pros and Cons
Here are the most common pros and cons of trading the harmonic butterfly pattern:
- An accurate and reliable chart pattern, especially when combined with Fibonacci retracement levels
- Compared to other chart patterns, the butterfly pattern provides a strong indication for trend reversal
- Stop-loss placement is clear at the X level
- The butterfly pattern can often be mistaken with the double top and bottom chart patterns
- Relatively difficult to identify the pattern
- Requires knowledge of other technical analysis tools such as Fibonacci, moving averages, and RSI
To sum up, here are the key takeaways:
- The butterfly pattern is a trend reversal chart pattern used to identify trend reversals and find good entry levels
- Although it is a fairly complicated chart pattern to identify and use in forex trading, the butterfly pattern is among the most reliable and accurate patterns that help traders find trading opportunities, if used correctly
- To find entry levels by using the harmonic butterfly pattern – it is best to draw Fibonacci retracement levels from the X peak to the A level.
- When using butterfly patterns, a trader should enter a trade at point D
What is a hidden bullish divergence pattern?
A hidden bullish divergence occurs when the price is making higher highs while the indicator is making lower lows. It is the opposite of the bullish divergence pattern, however, it has a different meaning. Unlike the bullish divergence pattern which is a trend reversal pattern and indicates the momentum’s weakness, the hidden bullish and hidden bearish divergence patterns indicate that the trend is about to continue (hence, it is a continuation chart pattern).
What indicators are best for divergences?
Among the best indicators for divergence trading include the RSI, MACD, and the Stochastic Oscillator. Other indicators that also can be used for divergence are CCI and ROC (price rate of change ROC).
Where to place a stop loss when trading the bullish divergence pattern?
Frankly, this is one of the major problems of trading divergences. This trading method does not provide a clear price level to place a stop loss like other chart patterns such as the butterfly pattern or the double bottom chart pattern. Still, when trading the bullish divergence patterns, it is best to place a stop loss below the last bottom on the chart.
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