Technical analysts study historical price charts and indicators to capitalize on up and down market movements through more frequent, smaller profits. While some question the reliability of certain technical markers, most patterns have proven accurate enough for traders to evaluate market behavior and spot entry and exit spots.
From this quick guide, you will learn what this figure appears like, how to detect and, what is even more crucial, and more importantly, what you can do to trade with it.
How do you know what the Harmonic Butterfly pattern is?
The Harmonic Butterfly is a 5-point reversal structure used in technical assessment to define pivotal moments in the market. Its distinct shape features set distances between each price wave.
This pattern applies to any liquid market, like cryptocurrencies. It belongs to a harmonic pattern family, which also comprises the Gartley, AB=CD, the Bat and the Crab patterns.
Harmonic price models first emerged by Harold Gartley in 1935. He described the 5-point formation that came to bear his name. Subsequently, harmonic patterns were improved by including relative distances between each point in the configuration. The improvement was made possible by appending Fibonacci coefficients to the results of the analysis, helping dealers realize the probability of pattern development in real time.
Many analysts have contributed to the improvement of the Gartley pattern. Perhaps the best work of its kind is the book by Scott Carney.
What is the Harmonic Butterfly like?
The Harmonic Butterfly consists of 5 points labeled X, A, B, C and D. When you draw a line between each of these points, it outlines four waves. Connecting these points with drawn lines resembles the image of a butterfly.
Whether it is an uptrend or a downtrend, the pattern initiates at X. If the trend from X to A is downward, the figure will appear like a butterfly and will lead to a bearish reversal.
Conversely, an uptrend from X to A exhibits an inverted butterfly indicating an impending bullish turn.
Both bullish and bearish scenarios display butterflies. The butterfly pattern that leads to a bullish rally, that is, a rise to a renewed high, appears as an inverted butterfly (bullish butterfly).
The butterfly model that leads to a bearish correction looks like a straight butterfly (bearish butterfly).
Such a figure can show up on every market, for example cryptocurrency, or on any time frame of the chart because financial markets are fractal. This means that the patterns which you view on the lower timeframe graphs are smaller versions of the same patterns you see on the higher timeframe graphs.
Once the X-A-B-C-D pattern is formed, traders can predict further development and target a complete pullback of the entire pattern beyond the extremum of point A. Essentially, when a user has spotted 5 points, they can make a deal aimed outside of A point.
Definition of the Harmonic Butterfly figure
This figure is called a «harmonic» pattern because it is a mix of shape and math that periodically shows up in the financial markets. This harmony is based on a derivative of the Fibonacci sequence, which produces correlations of 0.618 and 1.618. Found in natural structures such as sea shells or sunflowers, these ratios are common. Because these ratios are often found in nature, many traders find them important in the financial markets as well.
You can define this pattern with the help of the Fibonacci correlation tool and maybe your fantasy.
Starting with a bearish butterfly pattern, after the downtrend creates wave XA, the market rises higher to point B, which should be the 78.6% retracement of the downtrend XA. Employ the Fibonacci correlation tool starting from X point to A point, and then trigger the 78.6% and 127% levels (we are going to use the 127% level).
Starting from the B point, the current market is experiencing another downtrend to the C point. But the power of the 2nd downtrend (BC) isn’t as intense as the 1st downtrend XA.
In addition, point C usually passes from 38.2% to 88.6% of the AB section. As a result, the C point is a partial recovery of AB and does not break below the lowest cost at the A point. Employ a further Fibonacci pattern from A point to B point and trigger the levels at 38.2% and 88.6%. Point C should fall inside this zone created by the Fibonacci correction levels.
After this false downtrend is over, the market rises sharply, breaking above point X. This new high becomes point D. Point D can be pre-measured and predicted as a 1.27x extension of the length of XA. The 127% pattern from our first Fibonacci retracement pattern has returned and becomes a potential target.
Keep in mind that these pullback levels and target zones are just zones. Prices rarely reverse exactly at these price levels. So look for a reaction to occur nearby. In some cases, the value may fall off a bit or move slightly outside of these zones. If prices do move outside of these zones, you would want to see a sharp reversal indicating that the market is respecting these reversal zones.
Bitcoin example
As Bitcoin’s price rose in the beginning of 2021, impetus started to decelerate and BTC embarked on a process of reaching a top that formed a bearish butterfly model.
On 13 March 2021, Bitcoin began a small correction to the low of 25 March. This correction’s 78.6% retracement level was located at $59,326. The market price then rose to a maximum of $60,365 on the 1st of April, ticking off the B point. This high in price constitutes a pullback of about 85.8%, which is a little more than the ideal 78.6%, and that’s okay.
Then another correction lower led to point C, which is a 49.0% correction from the A to B upward trend. That’s directly in the midpoint of the 38.2% to 88.6% correction area, which is considered normal for a Butterfly pattern.
Since April 7, Bitcoin has been making its last period of continuous price growth, the final formation. In Butterfly models, the final high is usually recorded around the 127% expansion of the XA tendency. In this case for bitcoin, the 1.27 extension was valued at $65,573. This rally approached new historical maximums and reached a high of $64,999, less than 1% off the estimate, reaching the 1.26 extension.
A good looking bearish butterfly model has emerged on Bitcoin’s April 2021 high.
How to trading based on the Harmonic Butterfly model
Once you’ve noticed a prospective Butterfly model, creating a trading opportunity is quite simple. Thanks to this formation’s harmonic wave character, we can determine in advance its possible pivot area. That way, if price reaches this zone, we can look for symptoms of a trend change.
Placement of a long input position
The easiest way to open a long position is to utilize a breaking out deal. It can be set up using a descending resistance trendline, the breakout of which can serve as an entrance trigger. Alternatively, you could define horizontal resistant layers and await for price to break above, signaling the opening of a long position.
Usually a trader will choose to trade one of these resistance levels, but we are showing both so you can see how they can manifest themselves. Basically, once the resistant line, this will be a trigger signal for a long-term position.
Strategy for exit
Once the position has been opened and the stop loss is set, we may schedule the target profit. In many cases, a positive Harmonic Butterfly reaches an extremum of price outside the A point.
This level can be seen as an early target.If this pricing level is achieved, the trader could want to cover some of the position and the rest will continue to float. This way, if the current trend gets real intense, the broker can monitor the stop loss and lock in gains at a lot higher levels.
What happens if a breakout takes place?
It is possible that the market doesn’t reverse out of the potential 127% reversal area.In such cases, the market might break out, yet it would keep going beyond the 127% area.
This is why using the described breakout trading pattern is useful. Let’s assume that ether fails to rise to the 127% zone. If we open a bullish breakout deal at horizontal resists and the price cannot achieve the breakout trigger, then we will never get into a bullish transaction. In effect, we are saved from a losing trade.
Keep in mind that this bullish breakout setup will not keep you out of all unprofitable deals. Sometimes the market rallies and reaches your bullish breaking out signal at a horizontal resist level, but then corrects lower (see the first image on the right above).
This is why it is essential to put a stop loss on each trade. In these situations, your stop loss will work, taking you out of the trade before much larger losses. Yet a short losing position is better than a large losing trade that can destroy your account balance.
Key differences between the Butterfly Patterns
Aside from the bullish and bearish types of butterflies («upside down» and «right side up»), the biggest difference between them is how each pattern starts.
If XA begins as a rising trend, the model will settle as a bearish butterfly.
If XA is initiating as a descending trend, the figure will resolve as a bullish butterfly.
Other elements like geometry and point-to-point relationship levels are correlated and remain unchanged.
Is the Harmonic Butterfly pattern dependable?
Harmonic Butterfly has several commonalities and distinctions with some other chart reading models. Traders always want to know how reliable a pattern is. However, it is worth understanding that the reliability of the pattern is based on the analyst’s ability to read it correctly.
Pros of the Harmonic Butterfly pattern
The geometric nature of the butterfly pattern can give an investor certainty if they can easily recognize the pattern on the chart. Moreover, the pattern has a certain range of correlations to help make its detection more reliable. If these ratios and structures are present, the more probable it is that the pattern will also be present.
Final insights
The Harmonious Butterfly pattern is a popular model that experienced dealers are following. However, no pattern in trading is 100% correct. There are times when a figure shows every right correlation and has the correct appearance, but then fails. The market can reverse sharply, so it is important to put a stop loss on each trade.
