Reversal Strategy: The 1-2-3 Pattern

Introduction

One of the reversal strategies that can be used to trade market reversals is the Fibonacci-based 1-2-3 pattern strategy. No matter how far markets move, there will always be room for a market reversal when the fundamentals which pushed the previous trend change. The 1-2-3 reversal pattern is designed to catch such market reversals way before they occur so that at the time of the reversal, you would already be waiting to pull the trigger.

The 1-2-3 reversal strategy depends on the trader being able to:

  1. Recognize a setup for a market reversal.
  2. Convert the setup into profits.

The Strategy

Pattern identification starts with identifying the 1-2-3 movement of the price action on the charts. The daily chart provides room for such analysis, though the 4-hr chart can also be used as a substitute. These charts are used for trend identification. True market reversals are predicted from the true trend. Smaller time frame charts do not show the true trend as they only reflect intraday market movements.

Once the trend is identified, the next step is to identify the 1-2-3 pattern when it occurs. The “1-2-3” sequence is the move the price action makes prior to the reversal. The price action moves in the trend and either tops out or bottoms out at point 1, moves in the opposite direction as a retracement to point 2, then moves back in the initial trend direction to a point 3 which represents a Fibonacci retracement level of a line 1-2, then the price action moves in the reversal mode from point 3, taking out a key level of support or resistance formed by point 2 in its path.

So identification of the 1-2-3 reversal setup requires an understanding of these points:

  1. You need a trend line tool to draw the line from point 1 to 2.
  2. You need the Fibonacci retracement tool to identify the 38.2% or 50% retracement of a line drawn from point 1 to 2, which is lower than point 1 in an uptrend and higher than point 1 in a downtrend.
  3. The retracement level is point 3.

Understanding the extent of retracement will therefore aid the trader as to where the entry for the reversal trades will be made.

a) Short Trade

The short trade is a downside reversal following the 1-2-3 pattern forming from a previous uptrend. The uptrend tops out at point 1, then reverses downwards to find support at point 2. Point 3 is a 38.2% or 50% retracement of a line drawn from line 1 to 2. Point 3 is at a lower horizontal level than point 1. From point 3, price reverses downwards, breaking the support at point 2. The trade is actually initiated at the point where this support level is broken. So all the trader needs to be doing is looking out for the 1-2-3 formation which forms prior to the trading point.

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Once the 1-2-3 pattern is identified, the next stage is to trade the break of the support at point 2. A horizontal line needs to be drawn from point 2 outwards, so that the line can be used as the entry point, as well as the reference point for setting a Stop Loss.

 

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1-2-3 Reversal Setup for Short Trade

 

We can see from this snapshot that Point 3 is at the 61.8% retracement level of line 1-2 (not shown). This can be confirmed by tracing the Fibonacci extension tool from point 1 to 2 and making a note of what level point 3 will lie on. The price moves downward from point 3, and the trade can be taken as a Sell order on breakout of the horizontal support at point 2.

b) Long Trade

The long trade is an upward reversal following the 1-2-3 pattern forming from a previous downtrend. The downtrend bottoms out at point 1, then reverses upwards to find resistance at point 2. Point 3 is a 38.2%, 50% or 61.8% retracement of a line drawn from line 1 to 2. Point 3 is at a higher horizontal level than point 1. From point 3, price reverses upwards, breaking the resistance at point 2. The long trade is actually initiated at the point where this level is broken. So all the trader needs to be doing is looking out for the 1-2-3 formation which forms prior to the trading point.

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After allowing for formation of points 1, 2 and 3, draw a horizontal line from point 2 outwards to form the reference resistance line. Go long when this resistance line is broken by upward reversal price action. Sometimes after the candle has closed above the resistance line, the price action may attempt to pullback to the broken resistance. When this happens, enter long at that point. A Limit Buy order will work fine in this case.

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1-2-3 Reversal Long Trade Setup

 Stop Loss

The horizontal line is the reference line in this case, and a stop loss placement few pips below the line (long order) or above the line (sell order) will work ok. This line is usually a strong level of support or resistance and will usually hold most of the time.

Take Profit

The Take Profit is usually left at the discretion of the trader. However, this must be set according to sensible guidelines. For instance, a trader may decide to set the Take Profit as double or triple the stop loss, or may decide to use a trailing stop once a set number of pips has been attained.

Conclusion

The 1-2-3 reversal strategy must be rehearsed on a demo platform. Careful attention must be paid to the use of the Fibonacci tool in determining point 3, and also to drawing the complete 1-2-3 pattern once it has formed.

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