If you plan to succeed in trading over the long haul, you will need a reliable way of distinguishing between high-probability and low-probability trade setups. Blindly taking all trading signals produced by most trading systems is simply not a good idea and will likely be a road to ruin in many cases. I began trading in the late 90s, and as a result, I have come across various methods for separating the good trades from the bad ones. A filter that I still use to this day is one that I call the Butterfly Pattern. This pattern uses moving averages on a multiple time frame basis to reveal the true supply and demand forces that are driving a stock.

I have found that when a Butterfly Pattern exists, you should look to aggressively buy stocks on pullbacks for long trades and sell stocks on rallies for short trades. This pattern is a great way to screen many of your signals for the best trading candidates because you can instantly see which side - i.e., the buyers or the sellers - is in control of a stock.

Even though a Butterfly Pattern is a highly effective screening tool, the rules for identifying the pattern are remarkably simple. First, you must select two different time frames that are larger than the time frame in which your entry signal occurs. Second, a Butterfly Pattern exists when the 20-period simple moving average is above the 200-period simple moving average in both of the larger time frames. That's really all there is to it.

A good rule of thumb is to require the first higher time frame be larger than the entry signal time frame by a factor of 5 and the second higher time frame be larger than the first higher time frame by a factor of 12. For example, if the entry signal occurs on the 1-minute chart then select both the 5-minute and 60-minute time frames for your higher time frame analysis. Therefore, in order for a valid bullish Butterfly Pattern to confirm a 1-minute entry signal, the following criteria must both exist (note: reverse the logic for a bearish Butterfly Pattern):

1. The 20-period simple moving average must be above the 200-period simple moving average on the 5-minute chart (i.e., first higher time frame).

2. The 20-period simple moving average must be above the 200-period simple moving average on the 60-minute chart (i.e., second higher time frame).

Why is this pattern so effective in picking out great trades? In the case of long trades, significant new buying activity would have to occur in the higher time frames for the shorter term 20-period moving average to cross above the longer-term 200-period moving average. A moving average crossover on two different higher time frames is clear and compelling evidence that a bullish change in sentiment has occurred. Apply the reverse logic for short trades.