Updated: May 2015
Butterfly Patterns are the fraternal twins of Crab Patterns. They require a Point B at the .786 XA retracement, rather than the Crab’s more generous range. And, they complete at either the 1.272 or the 1.618 extension.
In the example below, we saw a completion only 14 cents away from the 1.272 extension target. Note that a Crab Pattern had just completed and, then, melded into a Butterfly: the Crab’s Point C became the Butterfly’s Point X. And, the Crab’s Point D became the Butterfly’s Point A.
Because Butterfly Patterns can extend to the the 1.272 or the 1.618 Fib levels, they can be a little tricky. Playing a reversal at the 1.272 means placing appropriate stops, just in case it’s the 1.618 that shows up instead. The results are similar to other harmonic patterns — with objectives starting at the .618 of the AD, and going up from there.
Here, we saw a nice move to the .618, which reversed to the .236 before moving on to the .886. There, it reversed to the .618 before zooming on to the 1.272 and eventually, the 1.618. Total move: 53 points for about 4%. Again, playing patterns that pay off in the direction of the trend usually means greater payoffs. Anyone who doubts the power of Fibonacci would do well to study that chart!
Those readers not yet asleep or cross-eyed from the above might notice that the payoff from the Butterfly Pattern created yet another Crab Pattern. Note how the original small purple Crab Pattern melds into the medium-sized, yellow Butterfly Pattern that morphs into the larger, purple Crab Pattern.
Relabeling the points, it’s easy to see. Yet, I’ll be the first to admit that in the heat of the battle, it’s sometimes tricky to keep all the various possibilities straight — especially when dealing with smaller patterns that might or might not be part of larger patterns. A quick look at technical analysis, chart patterns and fractals often helps sort it all out.
A Practical Application
The biggest Butterfly Pattern, which has been on our radar for years, is the one set up by the drop from 1576 in October 2007 to 666 in March 2009, and subsequent retracement to the .786 Fib in May 2011. It might have reversed at 1823, the 1.272 extension, but didn’t.
Thanks to a massive devaluation in the Japanese yen [see: The Yen Carry Trade Explained] SPX shot past the obvious turning point and has since relied on a series of backtests designed to cast it as support rather than resistance. I suspect that SPX’s 1.618 extension at 2138.04 will serve as a more important top.
For more, see The Last Big Butterfly.