There are numerous methods of technical analysis, and it is impractical to learn them all. At such times, we need to filter out some that are more universally applicable and simple yet effective technical criteria to help us enter a profitable state more quickly.
My own trading system uses the 1-2-3 rule, which was proposed by Victor Sperandeo in his book "Trader Vic: Methods of a Wall Street Master." This rule is used to determine trend reversals.
He has over 40 years of trading experience across various fields and has not suffered losses for more than a decade. Based on Dow Theory, he simplified the complex identification and following of trends into the 123 rule and the 2B rule, which are well worth learning.
The reason I particularly like this rule is that it is simple and easy to use, easy to learn, and can be applied in many different scenarios, including as a standard for judging trends, as well as standards for entry, exit, and stop-loss, applicable in different time frames and markets.
Today, I will explain the 1-2-3 rule clearly, including its pattern standards and four practical applications, so that everyone can quickly apply it to their own strategies.
1. What is the 1-2-3 rule?
Many friends may not be familiar with the term 1-2-3 rule, but everyone should have seen the pattern of the 1-2-3 rule in trading.
Below, I will summarize the 123 pattern in words, and it will be easy for everyone to understand when referring to the images.
Top reversal:1. Prices reach a new high (Point 1)
2. Prices pull back, forming a secondary low (Point 2)
3. Prices rise again, but fail to reach a new high (Point 3)
4. Prices break below the secondary low (Point 2) = Confirmation of trend reversal
Bottom Reversal:
1. Prices reach a new low (Point 1)
2. Prices rebound, forming a secondary high (Point 2)
3. Prices fall again, but fail to reach a new low (Point 3)
4. Prices break above the secondary high (Point 2) = Confirmation of trend reversal
By this point, one should have an epiphany that the 123 pattern is essentially a rise-fall-rise, or fall-rise-fall structure at the top or bottom.And the reason it can be used to confirm trend reversals is also derived from the concept of trend reversal in Dow Theory: during the rise in the market, it no longer sets new highs, and during the pullback, it breaks below the previous pullback low, breaking the definition of a trend as "ever-rising highs and pullbacks that do not break the low," so the appearance of a reverse 123 pattern can be understood as a trend reversal.
The pattern of the 123 rule is not complicated; the key is its application in practical combat. So, I will explain four practical application methods of the 123 rule next.
2. Practical Application of the 1-2-3 Rule
In Victor Sperandeo's logic of using the 123 pattern, a trend line is added as a resonating indicator, requiring the market to break the trend and then form a 123 pattern to be considered as a standard for confirming a reversal.
The purpose of doing this is because the 123 pattern is a basic pattern of the trend, which is very common on the chart. If other indicators are not added for filtering, the stability will be relatively poor.
If you are not proficient in using the trend line, you can also add one or two moving averages to resonate with the 123 pattern to confirm, which can also achieve the effect of improving stability.
In the chart on the left, after the market broke above the downtrend line, it formed a 123 reversal pattern, and the market reversed upwards. On the right side of the chart, at the top, a downward 123 pattern was formed, and the market broke downwards at the same time, breaking through the moving average, and the market reversed downwards.
Usage one of the 123 pattern: Confirm the trend.
Confirming the trend is the first step in trading. After confirming the trend, you can proceed with trend-following operations.
The basic logic of the formation of the 123 pattern we discussed above allows us to discover that the 123 pattern, like the double top and double bottom patterns, as well as the head and shoulders pattern, are all reversal patterns. The point where the market reverses and breaks through is when the market starts from point 3, breaking through the break point of point 2.After a period of a bullish or bearish trend, the emergence of a reverse 123 pattern can be interpreted as a trend reversal.
Following a continuous bullish trend, the appearance of a bearish 123 pattern confirms that the trend is about to decline.
After a continuous bearish trend, the emergence of a bullish 123 pattern confirms that the trend is about to rise.
I will not provide any more images here; the images above illustrate the two scenarios where the 123 pattern confirms a shift from a bearish to a bullish market and vice versa.
Let me remind you once again: only a reverse 123 pattern following a trend has the significance of a reversal.
The second use of the 123 pattern: as a signal to close or reduce positions.
There are two reasons for using the 123 pattern as a signal to close positions.
Firstly: The 123 pattern is a reversal pattern for tops and bottoms. In trend-following trading strategies, the principle of closing positions is to exit when the market shows a reverse pattern, and the 123 pattern fits this perfectly.
Secondly: Comparatively, the 123 pattern occurs more frequently because it is derived from the basic laws of trends. Often, market reversals do not necessarily form double tops or double bottoms or head and shoulders patterns, but the probability of a reverse 123 pattern appearing is quite high, and its widespread occurrence allows for timely position closure.
Therefore, in trend trading, one should always hold positions and wait for the market to show a reverse 123 pattern before closing the orders.The chart shows the 15-minute candlestick chart of gold.
After a continuous large space decline, the market formed a reverse 123 pattern at the bottom, and after the price broke through the 2401 liquidation point, the order was closed.
The 123 pattern can also be used as a signal for reducing positions. Still, using the example of gold, after the market formed a reverse 123 pattern at a low level, only a part of the position was reduced, and the remaining order continued to hold, aiming for greater profits.
Some traders even use the reverse 123 structure of different time cycles as the standard for reducing and closing positions.
For example, after entering the market on the hourly chart, first, a 5-minute reverse 123 is formed to close 30%, then wait for the 15-minute reverse 123 to close another 30%, and the remaining position is fully closed when the reverse 123 appears at the hourly level.
Using the 123 pattern to reduce positions, the signal for reducing is dynamic, more objective and flexible, which is very helpful for protecting profits and stabilizing trading mentality.
The third use of the 123 pattern: entry criteria.
The 123 pattern is a pattern of breakthrough, and breakthroughs are usually signals for the market to start, coupled with the high frequency of occurrence of the 123 pattern, so the 123 pattern can be used as a signal for order entry.
The breakthrough point of the 123 pattern is easy to identify, with clear and definite points, and it is highly feasible in practice.
The chart shows the candlestick chart of the euro against the US dollar, with the left side being 1 hour and the right side being 5 minutes.After completing the first wave downward in 1 hour, a correction unfolds, testing the 38.20% Fibonacci retracement level. Upon encountering resistance, observe the 5-minute chart pattern. When a bearish 123 pattern break occurs, enter the position with a stop loss at point 1, which is the high point of the pattern.
The market then continues to oscillate but does not break the high point again. After two days of consecutive oscillation, it finally breaks downward.
Some friends may have noticed that I am using a 5-minute candlestick entry, not at the 1-hour level, because the entire structure of the 123 pattern requires many candlesticks to form. If the 1-hour candlestick is used directly as the entry signal, the signal will be delayed, and the stop loss space will be large. The flexibility in actual combat is too poor, especially for swing trading or short-term trading, it is best to use a smaller time frame pattern for entry.
Use of the 123 pattern in combination with the RSI indicator:
The RSI overbought/oversold has two significant drawbacks.
1: Overbought/oversold points to an area. As the market continues to rise, the RSI enters the overbought area, and the corresponding area on the candlestick chart is also an area. Where exactly should one enter the position?
2: In a continuous one-sided market, the RSI indicator becomes dull. For example, as the market keeps rising, the RSI indicator will keep overbought, return, overbought again, and return again. At this time, without reasonable trading signal screening, there will be a serious consecutive stop loss.
In practice, the 123 rule can be used as a trading signal, which allows for more precise entry in the overbought/oversold area. It can also filter out some wrong signals when the RSI indicator becomes dull and ineffective, increasing the success rate of trading.
The chart shows the 1-hour candlestick of gold. In a rising trend from 2355 to 2403, the market formed a top overbought near 2390. At this time, there was an expectation of a correction or decline, but there was no downward 123 pattern formed on the candlestick chart, and there was no entry signal. Afterward, the market continued to rise, avoiding a wrong trade.
When the market tested 2403, the RSI was overbought again, and for a long period, it remained in the overbought area above 70. Wait until the 123 pattern is formed before entering. After the market consolidated and formed the 123 structure, it broke and entered at the position of 2394, and the market fell.Here is the translation of the provided text into English:
This is in the context of an hourly candlestick chart, where one enters a position using the 123 pattern at this level, so the exit should also be on the same level candlestick chart to ensure a reasonable profit margin.
The 123 rule is a technical standard that I have found to be very effective in my current use. It can also be combined with other technical indicators to create more practical strategies. We can master it thoroughly, and trading will definitely improve.
