# The Bearish and Bullish Butterfly Pattern

Video Transcript:

Hello, traders. Welcome to the seventh module of the advanced technical analysis course, harmonic patterns. In this lesson, we are going to learn how to spot and how to trade a bearish and bullish butterfly, and what are the rules and the ratios that are in play for us to be able to trade it.

Now, the structure of the butterfly was discovered by Bryce Gilmore, and it was developed by Scott Carney. The structure includes a mandatory .786 retracement of the XA leg at the V point, and a 1.27 to 1.618 retracement of the D point, which is also a retracement of the XA leg. Now, here is how a butterfly looks. Here’s a bullish butterfly, and here’s a bearish butterfly. And as we said before, the .786 V point, which is the retracement of the XA leg, must be at the .786 ratio. And the D point, which is also a retracement of the of the XA leg, must be a ratio between 1.27 and 1.618.

There are a few other rules that we need to take into consideration before we can actually trade it. The pattern should possess a distinct AB=C pattern in it, and the AB=C patterning is, of course, the point A, B, C, and D. The difference is that the CD leg, which is this one right here, is an extended leg of the AB wave. This means that, even though this is an AB=CD, the CD is an extended leg to the ratios 1.618 to 2.618. So as you can see, this harmonic pattern is a little bit more extended than the other patterns that we have gone through on this lesson, on this module. And the point D has to converge with the 1.27 to 1.618 XA retracement and the 1.618 to 2.618 BC extension.

So, in order for us to have a valid butterfly, the first thing we need to is grab a retracement, and the first retracement must be a .786. Then, the C wave, which is a retracement of the AB leg, must be between .382 and .886, and the D point must be a retracement between 1.27 and 1.618 of the XA leg and an extension of 1.618 to 2.618 of the AB leg. So these are the ratios that you need to have in play for you to be able to buy the D point in a bullish butterfly or sell the D point in a bearish butterfly.

Now let’s go through an example so you can better visualize what we’re talking about. First of all, you need a wave, the first wave and a retracement. As you can see here, we have the first wave, which is the XA, the X point and the A point, and we have now a retracement. The first thing we’re going to do is we’re going to calculate the Fibonacci retracement level that has been hit around these levels. In this case, we have hit the .786 so the first rule of the butterfly has been met. We can start to follow this chart to see if we actually have a butterfly completion for us to have an excellent risk to reward buy zone.

So the .786 retracement is the B-point and in this case, price bounces to the offside and hits the .886 retracement of the AB leg. This is the second rule that has been met so we name this high the C point. If price does not bounce to the downside and continues to the offside, we don’t have a valid butterfly so we let it go and we go to the other charts to try and find a new harmonic pattern. Now, in this case, price goes all the way down, taking out the B-low and the X-low. Most traders might think that this is a complete trend reversal because we’ve now taken the previous lows. But you need to be careful because you need to know that sometimes, Fibonacci ratios get into play to form harmonic patterns and push price up. So in this case, we hit the 1.272 retracement level of the XA leg.

Now, for you to understand this, it’s easy. If price would have stopped at this low, it would have mean that this point had retraced 100% of the XA move. Because it went below the X point, it retraces more than 100% so it retraces more than 1 on the Fibonacci ratio scale. And in this case, it had retraced 1.227, and it also has hit an extension of 1.618 of the AB wave. Now, we almost have a completed set-up if in fact, this area is rejected, and because it’s rejected, we call it the D point, and we have a completed butterfly.

So now, we can go long on a very low risk to reward ratio and high probability set-up. So, this is how you play these harmonic patterns. First of all, you need to pick a leg and a retracement, and if one of the mandatory Fibonacci retracement levels are hit, you start to follow price, and you start to draw your levels of the next leg and your extension levels to see if, in fact, the D point converges with the necessary retracement of the XA leg, and the necessary extension of the AB move.