The butterfly pattern has its origins in the work of Larry Pesavento and Bryce Gilmore. Larry told me that he discovered it in 1991 while sitting on the beach with Bryce Gilmore looking at some charts produced on the “Wave Trader”. The pattern as described by Larry contains an AB =CD move that completes at a new high or new low.

    This pattern produces some spectacular wins and losses. My experience with this pattern over the past decade  has led me to offer some additional guidelines for identifying and trading this pattern:

• The final leg of the pattern, what Larry would call C:D, can be either a Elliott W. 3 or 5.
• The pattern should only be traded if it completes with a clear momentum divergence (price makes an new high but RSI or oscillator does not)
• The final leg of the pattern should subdivide into 5 smaller waves
• Profits should be taken aggressively.

    Here are two examples:

 

    This is a fairly common pattern to see on short term intraday charts and can be used effectively for scalping any liquid market. As you move to the larger time frames, it occurs infrequently and the pattern is more challenging to trade. Understanding where the pattern fits into the larger picture or context is very important as is following a very good trading plan to manage the risk.

    Subscribers to Harmonic Edge have access to our database of closed trades dating back to 2000 which contains well over 1000 closed trades and is an invaluable resource for individuals interested in learning how to trade harmonic patterns like the Butterfly.

Harmonic Numbers

    Harmonic numbers are the "Davinci Code" of most liquid financial markets. The numbers are derived from the Fibonacci summation series which starts with 0 and adds 1. Each succeeding number in the series adds the previous two numbers thus we have 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 to infinity. If you divide 55 by 89 you have the golden mean - .618. If you divide 89 by 55 you have 1.618.