The Butterfly Pattern is an extension harmonic pattern (that is - the D point exceeds the X point) and is used to trade highs and lows at key reversal points.
As an extension pattern, the CD leg extends towards a 1.272 to 1.618 Fibonacci extension of the XA leg. Note, that Fibonacci extension can even be as far as 2.618 - but beyond that then the pattern is invalid.
Systematic tests by FxGroundworks showed Butterfly pattern success rates to be 87.4%-89.79%.
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Bullish Butterfly example
The great thing about this pattern is that, because it indicates a high probability of a reversal at the end of a trend, you can get into a new trend much earlier than most other traders.
In fact it's quite likely that most other traders will still be trading the continuation in the CD direction, while you are taking a "contrarian" view, and taking the opposite trade.
The key thing to bear in mind about the butterfly is when it fails, it can fail quite dramatically in a continuation of the trend in the CD direction. So careful risk management in terms of a tight stop-loss is required.
Here is a good example why a close Stop-Loss is absolutely necessary. This is a bullish butterfly pattern on the Eur-Gbp 30M chart. Price has just touched a Support zone at 0.8180.
The 1.618 XA leg is at the same level - and the 2.628 of the BC leg is just a few pips lower.
This is how I traded it:
This gives a risk/reward ratio of just over 1:3 (risking $1 to make $3).
Bearish Gartley example
As the Butterfly is a test of an end of a trend, it's important to notice the momentum of price action on the CD leg, and watch out for strong momentum that could push through the PRZ and make the pattern invalid.
How the CD leg develops sometimes gives us a clue. If the CD leg is steeper than the AB leg, then a 1.618 XA extension is more likely than a 1.27 XA extension. Similarly, if there is a gap or unusually long candles in the CD leg we can also expect a 1.618 of the XA leg.
Generally speaking I only trade a butterfly pattern if there is a significant Support or Resistance zone near to the 1.27 or 1.618 Fibonacci XA extensions that I can use for placing a Stop.
Taking note of Price Action momentum and any close by Support/Resistance areas will help determine if we are dealing with a 1.27 extension of the XA leg or a 1.618 extension.
I don't trade a Butterfly pattern if price is already past the 1.618 XA extension. If that happens it's likely to be a continuation of the trend in the CD direction, and therefore a reduced probability of a reversal.
I recommend the following pages for further details on harmonic patterns.
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