1-2-3 – The Foundation of Potential Change in TrendBy on 2012 Mar 17 Sat 18:56:58
Part of Art of Chart Reading
If there is only one chart pattern you are allowed to learn, 1-2-3 is the one.
1-2-3 is often a reversal pattern that marks the termination of a trend. The pattern is made up of 3 swings where the first and third swings are pointing to the opposite direction of the current trend. Once the third leg has exceeded the first one the setup is triggered in the direction they are pointing to. If the 1-2-3 setup happens at important support/resistance price level, it often signals a major reversal, or at least a more significant pullback in the making.
Following is an example of 1-2-3 Sell from a 5-min chart of emini S&P.
First leg is marked in red, second leg is marked in blue, and third leg is marked in orange. The green horizontal line is the triggering line based on the start of the second leg. Once the pattern is triggered, meaning that the orange line breaching the green line, the end of second leg should act as resistance (the purple line). Sometimes that would be violated but the 50% level of first leg acting as resistance can still keep the pattern intact. As long as this resistance zone is not breached, it is more likely that price will continue to move lower.
It is important to remember that first leg must be at least as strong as the previous up swing to make this a good reversal pattern. From our example, the first leg is one quick drop has taken out the previous swing low.
Here is an example of 1-2-3 Buy.
Using the same colouring scheme, first leg is marked in red, second leg is blue, third leg is orange. The green horizontal line is the triggering price level.
Notice how the first leg in one quick swing taking out the swing highs before the start of the leg.
And that there is a mini 1-2-3 buy at the start of first leg too.
The Big Picture
It is now time to show you how the 2 setups played out historically.
The 1-2-3 sell setup is the beginning part of the chart above.
Since then, the price started to move lower and at the bottom of the price move, it keeps failing to go higher until the 1-2-3 buy setup finally showed up to break the down trend.
Many bots are programmed to monitor this swing structure concept. The moment a down trend defined by lower low swings and lower high swings is broken, these bots would bail out of their short positions quickly to protect profits or even jump onto the long side if there are other things supporting to go long.
The 1-2-3 Failure
A 1-2-3 pattern can fail. When it fails, it will turn into a continuation pattern for the original trend. Thus, it is not a good idea to average losers or keeping a wide stop if you trade the pattern on confirmation only (i.e. after the break of the green line).
For example, a 1-2-3 sell formed after a top that was produced from an explosive up move may not work out even if it happens at some important resistance price zone. The reason is quite simple. There are enough trapped shorts that have to bail out and have not yet done so. Hence at the first opportunity to bail out at breakeven or a smaller loss, these trapped shorts will be the renewed supply of buyers.
The moment the 1-2-3 sell resistance area (i.e. the purple line to slightly below the start of the first leg) is breached, especially with a much shorten third leg relative to the first one, will product a powerful continuation move. This is often manifested in the form of an unevenly shaped bull flag.
1-2-3 as Primary Entry Method
Most self-taught traders prefer entering a trade early. What I mean by that is not necessarily fading a move, or, picking a top or bottom. Instead, traders often like to enter their trade at a more favourable price level once early signs that their trading setups could be in place. It is not really a matter of good practice or bad practice in terms of trading. It is just a personal preference.
When you enter a trade, specifically a potential reversal, at the early stage of the formation, you risk reducing your probability of getting a winning trade because all the necessary conditions may not happen afterwards. On the other hand, the early entry likely gives you a better entry price and in turn reduced the risk. That, if done properly, this will offset the reduced winning rate. The key thing to remember here is that you have to be consistent in your approach. If you like to enter a trade without all the confirmations first in exchange for a better entry price, then have an absolute exit plan in place and do not deviate from that, because being able to control your risk is the only way to ensure that you gain back the advantage from better profit factor.
This is where 1-2-3 pattern can really help. If your early entry produced a 1-2-3 setup right after to confirm the direction of your trade, you know you are in good shape. You can also reduce your risk in the trade quickly if mini 1-2-3 happens at the early stage of the reversal, making it possible for you to cut down the risk further.
If you choose to enter your trade based on confirm signal, in this case the breaking of the green line price level, your entry price is quite far away from the actual start of the move. The interesting fact on this is that you gain significant short term advantage from entering the trade later in both winning rate and also a strong bias of price going in your favour for at least a short period of time. Some traders take advantage of this bias to scale out part of the position quickly to lock in a small profit there. This extra profit generated from the scalping would compensate the profitability of the rest of the positions taken and making the ride of the rest of the trade a bit easier emotionally.
Another form of trading based on 1-2-3 confirmed signal is straight-forward scalping off the signal itself. Instead of waiting for an important reversal and try to enter the trade on the first 1-2-3 setup only, the scalpers would trade mainly the 2nd, 3rd and sometimes 4th continuation break. The advantage of this is that the entry and exit rules are well defined and can be done in higher frequency timeframes mechanically.
Many reversal patterns in higher timeframe often start with a 1-2-3 formation that is visible in the smaller timeframe only.
For example, a double bottom formation visible on hourly chart often have its right side second bottom rally off a mini 1-2-3 buy that is only visible in 15-min or higher resolution charts. Thus, it is possible to anticipate the development and completion of more complex price patterns by paying attention to the smaller timeframes that has 1-2-3 in the making. This gives one the ability to join a run before the complex price patterns are fully developed.
Think of it like a waterfall effect where the smaller timeframe reversal giving the market a shock that in turns catching the higher timeframe players by surprise and by running through their stops. The last chart above showing the big picture scenario is a good example. The double bottom formation of that chart was started from a tiny 1-2-3 buy that zoomed the price higher, which in turn breaking the double bottom neckline in one swing. That turns into a bigger 1-2-3 buy and the snowball effect forced the price much higher quickly.
I hope I have covered all the basics on using 1-2-3 here.