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Monday, May 30, 2011


123 pattern is the topic of the post. I hope you have heard about this technical pattern or read somewhere on the net. I have been mentioning it in my posts quite often and want to discuss it in more detail today. This technical structure can be found in large, medium and daily trends, usually at the end of them and it is a sign that the trend is about to end. To tell the truth you can find it also in small time frames, but those are not that significant as long time frames. It is a reversal pattern. One thing you will notice with all possible patterns and indicators is that they best work on long term time frames: monthly, weekly and daily charts. Some traders use this reversal formation and trade it without any other indicators on monthly and weekly charts. Daily charts, hourly charts and of course minute charts require more filters in order for you to trade the pattern. 


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Structure of the pattern

Formation in silver (reversal in an uptrend)

Let us study an example with the pattern both in the uptrend and the downtrend in silver commodity. Silver has been in an uptrend since the end of 2008 collapse in the markets. When markets picked up, silver was probably the strongest of all commodities. However, after rallying for quite a long time it finally exhausted itself and in the days of April 25th through 29th  (2011) it formed a reversal pattern and collapsed. So, number 1 was the top of the price (49.78), number 2 was the bottom of the corrective rally down and number 3 was one more attempt to take previous high (unsuccessful one). After that silver went through number two and a downtrend started. 

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Structure in silver (reversal in a downtrend)

After a few weeks silver finished its downtrend by forming 123 pattern in the days of May 12th through 23rd  (2011) and started going up again. So number 1 in this case was the bottom of the price, number 2 was the corrective rally upwards and number 3 was an attempt to take previous low of 32.31 (unsuccessful one). 

Speed of development of the patterns and the pace of trends that follow them

In both situations the price reversal happened very fast. The top was formed in 4 days and the bottom in approximately 2 weeks. It is a general rule that tops are formed faster and downtrend is much faster and more dramatic than an uptrend, while bottoms are formed more slowly and then uptrends develop slowly as accumulation increases with time. When 123 is formed at the top and prices starts going down fear rules in the market. This could be the reason why downtrends are so dramatic. Optimism takes time to develop and that could be the reason why prices do not go that fast in uptrends. It is sometimes said that what bulls have built in 3 months, bears destroy in 1 month. Looking at present markets you can change the ratio and say that what bulls have built during 10 months, bears destroy in 1 month. So, have this in mind when you trade these patterns. A lot of great and famous traders made their fortunes in downtrends. 

We should also remember that markets change and sometimes they develop ugly ranges of 6 months or more and only then a new trend begins. If you looked at gbp/jpy daily chart you would see that we have a lot of swings up and down and no real long trends in the pair for about a year. 

How to trade it

I believe you must know the answer by now. If you have it at the end of an uptrend, you place a sell stop below the point two of the pattern and when it is broken you go down together with the market till it exhausts itself (or another 123 pattern is formed at the bottom). If you have it at the end of a downtrend, you place a buy stop above the point two of the pattern and when it is broken you go up together with the market till it exhausts itself (or another 123 pattern is formed at the top). 

Exit rules can be trickier than those for entering the pattern. If you do not want to use any indicators I would say you should use only long term charts: monthly and weekly (monthly would be more advisable) and search for those patterns on large time frames. In that case you would be a true investor who invests only long term. However, your capital would be much safer. Of course, be sure that you do not invest more than you can afford to lose. 

Trading on monthly charts enables you to trade all possible securities: forex, stocks and commodities. So, you will have more opportunities to trade than you had following just one market. 

If you want to trade the pattern on smaller time frames, you should use 123 pattern as part of your other trading system and never alone, for you will have a lot of bad signals by following the system on smaller time frames. 

How I use the structure for day trading

I like the pattern as it helps me to day trade. I firstly determine the direction the market is in. If it is a swing up I wait for counter trend rally down so that I could add on dips. When the rally does come I open 1 hour chart of the security I am watch and wait for 123 to develop on the chart. Then I follow the same rules for entry I described you above. 

You can in the example below that gbp/usd is in short term swing upwards with higher highs and higher lows. It means you need to wait for counter trend rally to enter your position in the direction of the trend. You see it forming on one hour chart during Asian session and a nice breakout off the pattern during London session. You place the stop below the low of the pattern and take your profits at the previous high.

Good luck in trading 123 patterns. 

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Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.