Module 6: The Butterfly Pattern
The Butterfly pattern is commonly seen at extreme turning points, making it ideal for low-risk entries. This pattern is specifically designed to catch highs and lows at market reversal points. Typically, it completes at major tops or bottoms across all time frames, making it highly versatile.
What makes the Butterfly pattern so appealing to traders is the favourable risk/reward profile it offers. The best setups tend to reverse near or precisely at the completion point, making it one of the few reliable patterns for finding tops and bottoms in the market. However, as with all patterns, the Butterfly is not 100% effective, and stop-loss orders are critical to limit risk in case the pattern fails.
Butterfly Pattern Description
The Butterfly pattern is classified as an extension pattern. It is essentially a failed Gartley pattern where the D completion point extends beyond the X point. In a Gartley pattern, such an extension would invalidate the setup, but with a Butterfly pattern, this extension is expected.
The most important parts of the Butterfly pattern to focus on are the AD swing and the CD leg, where the market is often overbought or oversold, signalling a potential reversal. Even if the full reversal doesn’t happen, traders can still profit by exiting on retracements of the CD leg or the AD swing.
Butterfly Pattern Structure
The Butterfly pattern should exhibit symmetry in its formation and structure. Like the Gartley pattern, it consists of four legs, but the key difference is that the final leg (the CD leg) extends beyond the X point, often moving towards the 127.2% or 161.8% extension of the XA leg. The BC leg also forms an extension, but its completion point is generally based on the XA swing.
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The AB leg typically retraces to 61.8% or 78.6%, although the pattern remains valid if the retracement is at 38.2% or 50%.
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The AB leg will invalidate the pattern if it extends beyond the X point.
A potential clue that a Butterfly pattern may be forming is if the first retracement, the AB leg, reaches 78.6% or further.
Below are five characteristics that can invalidate the Butterfly pattern:
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The AB=CD pattern is missing within the AD swing.
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The AD extension exceeds the 261.8% level of the XA leg (the maximum risk is generally at 161.8%).
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The B point exceeds the X point (for a sell pattern) or is below the X point (for a buy pattern).
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The C point exceeds the A point or falls below it.
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The D point fails to extend beyond X; to be considered a Butterfly, D must extend beyond X.
It is not uncommon to see smaller ab=cd patterns within one of the main legs of a Butterfly, often embedded within the larger AB=CD formation of the AD swing. Some of the most effective setups feature multiple patterns from different time frames converging at the same price level.
Important Characteristics of the Butterfly Pattern
The Butterfly pattern can be highly rewarding, especially when it occurs at a major market turning point. It is a contrarian’s dream pattern, signaling potential reversals at the points of highest bullish or bearish sentiment. However, this pattern also carries significant risks if not assessed properly, making it essential for traders to study the pattern in-depth.
Here are three crucial characteristics of the Butterfly pattern:
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Thrust: The move from the C point provides key information about whether the pattern will form as a Butterfly instead of a Gartley. Pay attention to long bars or gaps through 61.8% or 78.6% retracement levels. Gaps are important indicators, as they often suggest changing market conditions.
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The strength of the CD leg often indicates whether the price will extend to 161.8% or just 127.2% of the XA leg.
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Symmetry: The pattern’s symmetry is crucial to its validity. Study the symmetry of the AB=CD formation by comparing the slope and angle of the AB leg with the CD leg. If the CD leg shows a steeper angle, it may indicate a Butterfly is forming.
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Ideally, the time bars of the AB and CD legs should be similar. For instance, if the AB leg takes eight bars to complete, the CD leg should take approximately the same number of bars for an ideal Butterfly formation.
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Failure signs: If the price extends beyond the 161.8% expansion of XA, it typically signals a continuation of the trend rather than a reversal. Watching for this failure signal can help avoid entering a bad trade.
Psychology of the Butterfly Pattern
The Butterfly pattern forms at major tops or bottoms and signals a major reversal. This pattern is a reflection of mass crowd psychology at its extremes, with emotions like fear and greed in full effect.
At such extremes, the market often turns quickly, and many participants rush to exit their positions, amplifying the market move. This creates a chaotic situation where market sentiment shifts from extreme bullishness (in the case of a sell pattern) or extreme bearishness (in the case of a buy pattern) to the opposite sentiment in a very short period.
It is not uncommon to see the media intensely covering these events, with headlines either strongly bullish or bearish, reflecting the market’s prevailing sentiment. At these points, it becomes increasingly difficult to find anyone willing to take the countertrend position, even though the Butterfly pattern indicates a reversal.
As a trader, it's crucial to remember that very few participants manage to buy at the absolute bottom or sell at the absolute top. The Butterfly pattern signifies a turning point, often when the last bull buys at the top or the last bear sells at the bottom.