What Is A Reversal?
A Reversal is exactly what it sounds like. The market stops going in one direction and reverses to the opposite direction. Reversal trades can be very powerful. The problem is, how do you know you have a reversal and not just a small retracement? I’ve discovered that a well-defined 123 Reversal pattern can be the answer.
What financial instruments and time frames show the 123 Reversal pattern?
The 123 Reversal pattern appears in all financial instruments and time frames. I’ve successfully used this strategy on equities, index futures, grain/meat futures and forex currency pairs. I’ve also used this on many different time frames. Typically, the lower the time frame, the smaller the risk, but the target will also be smaller. Obviously, you will find more of these on the lower time frames and they will play out much more quickly.
What do I look for?
I will describe what to look for by describing a 123 High (uptrend reversing to a downtrend), in parentheses, I will include the direction if you are looking at a 123 Low (downtrend reversing to an uptrend.) The 123 Reversal pattern is just as effective in either direction – particularly in the Forex market.
The first thing to look for is a strong trend, which is fairly easy to identify just by glancing at the chart. A reversal is not going to be very powerful if it resides in a trading range. 123 Reversal patterns as well as other reversal patterns, happen all the time within the context of a trading range. The success of the 123 Reversal lies in the trend that leads up to it. The strong trend should include candles that break prior highs (or lows) and pushes on for many candles. The quickest way to find these is to scan all your charts for a strong trend.
At the top (or bottom) of the trend, you will want to see a quick reversal of the price. That is your #1 point. It should then drop (or rise) to your #2 point at which time it will reverse again and go in the direction of the original trend. If it goes higher (or lower) than your #1 point, then the pattern is broken and you can look elsewhere. You will be looking for a #3 point where the price action reverses again to go against the original trend. This #3 point must be lower (or higher) than the #1 point or you don’t have a 123 Reversal pattern.
How do I trade the 123 Reversal strategy?
There are several ways to handle the 123 Reversal. For the purposes of this article, I’ll discuss the most common way strategy. In a future article, I’ll present additional strategies to profit from this pattern (you can actually use three different entries on each 123 Reversal you find – but that’s a subject for another day.)
The most common way to trade the 123 Reversal pattern is to sell (or buy) a break of the #2 point of the pattern. For a 123 High (after an uptrend), I set a sell stop order a few pips below the #2 point. The stop loss can go a few pips above the #1 point and you should target the height of the pattern. In other words, measure from the #1 point to the #2 point and use that number of pips/ticks as your target.
Of course, in the case of a 123 Low (after a downtrend), you would use a buy stop a few pips above the #2 point with your stop loss below the #1 point. Once again, you will target the height of the pattern.
A very common management strategy would be to place two orders beyond the #2 point with the first one targeting the height of the pattern. When the first order hits its target, move the stop on the second order to break even and let it run. It could run all the way back to the beginning of the trend or more.
Understand that the price action will most likely take a bounce when it hits the #2 point. That’s expected. Hold on and it should break in due time.
Hope this quick strategy tip was helpful to you and thanks for reading.