Trading the 1-2-3 Reversal

[RichardCox 10]

Trading the 1-2-3 Reversal

 

Getting the best price on your trades (whether they are long or short positions) will generally depend on your ability to spot reversals in trends. Markets tend to work in extremes, as the “dumb money” tends to pile onto trend momentum when it is ready to reach its exhaustion point. This final push that is driven by traders that are late to the party should be viewed as an opportunity, however, as this creates excellent opportunities for those looking to establish contrarian positions. The key word here is “reversal,” as this suggests that prices have become too cheap or too expensive and are ready to change course.

 

Those that can spot the earliest signals in these changes are the traders that will be able to best capitalize on the new trends that come next. There are many ways of assessing when a trend has run its course. For example, some traders might look at an indicator like the Average True Range. This tool gives us a sense of how far (in pips) a currency pair is likely to travel over a given period. Once this range is exhausted, it is unlikely that prices will be able to travel further. Other common strategies can be seen in overbought/oversold indicators (such as the Relative Strength Index), which signals instances where prices have deviated too far from their historical tendencies. For candlestick traders, there is a three-candle reversal pattern that is often referred to either as an evening star (for sell signals) or a morning star for (buy signals). The basic rules for these structures can be found below.

 

Evening Stars - Essential Criteria for Sell Signals:

 

• The second price bar posts a higher low, and higher high when compared to the first and third price bar.
  
• The first price bar is bullish (posting a higher close, relative to the open)
  
• The third price bar is bearish (posting a lower close, relative to the open)
  

 

Morning Stars - Essential Criteria for Buy Signals:

 

• The second price bar posts a lower low, and lower high when compared to the first and third price bar.
  
• The first price bar is bearish (posting a lower close, relative to the open)
  
• The third price bar is bullish (posting a higher close, relative to the open)
  

 

The 1-2-3 Reversal Defined

 

For those that like to focus more on price activity itself, we can look at a longer term variation of the candlestick reversals shown above. Here, we will look at the 1-2-3 reversal pattern, which presents a stable price structure that is easy to identify. The basic 1-2-3 reversal is composed of two simple price structures but there are many variations that can be identified depending on how market activity unfolds prior to and as the reversal pattern is progressing. Next, we look at the basic criteria for the buy and sell signals, using the 1-2-3 reversal pattern.

 

First, it is important to view the 1-2-3 reversal for what it is: The end of an old trend and the emergence of a new price direction. Once an extreme market move has taken place (bearish or bullish), prices will then retrace the previous move with a larger-than-normal price length. In the next charted example, we can see that prices push lower, and find a bottom at point 1. Prices then correct in an upward fashion, finding initial resistance at point 2. After some downward stalling, prices then break the short term resistance level defined by point 2, and surge higher (this is the larger-than-expected retracement). It is important to note, however, that the pattern only remains valid if a higher low is established at point 3. If support at point 1 is re-tested, you are not seeing a 1-2-3 reversal. Breakout buy positions can be taken once resistance at point 2 is violated.

 

 

In a downtrend, we would not typically expect to see breaks of important resistance levels, and this is the first indication that the original downtrend has completed. In an uptrend, the reverse would be seen, as prices would begin breaking closely-watched support levels, without re-testing upside resistance at point 1. This can be seen in the structure shown below. Breakout sell positions could be taken once prices violate support defined by point 2. In both cases, stop loss levels could then be defined by the support/resistance levels at point 3.

 

 

Live Chart Examples

 

Now that we can see the “bare bones” structure, lets look at some live chart examples. The first step in the process is to determine the overriding trend, and then draw a trendline to define that trend. In a downtrend, we start from the swing high (labeled C in the chart below) and continue to the price low (labeled A). Once this trendline breaks to the topside, we can identify point 1 (which is the trend low), and the price pattern has now started.

 

 

The live chart below shows a defined downtrend, a corrective reversal at point 1, a small downward move to point 2, and finally a break of point 1 resistance, which is the move that defines point 3. Buy orders can be set above resistance (the new higher high at point 1), which stop losses set below point 2.

 

 

Reversals in Uptrends

 

Next, we look at reversals in uptrends that present opportunities for short positions. We first must define the uptrend with a upward trendline (starting at C and ending at A in the graphic below). Once prices fall below the upward trendline, we have our origination area at point 1. The reversal has now begun.

 

 

The live chart below shows a defined uptrend, a corrective reversal at point 1, a small upward move to point 2, and finally a break of point 1 support, which is the move that defines point 3. Sell orders can be set below support (the new lower low at point 1), which stop losses set above point 2.

 

 

Conclusion: The 1-2-3 Strategy Allows Traders to Bet Against the Dominant Trend as it Ends

 

In these articles, I often about the commonly used market maxim “the trend is your friend, ride it until it ends.” To be sure, this little gem holds a great deal of wisdom that can be used to capitalize on the market’s overriding momentum in a way that is easy to spot on your price charts. But we must also remember that trends cannot continue forever, and if we can spot instances where a trend has exhausted itself, there are some excellent opportunities to get into the new trend at highly favorable levels.

 

There are many different ways to determine whether or not a trend has completed. Some of the most common techniques involve the implementation of tools like the ATR, RSI, or candlestick patterns. The 1-2-3 reversal pattern offers something of a variation on these techniques and should be viewed as preferable for those that prefer to place most of their focus on price action itself. There is no rule that says some of these strategies cannot be used in combination, however. So, for example, if we were to see a bullish 1-2-3 reversal pattern as prices have fallen into oversold territory on the RSI and prices have reached the lower end of their projected range using an ATR indicator, we would essentially have a “perfect storm” scenario for new buy positions in your currency pair.

[Braam de Villiers 10]

Thanks Richard. I enjoy your posts

[handle 10]

Good post with a lot of information.

 

Thank you.

[RichardCox 10]

  Braam de Villiers said:

Thanks Richard. I enjoy your posts

 

Hi, thanks for the comments. If there are specific topics you are interested in, let me know and maybe we can cover them.

[tradingwizzard 10]

  RichardCox said:

Hi, thanks for the comments. If there are specific topics you are interested in, let me know and maybe we can cover them.

 

hi Richard,

 

you're one of he main and most important contributors here so thank you

 

I would really appreciate a topic about fractals

 

a real one

 

thanks

 

TW