Notices

1-2-3 formation

From Traderpedia

Definition:
A common chart pattern consisting of 3 definable points.


A 1-2-3 formation is a well known chart pattern which crops up regularly across most liquid markets. Unlike some chart patterns such as a triangle or head and shoulders, which are subjective in nature, a 1-2-3 formation can be accurately defined by an objective set of rules.

Contents

[edit] Simple definition:

Commonly known as "Trader Vic", Victor Sperandeo included this simple definition in one of his books.

Following a trend, a 1-2-3 high or low is confirmed if:

  1. The trendline is penetrated
  2. There is a lower high in an up trend, or a higher low in a down trend.
  3. There is a break below the previous low in an up trend, or above the previous high in a down trend.


image:1-2-3.jpg Examples of a 1-2-3 high

[edit] Complex definition:

Joe Ross is an author, trainer and trader who included this definition is his "Law of Charts" free manual. This definition is more complicated but the spirit is much the same.

[edit] 1-2-3 high

A typical 1-2-3 high is formed at the end of an up-trending market. Typically, prices will make a final high (1), proceed downward to point (2) where an upward correction begins; then proceed upward to a point where they resume a downward movement, thereby creating the pivot (3). There can be more than one bar in the movement from point 1 to point 2, and again from point 2 to point 3. There must be a full correction before points 2 or 3 can be defined.

A number 1 high is created when a previous up-move has ended and prices have begun to move down.

The number 1 point is identified as the last bar to have made a new high in the most recent up-leg of the latest swing.

The number 2 point of a 1-2-3 high is created when a full correction takes place. Full correction means that as prices move up from the potential number 2 point, there must be a single bar that makes both a higher high and a higher low than the preceding bar or a combination of up to three bars creating both the higher high and the higher low. The higher high and the higher low may occur in any order. Subsequent to three bars we have congestion. It is possible for both the number 1 and number 2 points to occur on the same bar.

The number 3 point of a 1-2-3 high is created when a full correction takes place. A full correction means that as prices move down from the potential number 3 point, there must be at least a single bar, but not more than two bars that form a lower low and a lower high than the preceding bar. It is possible for both the number 2 and number 3 points to occur on the same bar.

1-2-3 high
Examples of 1-2-3 highs

[edit] 1-2-3 low

A typical 1-2-3 low is formed at the end of a down-trending market. Typically, prices will make a final low (1); proceed upward to point (2) where a downward correction begins; then proceed downward to a point where they resume an upward movement, thereby creating the pivot (3). There can be more than one bar in the movement from point 1 to point 2, and again from point 2 to point 3. There must be a full correction before points 2 or 3 can be defined.

A number 1 low is created when a previous down-move has ended and prices have begun to move up. The number 1 point is identified as the last bar to have made a new low in the most recent down-leg of the latest swing.

The number 2 point of a 1-2-3 low is created when a full correction takes place. Full correction means that as prices move down from the potential number 2 point, there must be a single bar that makes both a lower high and a lower low than the preceding bar, or a combination of up to three bars creating both the lower high and the lower low. The lower high and the lower low may occur in any order. Subsequent to three bars we have congestion. It is possible for both the number 1 and number 2 points to occur on the same bar.

The number 3 point of a 1-2-3 low exists when a full correction takes place. A full correction means that as prices move up from the potential number 3 point, there must be at least a single bar, but not more than two bars, that form a higher low and a higher high than the preceding bar. It is possible for both the number 2 and number 3 points to occur on the same bar.

The entire 1-2-3 high or low is nullified when any price bar moves prices equal to or beyond the number 1 point.

1-2-3 low
Examples of 1-2-3 lows

[edit] Trading strategies

Because a 1-2-3 formation can be objectively defined, it forms an excellent base on which to build a trading system. There are an infinite number of ways of doing this, but here are some common examples:

[edit] 1-2-3 breakout

  • Buy a breakout of the #2 point of a 1-2-3 low.
  • Sell a breakout of the #2 point of a 1-2-3 high.

A protective stop loss could be placed just below (for longs) or above (for shorts) the #3 bar.

The initial target might be a fixed number of ticks, or the distance between points #2 and #3 "added on" to the entry point*. If this target is met then a portion of the position could be left to run with a trailing stop based on subsequent bar formations.

*So if #3 was at 10000, #2 at 10015 and the trader bought a breakout at 10016 then the initial target would be 10031.

The trouble with 1-2-3 breakouts is that a large number of traders know of them and may all be trying to get in at the same point. Meanwhile professional traders may look to fade the breakout, i.e going the opposite way as all the smaller traders' buy or sell stop entries are triggered.

[edit] 1-2-3 Traders' Trick Entry (TTE)

The Traders' Trick Entry is a term coined by Joe Ross. However the method described below may differ slightly from his original definition.

This method allows the trader to enter at an earlier point in the formation's development. The idea is to "beat the crowd" with minimal risk.

  • Buy on penetration of the high of a potential #3 bar during a 1-2-3 low.
  • Sell on penetration of the low of a potential #3 bar during a 1-2-3 high.

The #3 point is referred to "potential" because subsequent bars can confirm or negate it.

A protective stop loss could be placed just below (for longs) or above (for shorts) the potential #3 bar.

The initial target might be the #2 point or a fixed number of ticks. If there is a breakout at the #2 point then a portion of the position could be left to run with a trailing stop based on subsequent bar formations.

[edit] Notes

Entry would be taken with a stop order or a stop limit order. Both methods are suitable for futures and stocks traded on an exchange. Discretion can be used to filter out some 1-2-3s that do not "feel right". The methods lend themselves well to scaling out.


image:1-2-3TTE.jpg
1-2-3 high and low showing both entry methods

[edit] See also

[edit] T2W links

1-2-3 formations and Ross Hooks forum thread