Trading
Bybit Learn
Bybit Learn
Intermediate
Jan 28, 2022

How to Identify & Trade Harmonic Butterfly Pattern for Profits

Technical traders analyze the market using trading patterns and signals to profit from the rising and falling markets with smaller yet more frequent profits. Though the accuracy for some technical indicators is debatable, but most patterns have proven their reliability for traders to gauge the market behavior and help to critically identify the entry and exit points.

So what exactly is a harmonic butterfly pattern? In this article, we’ll discuss what the pattern looks like, how to identify it, and more importantly, how to trade it.

What Is a Harmonic Butterfly Pattern?

The harmonic butterfly is a five-point reversal chart pattern used in technical analysis by traders to help identify turning points in the market. It is a trading pattern with a specific shape and distances between each trend of the pattern.

The harmonic butterfly can be used in any liquid market, such as crypto, and on any time frame chart. The butterfly is a part of the harmonic family of patterns, which include other formations such as Gartley, bat, crab, and AB=CD.

Harmonic Butterfly Pattern

The genesis of harmonic price patterns was established by H.M. Gartley back in 1935. He wrote about a 5-point pattern which became known as the Gartley. Harmonic patterns were eventually improved upon by including relational distances between each of the points in the configurations. This was accomplished by adding Fibonacci ratios to the analysis to help traders analyze the likelihood of the developing pattern in real-time.

Many people have worked on improving Gartley’s work. The most comprehensive of all is perhaps that completed by Scott Carney in his series of books on Harmonic Trading.

What Does a Harmonic Butterfly Look Like?

The harmonic butterfly pattern is a five-point pattern, with points labeled X, A, B, C and D. When you connect a line, or trend, between each of these points, it delineates four waves.

The harmonic butterfly pattern earned its name because when the formation is completed, the resulting image with the lines drawn resembles a stick-figured butterfly.

Bullish and Bearish Butterfly

This pattern can print within an uptrend or downtrend, but always starts at point X. If the trend from X to A is a downtrend, then the pattern will look like a butterfly and result in a bearish reversal.

If the trend from X to A is an uptrend, then the pattern will look like an upside-down butterfly and result in a bullish reversal.

The harmonic butterfly appears in both bullish and bearish scenarios. The butterfly pattern which results in a bullish rally (bullish butterfly) to a new high looks like an upside-down butterfly.

The pattern which results in a bearish correction (bearish butterfly) looks like an upright butterfly.

This pattern can appear within any market, such as crypto — or within any chart time frame — because financial markets are fractal. That is, the patterns you see on smaller time-frame charts are smaller versions of the same patterns you see on larger time-frame charts.

Once the X-A-B-C-D pattern is completed, traders can anticipate and target a full retracement of the entire pattern beyond the extreme of point A. Essentially, when a user spotted the five points, they can make a trade that targets beyond point A. 

Identifying the Harmonic Butterfly Patterns

The butterfly pattern is heralded as “harmonic” because the formation is a combination of shape and math which appears repeatedly in financial markets. The basis of this harmony is a derivative of the Fibonacci sequence, which creates ratios of 0.618 and 1.618. These ratios are found in natural structures, such as seashells or sunflowers. Due to these ratios appearing repeatedly throughout nature, numerous traders have deemed them significant within financial markets as well.

Harmonic Butterfly Patterns

Identifying the harmonic butterfly pattern can be done with the Fibonacci retracement tool — and perhaps some imagination.

Starting with the bearish butterfly, after the downtrend creates the XA wave, the market rebounds higher to point B, which must be a 78.6% retracement of the XA downtrend. Apply your Fibonacci retracement tool from point X to point A, then activate the 78.6% and 127% levels (we’ll use the 127% level later.)

Beginning from point B, the market experiences another downtrend to point C. However, the strength of the second leg down (BC) isn’t as strong as the first XA trend lower.

Additionally, point C generally retraces about 38.2% to 88.6% of the AB leg. As a result, point C is a partial retracement of AB, and doesn’t break below the low price at point A. Apply another Fibonacci drawing starting from point A to point B, and activate the 38.2% and 88.6% levels. Point C should fall inside that zone, which has been created by Fibonacci retracement levels.

After this false trend lower is over, the market then rallies hard, breaking above point X. This new high becomes point D. Point D can be measured and anticipated ahead of time to be an extension of the length of XA by a factor of 1.27. The 127% figure from our first Fibonacci retracement drawing has come back to provide a potential target.

Keep in mind, these retracement levels and target zones are just that — zones. It’s rare for prices to reverse exactly at these price levels. Therefore, look for a reaction to take place nearby. In some instances, prices may fall a little short or move slightly beyond these zones. If prices do move beyond these zones, you would want to see a sharp reversal, indicating the market is respecting these pivot zones.

Bitcoin’s Example

As Bitcoin’s price rallied into the early portion of 2021, momentum began to slow, and Bitcoin started a topping process — which carved a bearish butterfly pattern.

On March 13, 2021, Bitcoin starts a small correction to the March 25 low. The 78.6% retracement level of this correction is at $59,326. Then, the price rallies to a high of $60,365 on April 1, marking point B. This price high is about an 85.8% retracement, a little larger than the ideal 78.6%, which is okay.

Bitcoin’s Example 2

Then, another correction lower leads to point C, which is a 49.0% correction of the A to B uptrend. This is right in the middle of the 38.2% to 88.6% corrective zone, considered normal for the butterfly pattern.

Bitcoin’s Example 3

Beginning April 7, Bitcoin undergoes one final rally to complete the formation. Within butterfly patterns, the final high typically registers around the 127% extension of the XA trend. In this case, for Bitcoin, the 1.27 extension is estimated at $65,573. This rally carries to new all-time highs and tops out at $64,999, less than 1% from the estimate, arriving at a 1.26 extension. 

At Bitcoin’s high in April 2021, a beautiful bearish butterfly pattern has been completed.

How to Trade the Harmonic Butterfly Pattern 

Once you’ve spotted a potential butterfly pattern, setting up a trade opportunity is fairly straightforward. Due to the harmonic wave nature of this formation, we can identify its potential reversal zone ahead of time. That way, if the price does make its way to that zone, we can look for symptoms of a change in trend.

From late August to September 2021, Ether (ETH) appears to be carving a bullish harmonic butterfly pattern. The geometry of the form meets idealized parameters.

How to Trade the Harmonic Butterfly Pattern

For example, point B retraces 99.8% of the XA trend. This is a little more than we’d like to see. However, that deep retracement is immediately met with buyers, and the price pushes higher, leaving behind a very long downside wick. Over the next several days, Ether (ETH) tries to push lower, back to the 78.6% retracement level and is immediately met with buyers. Though the initial dip is larger than 78.6%, you can see how the market’s geometry is trying to carve this pattern.

How to Trade the Harmonic Butterfly Pattern 2

The subsequent rally to point C retraces 67.0% of the AB trend, which is normal. This generates a potential bullish reversal zone for point D at $2,718.05.

The price then dips, and corrects just beyond the 127% target zone, having started to rally. 

How would a trader manage this trading opportunity?

Placing a Long Entry Position

When Ether tagged the target zone, it left behind a large downside wick. This is evidence of buyers rushing to support the market’s pricing, as they believe ETH to be a good value.

Placing a Long Entry Position

The simplest way to set up the long entry is to use a breakout trade. This can be set up with a downward sloping resistance trend line that, when broken, can act as the entry signal.

Or, you can identify horizontal levels of resistance and wait for the price to break above, signaling a long entry.

Typically, a trader will pick one of these levels of resistance to trade from, but I’m showing you both so you can see how the two might appear.

In essence, once the price rallies and breaks the resistance level, it will signal a long position.

Managing Your Trade

Managing Your Trade

In the example above, using ETH, the price eventually rallies to break resistance. This places the trader in a long position.

At this point, the trader will want to set the stop loss just below the swing low at point D. This way, if prices continue to fall, then some other pattern is at play, and we can exit the trade with the majority of the account’s capital preserved.

Exit Strategy

Once the position has been entered and the stop loss is set, we can then plan out the profit target. On many occasions, a successful harmonic butterfly targets the extreme price beyond point A.

Exit Strategy

In our ETH example above, point A is near $4,035. This level can be seen as an early target. If this price level is reached, then the trader may want to close a portion of the position and let the remainder continue to float.

This way, if the trend becomes really strong, the trader can trail the stop loss and take profits at much higher levels.

It turns out that ETH’s trend was surprisingly strong, having run up to above $4,800, even though the breakout alert from the butterfly was originally triggered around $3,100.

What Happens If There’s a Breakout?

There may be some instances where the market doesn’t reverse from the 127% potential reversal zone. In these cases, the market may pause, but it continues to extend beyond the 127% zone.

This is why using a breakout trade setup as described is beneficial. Let’s assume for a moment that Ether is unable to rally at the 127% zone. If we set up a bullish breakout trade at horizontal resistance, and the price fails to reach the breakout signal, then we never enter into the bullish trade (see the left side of the image below). We’re essentially saved from a losing trade.

Breakout

Keep in mind that this bullish breakout setup won’t keep you from all losing trades. There are times when the market will rally and hit your bullish breakout signal at horizontal resistance, but then correct lower (see right side of the first image above).

This is why it’s important to place a stop loss on every trade. In these situations, your stop loss will trigger, taking you out of the trade before a much more significant loss. However, a small losing trade is better than a large losing trade — which can destroy your account balance.

Bullish vs. Bearish Harmonic Butterfly

Bullish vs. Bearish Harmonic Butterfly

Key Differences

Apart from the “upside-down” and “right side up” bullish and bearish versions of the butterflies, the biggest difference between them is how each pattern begins. 

If XA starts as an uptrend, then the pattern will resolve as a bearish butterfly.

If XA starts as a downtrend, then the pattern is forming the bullish butterfly.

The other components, such as the geometry and ratio levels between the points, are all relative to one another and remain the same.

Is the Harmonic Butterfly Pattern Reliable?

The harmonic butterfly pattern has some similarities to, and differences from, other chart reading patterns. We generally want to know how reliable a pattern is. However, the truth is that a pattern’s reliability is based on the analyst’s ability to read it correctly.

Pros

The geometric nature of the pattern which Scott Carney has thoroughly researched can make traders more confident when they clearly identify the formation on a chart. Moreover, the pattern has a specific set of ratios to make its identification more reliable. If these ratios and structures are present, the greater’s the chance the pattern is present as well.

Limitations

No pattern in trading is 100% correct. There are times when a pattern displays all of the correct ratios and has the right look — but then fails.

This is why it’s important to place a stop loss on every trade. Using the guide above, you can correctly identify a place to set the stop loss, without risking too much or too little.

Closing Thoughts

The harmonic butterfly pattern is a popular structure followed by seasoned traders. For those traders who are familiar with Fibonacci retracement levels, this pattern generates a specific look and ratio between each trend of the pattern.

However, the pattern is not without limitations. The market can abruptly reverse, which is why it’s important to place a stop loss on every trade.