If you know the correct strategies to employ, you can use the predictive information that harmonic patterns provide to strategize your trading successfully. Each type of harmonic pattern has distinct components and optimal strategies, and the Butterfly pattern can be particularly useful for predicting changes following an extended price move.
Within the harmonic pattern category, the Butterfly pattern is what is known as a reversal pattern. This means that observing this type of pattern on a trading chart tells you that a current trend is likely to imminently change direction.
Because the presence of a Butterfly pattern indicates price consolidation, developing the ability to consistently pinpoint the occurrence of this pattern will allow you to strategize your trend entries around price reversals. To fully grasp how to use different strategies to improve the reliability of this pattern, you first need to know what pattern elements to look for.
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Table of Contents
How to Identify a Butterfly Pattern?
When reading a butterfly pattern, you’ll be focusing on four discrete legs, which are marked and named based on five key points: X, A, B, C, and D, in that order from left to right. Together, the data in these points comprise a Potential Reversal Zone.
Based on these points, the four legs are referred to as:
- XA
- AB
- BC
- CD
The direction – either growth or loss – of the four legs alternate to form two peaks. The orientation of the two peaks will indicate to you what direction the pattern is expected to head following the end of the current price move.
Predictions that you make using Butterfly patterns can be refined and made more reliable when evaluated with specific tools and indicators that allow you to draw and/or identify this pattern type with greater consistency.
Types of Butterfly Patterns
Before we explore the tools and indicators you can use to help you identify a Butterfly pattern, you need to know how to differentiate the different types, as they will indicate whether your ultimate strategy will center on buying or selling.
There are two types of Butterfly patterns:
- Bullish Butterfly patterns
- Bearish Butterfly patterns
Structurally, these two patterns are equivalent, using the same five points and four legs to capture a price consolidation. The difference between these types of patterns lies in the recommended action in response to identifying them when trading.
Bullish Butterfly patterns indicate that trade prices are rising, which means that the optimal move would be to buy to capitalize on the rising prices. In contrast, bearish Butterfly patterns indicate trade prices are dropping, in which case you would want to sell.
Differentiating between the two is relatively straightforward:
- Bullish Butterfly patterns have peaks that point up, indicating upcoming prices increases. Keep in mind that point D should also sit below X.
- Similarly, the two peaks in a bearish pattern point downward, indicating an upcoming drop in trade prices. Here, point D should be higher in value than X.
Tools and Indicators to Identify or Draw a Butterfly Pattern
Like all harmonic patterns, the Butterfly pattern is based on geometric patterns in price fluctuations that are based on sequences of Fibonacci numbers. The presence of these sequences allows traders to make predictions about future price moves that guide their trade entry and closure to make a profit.
Specifically, a Butterfly pattern represents a convergence of Fibonacci extension ratios, and there are several tools and indicators you can use to help you locate these patterns, and one of the widely trusted concepts is Elliott wave analysis.
Elliott Wave Analysis
The basic idea behind this analytical concept is that market changes fluctuate in predictable, recurring waves, oscillating between impulsive phases, which establish a trend, and corrective phases, which retrace that trend.
According to the theory behind Elliot waves, impulsive phases are made up of five waves, while corrections are made up of three. There are a number of mathematical tools that can analyze trading data according to this theory and identify impulsive and corrective phases.
By using such tools, you’ll be able to compare the overall trend indicating by Elliott wave analysis with any Butterfly pattern that you identify. For example, if you identify a bullish Butterfly pattern (indicating a coming increase in prices), analyzing the data and finding an impulse that indicates an overall decreasing trend will support the prediction of your Butterfly pattern.
Remember, Butterfly patterns indicate an upcoming change in an ongoing trend. So, to confirm the predicted direction indicated by a Butterfly pattern you have found, you would want to see an Elliot wave impulse in the opposite direction.
How to Improve the Reliability of Butterfly Pattern in Trading?
There are a considerable number of tools you can use apart from Elliott wave analysis to enhance the reliability of your use of Butterfly patterns in your trading. Overall, each trader will develop their own approach to chart analysis, combining data on price reaction, historical indicators, and pattern analysis (such as the Butterfly pattern) to add market context to guide their trading.
To support reliable Butterfly pattern analysis, consider using the following tools:
- Andrew’s Pitchfork Analysis: This is a technical indicator that creates trendlines and trigger lines to identify support and resistance, which indicate price points where a reversal is more likely to occur, which would confirm exactly what Butterfly patterns are theorized to represent.
- Fibonacci Grid Structure: This approach combines historical data and current price reactions to provide clarity about whether a butterfly pattern can be trusted based on the likelihood of price exhaustion, which is when a price has reached an extreme that may prevent normal recovery.
- Divergence: Using divergence analyses on trading charts will indicate the likelihood that a price moves contrary to predictions based on existing indicators, which can help you decide whether to move forward with a Butterfly pattern trade.
- Multiple Timeframes: This type of analysis allows you to incorporate data from different time periods to understand the larger trends at work, which can help you confirm the reliability of your Butterfly pattern analysis.
These indices and analytical frameworks only represent a handful of tools that you can use to make your use of Butterfly patterns in trading more reliable. Other options include referencing technical indicators like moving averages, pivots, channels, and volume & vitality.
Overall, the goal of using any of these tools, or any others you choose to explore, is to gain insight either about a specific trade or about overall market conditions. This information will help you corroborate the likelihood that the trading decisions your Butterfly pattern analysis indicate are supported or unlikely to be sound.
How to Trade Using Butterfly Patterns?
Now that you are familiar with the structure and types of Butterfly patterns you may observe, as well as tools to improve the reliability of your trading, you should begin to explore specific trading strategies often used with this pattern.
Although bullish and bearish Butterfly patterns have the general recommendations to buy and sell, respectively, there are more detailed strategies that you can learn to guide what trades you make, how to identify when to make them, and what indicators to look for to know when to cut your losses on a bad trade and when to end a trading strategy, balancing profit and risk.
Butterfly Spread Trading Strategy
Butterfly option strategies, also known as Butterfly spreads, are actually not a single type of strategy, but rather a class of strategies used in options trading. All versions of Butterfly spreads are defined by the following features:
- Fixed risk
- Capped profit and loss
- Four puts or calls
- Three equally distributed strike prices
- Neutral strategy (When trade price is expected to remain within a narrow range.)
This strategy is three-legged because of the three strike prices involved, which are known as the In the Money (ITM), At the Money (ATM), and Out of the Money (OTM) options, with the ATM option at the middle value.
Based on your market analysis, using the tools and indices we discussed above, the specific strategy that you employ can use either four calls or four put options, which are made all with the same expiration date on the same underlying asset.
If using four puts to take advantage of high volatility, this strategy begins by buying one option at the highest strike price (ITM), followed by selling two puts for ATM, and then buying the final put at the OTM price. You would do the same when buying and selling four calls to capitalize on low volatility and a stable underlying option.
For this strategy, the maximum profit would be gained when the price of the underlying stock has stayed constant through the expiration date. In contrast, the loss equals the initial debt assumed for trade entry, so this would reach the maximum value when the price of the underlying falls below the OTM strike price or exceeds the ITM strike price. Outside these boundaries, the trade would no longer be worth continuing.
To calculate the take-profit targets before setting up the trades, you would need to set the upper target to the ITM strike price minus the net premium and the lower target to the OTM strike price plus the net premium.
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Conclusion
Butterfly patterns can be an invaluable tool in guiding your trading, but using the information you obtain from analyzing these patterns works best in combination with a comprehensive market context.
As you familiarize yourself with using the Butterfly pattern in trading, consider trying a variety of the tools discussed here to increase the reliability of your results. While Butterfly patterns are a valid way to predict market reversals, having additional information to confirm your predictions will help you make smart and profitable trades.
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