The 1-2-3 Pattern

If you have been trading for any length of time, you are very aware that a stock doesn’t simply trade straight up or straight down. It tends to stair step its way higher or lower. That is, prices rally, pull back and then rally again advancing with each new step. If correctly identified this stair stepping pattern can make for some very profitable trading. There is a name for this type of trading pattern; it is called the 1-2-3 pattern.

There are undoubtedly some people who base their entire trading off nothing other than these 1-2-3 patterns. Because of the nature of market behavior, it is next to impossible for a market to go up very far without creating some type of 1-2-3 pattern. In short, it is a basic indication of how markets move. If a market is making higher swing highs and higher swing lows, it is going up. If it is making lower swing lows and lower swing highs, it is going down.

Let’s talk about a potential buy signal. A 1-2-3 pattern is formed when the market has made a low point at some level, traded up in the next few periods to make a high, then fallen back down to a low that is higher than the previous low. These points (low-high-low) can be labeled as 1, 2, and 3 in that order. Once the market takes out the #2 point, a buy signal is indicated.

Some people only consider a 1-2-3 pattern to be in effect when the #1 point is the lowest low on the chart. However, we will consider any combination of (low-high-low) that forms the 1-2-3 pattern to be a potential buy signal.

It is even possible for the #3 point of a 1-2-3 to become the new #1 point in a higher 1-2-3. In a strongly trending market, you may find numerous 1-2-3’s in the same trend.  

Here is an example of a 1-2-3 buy pattern. The chart below is a 512-tick chart of the S&P E-Minis. [ES]. As you can see on the price chart, I have outlined where points 1-2-3 occurred. Marking a signal line at the high point or #2, we have a potential trigger price once prices move higher off point #3. As prices stair step their way higher, climb, and close above point #2, a buy signal is generated. The trader has the option of buying on a pull back to point #2 (the white line) or waiting for a deeper pullback to support such as a moving average. A very aggressive trader could use a Buy Stop order to get into the trade as soon as point #2 is taken out. My preference is to wait for prices to close above point #2 and then put in a buy order at the same price as point #2. In the example below, once prices close above point #2 or $1075.25, then I place a buy limit order at $1075.25, as prices quickly retrace, my order is filled and I ride the trend higher. Generally, speaking I will use a two-point stop and look for a minimum upside profit of one point. If the market is trending, then I’ll look for more profit.



Of course, markets don’t always move higher, they also move to the downside and so we need to have 1-2-3 sell patterns as well. A 1-2-3 sell sets up when the market has made a high point at some level, traded lower in the next few periods to make a low, then climbed back up to a high that is lower than the previous high. When the market trades back down past the low #2 point and closes below, we have a confirmed 1-2-3 sell signal.

The 1-2-3 pattern is a simple yet effective way to trade a market that it trending either higher or lower. It offers clear-cut signals as when to enter a market and it could be used as a stand-alone system. However, you’ll likely increase your chances of success if you combine it with one or two of your favorite other indicators.

QUIZ

1. True or False. If a market is making higher highs and higher lows, it is going up. If it is making lower lows and lower highs, it is going down.
2. True or False. A buy signal is given if prices rise above point #2. 
3. True or False. A 1-2-3 sell pattern is confirmed when prices close below point #2. 

1. True.
2. False. Prices must close above point #2, not simply move above and then back down again.
3. True. 

Chris Coval
chris.coval@incometrader.com