There are many harmonic chart patterns that traders use to spot potential price reversal periods, and the Butterfly pattern is one of them. But what is Butterfly harmonic pattern trading strategy?
The Butterfly harmonic pattern is a retracement and continuation chart formation that indicates a potential price reversal. It is a five-point harmonic pattern with the XABCD labeling. Similar to the Gartley pattern, the Butterfly pattern has four waves that are labeled XA, AB, BC, and CD.
In this post, we take a detailed look at this pattern.
What is the Butterfly harmonic pattern trading strategy?
Discovered by the renowned trader, Bryce Gilmore, the Butterfly harmonic pattern consists of four price swings and five swing points named X, A, B, C, and D. The four price swings are the XA wave created by an impulse price move from point X to A, the AB wave created by a corrective move from point A to point B, the BC wave created by a retracement from point B to C, and finally the CD wave created by an impulse price move from point C to D, which extends beyond point X where the formation started from.
The D point where the pattern is completed is also known as the potential reversal zone because from there, the price is likely to reverse, which is the opportunity traders want to profit from.
What are the Butterfly harmonic pattern rules?
The rules for identifying the Butterfly pattern are as follows:
- The AB wave should be a 78.6% retracement of the XA move.
- The BC wave may either be a 38.2% or 88.6% retracement of the AB wave.
- If the BC wave is a 38.2% retracement of the AB move, then, the CD swing should be a 161.8% extension of the BC wave; however, if the BC wave is an 88.6% retracement of the AB wave, the CD wave should be 261.8% extension of the BC wave.
- The CD wave should be 127% or 161.8% extension of the XA move.
How do you trade a Butterfly pattern?
Here are the steps for trading this chart pattern:
- Identify a potential Butterfly pattern: If you see three price waves that may indicate a possible Butterfly pattern, use the harmonic pattern tool in your trading platform to trace and label the price swings and then project the fourth wave to the D (PRZ) point, which is a 1.27% extension from point X where the pattern started from.
- Wait for the pattern to complete: When the price gets to your projected D point, check how the price behaves. If it forms a reversal candlestick pattern, such as the engulfing pattern, pin bar, or an inside bar, it may be an indication of a potential price reversal.
- Place the right order: If you see a reversal candlestick pattern, place a trade with a market order — go long if it is a bullish Butterfly pattern and short if it is a bearish Butterfly.
- Place your stop loss: Your stop loss should be below the D point in the case of a bullish setup and above it in the case of a bearish setup.
- Put your profit targets: It is best to take partial profits at multiple levels: the first target would be the 38.2% retracement of CD and the second target would be the 61.8% retracement of CD. A third profit target at the level of the C point is also fine.
Butterfly Harmonic Pattern Trading Strategy (backtest and example)
Unfortunately, we are not able to make a meaningful backtest of the Butterfly harmonic pattern strategy. Any backtest requires strict trading rules and some additional settings, but because this is a very subjective pattern, we are not able to jot down what is needed. It’s simply too many rules that are needed.
Because of the lack of objectivity, we believe traders are better off NOT trading on classical chart patterns (or technical analysis in general). Why spend time on something that is mostly based on subjectivity and not any objective standards? How do you know a pattern is profitable if you have not backtested it?
Backtesting is no sure thing, but at least you have an idea that something has worked in the past. If it has not worked in the past, you can skip it immediately. If you know how to backtest you can develop a portfolio of trading strategies pretty fast. There is no best trading strategy because you need many to smooth returns.
(If you are new to backtesting and it looks like a daunting task, you might be interested in our backtesting course.)
We believe you can get many trading ideas to form a trading strategy by looking at what we have to offer. We have hundreds of different trading strategies on this website – all of them backtested with strict trading rules. You find all our products in our shop.
– What are the rules for identifying a Butterfly harmonic pattern?
The AB wave should be a 78.6% retracement of the XA move, and the BC wave may be a 38.2% or 88.6% retracement of the AB wave. The CD wave should be a 127% or 161.8% extension of the XA move.
– How do you trade a Butterfly pattern?
Identify the pattern, wait for it to complete with a reversal candlestick pattern at the D point, and place a market order. Set stop-loss below the D point for a bullish setup and above it for a bearish setup. Consider taking partial profits at specific retracement levels.
– Why is backtesting challenging for the Butterfly harmonic pattern strategy?
Backtesting is challenging due to the subjectivity of classical chart patterns, including the Butterfly pattern. The lack of strict and objective trading rules makes it difficult to perform meaningful backtests.