The 123 pattern is a reversal
chart pattern which occurs very frequently and has a very high success ratio.
123’s occur at the end of trends
and swings, and they are an indication of a change in trend. They can also be
found within a trading range, and they take place when the directional momentum
of a trend is diminishing.
In the above illustrated example,
we have a typical 123 formation forming at the end of a downtrend.
Price will
make a swing low (point 1), retrace upwards to a swing high (point 2), where a
downward correction begins. Price would then form another swing low (point 3),
which is higher than the previous low (point 1).
From this higher swing low (point
3) price then resumes the upward movement, thus confirming the change in the
trend. A long trade is then entered when price breaks the previous high formed
at point 2.
Since this is all that the
pattern consists of, it is very easy to spot for a confirmation of the change
in trend.
At this point, everybody is going
long creating the extra momentum for the upwards trend.
This is because trader’s, who had
anticipated the downtrend to continue, would have placed their stops above
point 2 of this pattern. And when these stops are hit, these breakout traders
will tend to cover their positions by going long, driving the price up with
thrust.
Trade parameters.
Once this pattern has been
spotted, let us define some very simple rules for managing the trade.
Entry - The
ideal entry should be taken on the break of the point 2 – the previous high (or
low as the case maybe)
Stop -
The stops to be placed beneath the low of point 1. Aggressive traders may even
place the stops below the point 3, but it is always better to give price enough
room to move without hitting the stops.
Price targets -
While this pattern does not give any projected target, a minimum
target can be estimated by the measured move concept.
Calculate the distance from the point 1
to point 2 in the formation. Add this to the low of point 3, and this should be
the minimum distance that price will travel to.
Some practical points.
The setup of the entire pattern
from point 1 to 3 could take place in 3 bars or as long as 20 bars. But the
rules of pattern remain the same.
A point to keep in mind here is
that more the number of bars involved in the setup, bigger should be the move.
This is not a fixed rule, but more often not, this concept is followed by the
price.
Allow the pattern to prove itself
before entering a trade. If point 3 forms below point 1, the pattern is
negated.
Similarly price has to break the high of point 2 for confirmation.
There will be times when price will consolidate
within the area of points 2 & 3, without giving any indications of the
direction. At such times it is better to stay out, till price action confirms a
direction
Example of the setup - a bearish 123
pattern
In this example we can see that
price was initially in an uptrend. Price then moves down and a simple trend
line break will give us the indication of a change of trend. It is here that we
label the swing high as point.1 of the formation.
In this new downtrend, we then
have a swing low from where price retraces up again in the direction of the
previous uptrend. We label this as point.2 of the formation.
Now at this point, even though we
have the two initial points of the formation, we are not sure if this is a
retracement of the uptrend, or a reversal to the downtrend.
The confirmation comes when price
makes a swing high, which is lower than the high of point1 (the point.3). This
tells us that price does not have the momentum to break the previous high, thus
indicating a change of trend.
If you notice, we mentioned that
it only indicates a change of trend. This could just be a consolidation where
price could be pausing before resuming the uptrend again. This is where we wait
for the confirmation. As soon as price breaks the low of point.2, we enter the
trade.
As per our conditions, we place
our stops above the point.1 of the formation, and estimate the minimum distance
that price should go to. As we can see, price easily surpasses the minimum
distance, giving a good short trade.
Example of the setup - a bullish 123
pattern.
Trend line entry
An aggressive entry can be taken
on the break of a trend line plotted from the point 2 to 3.
While the profit objectives and
the stop levels remain the same, one must apply money management rules to this
type of trades, and take partial profits at the initial levels.
Target zone.
A pre-defined
exit / target of a trade is very important. If one has a fair estimate of the
extent of the move, then a trader can apply proper money management principles.
One can thus, take profits at certain levels and use trailing stops to reduce
the risk.
Let us define the exit for this
pattern by creating a “target zone” with a confluence of 2 different factors.
1.) The measured move concept.
2.) Fibonacci
Expansions
Fibonacci ratios
Fibonacci ratios are a very
popular tool among technical traders and are based on a particular series of
numbers identified by mathematician Leonardo Fibonacci in the thirteenth
century.
The Fibonacci sequence of numbers is as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc
One of the
remarkable characteristics of this numerical sequence is that each number is
approximately 1.618 times greater than the preceding number.
This common relationship between
every number in the series is the foundation of the common ratios used in
retracement studies.
The key Fibonacci ratio of 61.8% -
also referred to as "the golden ratio" or "the golden mean"
- is found by dividing one number in the series by the number that follows it.
For example: 8/13 = 0.6153, and 55/89 = 0.6179.
The 38.2% ratio is found by
dividing one number in the series by the number that is found two places to the
right. For example: 55/144 = 0.3819.
The 23.6% ratio is found by dividing one number
in the series by the number that is three places to the right. For example:
8/34 = 0.2352
Using the
Fibonacci ratios.
For some reason, these ratios seem
to play an important role in the financial markets, just as they do in nature,
and can be used to determine critical points that cause price to reverse.
Price has an uncanny way of
respecting Fibonacci ratio’s, often quite precisely. Hence one can use the Fib
ratios to ascertain the correct technical levels.
Price action is never random, and every
wave leaves behind the clues for the next move. We can thus, use the previous
price action to determine the anticipated price movement.
A common mis-interpretation of the
Fibonacci numbers is that traders tend to use the same Fibonacci ratio for all
kinds of situations.
Just like the different tools in a
carpenter’s tool box, each ratio should be used in a particular situation.
Using these ratios in a proper way gives us a tremendous advantage
over the crowd.
Fibonacci
Expansions
The Fibonacci expansion is a great tool for establishing profit
targets.
It offers a distinct advantage
over the other usual fib ratios, since it isn’t as widely used by traders.
Rather than drawing levels
“behind” the market, the fib expansions draw them in “front” of the market.
In other words, if the market is
moving up and making new highs, the standard fib retracements will draw levels
BELOW the current price, but the fib expansions will draw levels ABOVE the
current price.
The fib expansions determine where
prices could potentially move to. The advantage is that these levels are drawn
“front” of the market.
To draw Fibonacci Expansion
targets, we require three swing points. Below is a picture of what Fibonacci
Expansion Targets look like:
We measure the distance from
Point A to Point B. However, we can’t project price targets until Point C has
been established. Only when Point C has been formed do we have the necessary
three swing points.
In short, we identify a trend
that has started and pulled back, forming Points A and B, and wait for Point C
to form.
Once Point C has formed, we plot
the Fibonacci Expansion Tool on Point A, Point B, and Point C.
The Fibonacci Expansions are ideal for
estimating the price objectives of a 1-2-3 pattern.