By Don Dawson, Online Trading Academy Commodity Futures Instructor
As far back as my early days of plotting price charts on graph paper, this particular pattern has always kept my attention. I would find these patterns at market tops and bottoms. The problem was I also found a fair amount of them in the middle of the tops and bottoms, too. Over the years I noticed people started putting several of these patterns together to help identify the bigger picture and larger trend changes. There are two patterns I will show you that make up this reversal pattern. I will show you how to identify this pattern, some possible entry techniques and possible stop placements.
Notice I said "possible" on the entry and exit techniques. As I have said in the past, we are all individual traders and we must find something that fits our own style and comfort of trading. There is no Holy Grail or one strategy that works for all. So take a look at this and see if you can incorporate it into your trading plan.
The first pattern is one you will find at market tops. It takes 3 bars (minutes, daily, weekly, monthly) to make this pattern. What you are looking for is a situation where supply exceeds demand at the market top. You will see below that bar B made a new high over bar A but bar C made a lower high. The formula would look like this: B High > A & C High. Because bar C could not make a new high, this is where the supply came into the market for the moment.
Figure 1
To identify this Supply pattern, just remember to look for a situation where the highs of bars A & C are less than the high of B. The close makes no difference in this pattern. Also, the bar lows are irrelevant. If you are using Candles, use the exact high of the Candle, not just the body. We are just concerned with the highs of the 3 bars (bars must be sequential). This is the Supply pattern. Now let's go look at the Demand pattern.
The second pattern is one you will find at market bottoms. It takes 3 bars (minutes, daily, weekly, monthly) to make this pattern. What you are looking for is a situation where demand exceeds supply at the market bottom. You will see below that bar B made a new low under bar A but bar C made a higher low. The formula would look like this: B Low < A & C Low. Because bar C could not make a new low this is where the demand came into the market for the moment.
Figure 2
To identify this Demand pattern just remember to look for a situation where the lows of bars A & C are greater than the low of B. The close makes no difference in this pattern. Also, the bar highs are irrelevant. If you are using Candles, use the exact low of the Candle, not just the body. We are just concerned with the lows of the 3 bars (bars must be sequential). This is the Demand pattern.
Now that you have seen how to identify these patterns perhaps you can understand why they were so elusive to use by themselves. If you go back and review some charts you will see that the majority of tops and bottoms in markets contain one of these two patterns. You will also see many of them on your charts while the trend kept going in one direction. Below I will describe how you incorporate both the Supply pattern and the Demand pattern to help better identify these market turning points.
The pattern is called a 1-2-3 reversal. No, this is not that reversal pattern a gentleman who wore the cowboy hat sold us many years ago claiming to make you rich beyond your dreams. Many of you traders who have been around for several years will remember who I am referring to.
A point about using a reversal pattern deserves to be made here. Remember, a reversal pattern must have something to reverse. That simply means there must have been a trend to reverse when you spot this pattern. Do not try and use this in a sideways market; there simply is nothing for this reversal pattern to reverse. Below is a chart of a nice downtrend in the ES contract. We will start to look for a 1-2-3 reversal pattern here to go long the market.
Figure 3
Identifying the 1-2-3 is a very simple process. In this example we are looking for a buy signal. To get a buy signal you must have two Demand patterns (yellow rectangles) and one Supply pattern (aqua rectangle) making up the 1-2-3 pattern after a downtrend in the market. Below is a chart of our ES market identifying these patterns.
Figure 4
After an extended downtrend, you start looking for your #1 point first (Demand pattern). After market shows this pattern, watch for the rally and start to look for a #2 pattern (Supply pattern). Then the market will retrace that move to create the second Demand pattern at #3. Important point here is that #3 does not make a lower low than point #1 low.
Below is a chart showing where you would enter your Long position and place your protective stop.
Figure 5
For profit objectives you have some options with this strategy:
- Use Fib Projections off of the 1-2-3 pattern
- Look to the left of the chart and find a Resistance level
- Use a trailing stop to follow the new trend for as long as possible
Another tool to help with this pattern is using the MACD (standard settings). Make sure that the MACD is trending in the direction of your trade when you get your buy or sell signal.
Figure 6
For sell 1-2-3 reversal patterns you just reverse the pattern. You are looking for an extended uptrend. Then look for a Supply pattern (#1). This is followed by a market pullback forming a Demand pattern (#2). From there the market rallies up to create the second Supply pattern (#3). Make sure that the #3 high is lower than the #1 high. You then enter the market once the price breaks the #2 low and a protective Stop goes over the #3 high. Again, you can look at the MACD and see if the trend is confirming this reversal.
Figure 7
And there you have a very powerful market reversing pattern. This may seem a little confusing at first but once you go over this again, I am confident you will get a good grasp of how to use this technique.
Best of luck with your trading and I leave you with this thought, "It's not knowing what to do, it's doing what you know."
- Don Dawson
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