Butterfly harmonic patterns are high probability trade setups that identify reversals in trends. As discussed in our previous post on harmonics, the butterfly is created when price points reach exhaustion levels. Unlike the ABCD and the 3 Drive, this pattern starts with a long pullback, and is followed by a price rise and a breakdown in the continuation.
Execution speed is critical as the butterfly can identify quick breakdowns in the price. Some of the rules that govern the pattern are highlighted below.
Bearish Butterfly Specifics
• Point A to D is 127% / 161.8% greater than X to A
• X must be less than D
• Butterfly requires an ABCD formation
• Extension greater than 161.8% between X and D will make the pattern void
Although widely recognized as having a high probability of success (70-85%), trading this pattern requires adequate risk management and the use of secondary indicators for confirmation purposes. It is important to utilize trend and regression based indicators as these compliment price action systems like harmonics.
Confirmation Indicators for Bearish Butterfly
The ITrend is a unique technical indicator that identifies strength in buying or selling pressure within a trend. Very useful during periods of heightened volatility, the ITrend can be used effectively with harmonic patterns, particularly the butterfly, as it paints a picture of whether buying pressure has been exhausted.
The only drawback with the ITrend is the degree to which it gives whipsaw signals during flat periods of trade. If the market is trending without volatility, this indicator should not be used. It can be downloaded at http://codebase.mql4.com/441
Using linear regression with the bearish butterfly can paint a clearer picture of where the price is within the long term regression channel. For example, if a pattern is triggered indicating a reversal in the price, however the price is sitting towards the lower standard deviation channel, then the probability of reversal is less than if the price was sitting in a top linear channel.
The main drawback with using linear regression as a confirmation indicator is its adaptability to sharp price movements. If the linear lookback period is too short or too far, then the indicator will either whipsaw or it will not adjust accordingly.
One of the most important confirmation indicators to use with the bearish butterfly is moving averages. This provides the trader with a specific entry point, once the price crosses below the shorter moving average. A stop loss can then be set at a the level of the longer term moving average.
Moving averages may not adjust quickly enough to short term bursts of volatility.
Example – Using MA for Confirmation
In the GBPUSD diagram, we can see that the bearish butterfly formation develops when the price reaches new highs. The trader is supplied with the confirmation signal, when the price retraces and breaks out of the grid. Although this is a text book scenario, in many cases the currency may not retrace and could continue on its trend (hence the breakdown in the pattern).
In this example, we added the moving averages. Our entry point was when the price punctured the moving average at 1.51730. As we only added a short term moving average, we set out stop loss at 70 pips from the entry.