Trend is your friend, trade along the trend. This trivial truth looks at any beginner trader from every textbook on technical analysis. It would seem that nothing is easier: determine the direction of price movement, wait for the correction and buy something that has become cheaper if the market is dominated by bulls; or sell something that is more expensive if the initiative belongs to the bears. In reality, it's not so simple. The desire to act together with the crowd often turns into losses. Ultimately, if the majority were always right, the sun would still rotate around the Earth.
Tendencies often unfold on the background of the formation and implementation of countertrend patterns. One of them is 1-2-3. Graphically it looks like a combination of three extremes, the second of which is a correctional one. In this case, in the conditions of the bullish market, point 3 is always below point 1. If the situation is controlled by bears, point 3, on the contrary, will be located above point 1.
The article covers the following subjects:
1-2-3 Pattern: Easy to Hard
The 1-2-3 pattern filters
1-2-3 Pattern: from Roller coasters to Consolidation
1-2-3 Pattern: Easy to Hard
The classical approach to pattern 1-2-3 involves opening short positions at the break of the correctional low. The buyers who seriously expect the upward trend to be restored are most likely to have set their stop orders there. Their avalanche triggering allows you to see a sharp downward movement in the chart. It makes sense to set the stop order just above point 3. The simplest exit from a position is based on the formation and implementation of the reverse model.
The principle "sell (buy) and hold" is not good for everyone, because after having lost profit several times, the trader begins to doubt its effectiveness. They can use the method of partial consolidation of a positive financial result by using various methods of position management. In particular, a rather popular approach is the use of profit factor. It is based on the principle that the potential profit should be 3-4 times greater than the risk accepted by the trader. In this scenario, even a trading system with a probability of less than 50% will give positive financial results.
When opening a position, three lots (or three parts of the lot, depending on the size of the deposit) are used. The first of them is closed when profit reaches the stop order (R), which is then moved to the breakeven point. Reverse trades for the second and third lots are made when quotes fall to the 2R and 3R levels.
If you find the strength to use the principle "sell (buy) and hold", then instead of partially consolidating the positive financial results, you can simply move stop orders first to the break-even point, and then to the profit-factor levels indicated.
Using the methods of harmonious trading allows you to modify the above strategy. The places of divisible R are occupied by the Fibonacci levels 161.8%, 261.8% and 423.6%. At first glance, this approach looks more logical than the previous one, because initially the trader has no confidence in the trend reversal, so it makes sense to give preference to narrower stop orders. In the future, as faith grows in the changing trend, they can be expanded.
It should be noted that the classical approach based on the breakthrough of the corrective extremum is not the only one. Aggressive traders can take the trend line drawn through point 2 and the previous low by storm. A short trade is opened at the breakout price or at the closing price of the breakout bar.
Some traders like to take advantage of the 1-2-3 pattern, while others hate it. The latter, as a rule, are people who try to earn on each graphic configuration. This is an extremely dangerous approach. The pattern needs a system of filters to improve the efficiency of trading. We will talk about them in the following articles.
The 1-2-3 pattern filters
You don't like cats? You simply don't know how to cook them! Some traders consider the 1-2-3 pattern described in the previous articles as an essential element of the working trading system, but others, on the contrary, are sure that its use is a waste of time. Indeed, if you play out absolutely all the graphic patterns of this type emerging on the market, the number of trades will go off scale, but their effectiveness will not satisfy a Forex trader. To improve it, many people use a filter or a filter system, after histrical pre-testing of the trading strategy.
Filter is a matter of personal taste. It often cuts off losing trades, on the other hand, you can also miss the profitable ones. Perhaps the main advantage of the restrictions is the formation of a clear trading system that will be more effective than that of the competitor.
The simplest filter for 1-2-3 pattern is called rule 10-20-50. The first two digits are the minimum and maximum number of bars located between points 1 and 3, the last number is the size of the corrective movement from the descending (ascending wave), resulting in the formation of a low (high) in point 1. Thus, to make a trade using the 1-2-3 pattern in a 4-hour NZD/USD chart, it is required that point 2 is at a level of at least 50% of the last descending wave (in our example - between 50% and 61.8 %). If this does not happen, the 1-2-3 pattern is ignored.
The 1-2-3 pattern can be combined quite successfully with the principles and tools of volume spread analysis (VSA). So according to the latter, the strength of the trend is confirmed by growing volumes, while correction, as a rule, is characterized by a decline in the volumes. In the example with AUD/USD, the implementation of the reversal patter finds confirmation in the trading activity. At the same time, an important bar is being formed near point 3, indicating a high risk of a decline.
As filters for the described graphical configuration, we can use not only price action tools, but also standard or non-standard indicators. The trader will play out the 1-2-3 pattern only if they see a divergence - different locations of tops (bottoms) in the charts of currency pairs and indicators. For example, in a 4-hour time frame for EUR/CAD there is a discrepancy between the dynamics of the quotations and the MACD. In the chart, the tops in the growing market are declining, while the indicator consolidates their growth. Divergence allows a trader to effectively enter a short position.
As indicators, we can use both trend indicators (as in the above example - MACD) and oscillators, some of which are based on the detection of overbought-oversold zones.
If you succumb to the general criticism and believe that the indicators based on prices are lagging, you can return to the price action methods. My experience suggests that speed is important in the implementation of the reversal model. If the trend line constructed on the basis of point 2 and the previous fractal breaks through three bars, then the bulls in the growing market run away from the battlefield, having lost faith in their abilities to restore the uptrend.
It should be noted that the trader must initially determine the time interval to work with. This is necessary to ensure that by leaping from one time frame to another, filters are not artificially changed. Simply put, do not be like a pig that will always find mud.
1-2-3 Pattern: from Roller coasters to Consolidation
Sometimes after reaching the top, the market falls down like a stone, sometimes it starts to lose momentum and form consolidation ranges. As a rule, in the first case, large players do not have time to take profits at the optimal level, as they cannot find the required number of buyers. In order to reduce the risks of such a scenario, they deliberately try to assure their opponents that the uptrend is not yet complete, and the situation may become favorable for the bulls at any moment. Alas, this is just a deception, a trap created in order to take money from the plankton.
The formation of trading ranges
With regard to the 1-2-3 pattern, to which several previous materials have been devoted, the formation of consolidation allows us to talk about the varieties of the pattern. Often, the trading range is formed within the wave 2-3, but a wider spread of waves should not scare you, because it allows you to implement a variety of strategies.
The most popular variety of 1-2-3 pattern is the Splash and Shelf model described in Linda Raschke's best-selling book Secrets of Top Trading Performance. She assumes the formation of a peak in conditions of a bullish trend with the subsequent formation of consolidation. Within its framework, the big players who have had a change of heart about the Canadian dollar are trying to identify the presence of serious opponents and (or) close the previously formed long positions in the USD/CAD at acceptable levels. The market mood is changing rapidly, and the bears intercept the initiative in case the lower border of the trading range (the shelf) is broken. This is the entry point to the short position. Conservative traders should click SELL after the closure of the breakout bar. It must be below the shelf.
The Splash and Shelf pattern, unlike 1-2-3, is not an exclusively reversal model. It can be played out in BUY on the bullish market if the quotes have approached the upper boundary of the consolidation range, and then took it by storm and took the buyers to the operational space. However, bears often arrange traps for their opponents. One of them is related to the formation of the pattern Fakeout-Shakeout. The key condition for its formation is an unsuccessful testing or the so-called false breakout of one of the boundaries of the consolidation range.
If the quotes of a currency pair return to its middle, there is your entry point to the short position. A stop order should be set at the level of one of the previous extremes. Conservative trading involves entering into shorts at the breakout of the lower boundary of the shelf. In the EUR/USD example, it is located near point 2 of the 1-2-3 pattern. It should be noted that the Fakeout-Shakeout is an independent pattern and often appears in the charts with no connection to 1-2-3.
If the analyzed pair managed to rewrite both extremes one at a time, and then returned to consolidation, then the probability of the Broadening Wedge pattern formation is high. We will talk about it in great detail in one of the following articles. Now I would like to draw your attention to selling at the breakout of the lower limit of the consolidation range 85.85-87.5 in AUD/JPY and setting a stop order at the level of one of the previous highs.
Using consolidations within the implementation of various reversal graphical configurations is the favorite strategy of many traders. Trading ranges give the opportunity to win some time and think about best entry and exit points, position size and risk. As a result, you make a weighed decision that you feel confident in.
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