123 Pattern Reversal Trading Strategy

123 Pattern Reversal Trading Strategy: Setup and Backtest

An essential part of technical analysis is studying the chart patterns, and one common chart formation is the 123-reversal setup, which appears at the beginning of many price reversals. But what is the 123 pattern reversal strategy?

The 123 reversal chart pattern strategy is a three-swing price formation that indicates a potential reversal in trend. It is formed by three price swings or waves with three swing points, which is where the name of the pattern comes from.

The 123 pattern reversal starts with the price swing not making the expected higher high (in an uptrend) or lower low (in a downtrend) and then breaking below or above a support or resistance level as the case may be. This change in price structure can help predict a potential reversal.

In this post, we take a look at the 123 reversal pattern. We end the article by making a backtest of the 123 reversal pattern strategy.

What is the 123 pattern?

The 123 reversal chart pattern is a three-swing price formation that indicates a potential reversal in trend. It is formed by three price swings or waves with three swing points, which is where the name of the pattern comes from. There is nothing special about the chart pattern, apart from the fact that the price swing is no longer making the expected higher high (in an uptrend) or lower low (in a downtrend). However, the change in price structure can help predict a potential reversal.

As with any trending market, the market makes higher highs in an uptrend and lower lows in a downtrend. But when the trend is about to reverse, the price deviates from that structure, making a lower high (in the case of a potential bearish reversal from an uptrend) or a higher low (in the case of a potential bullish reversal from a downtrend).

As you would expect, these are the two versions of the 123 reversal pattern: a potential bearish reversal from an uptrend and a potential bullish reversal from a downtrend.

In the first case, the market is in an uptrend, making a series of higher swing highs and higher swing lows characteristic of a rising price. But at a time, the current price swing up doesn’t manage to rise above the previous high, giving rise to a lower swing high — an indication that the uptrend might be in danger.

If the next swing low breaks below the previous low, automatically implying a lower swing low, a bearish 123 pattern is confirmed, indicating that the prior uptrend has turned, as the recent price structure is now that of a descending market — lower swing high and lower swing low.

The 123 reversal pattern (bearish)

In the second case, the market is in a downtrend, making a series of lower swing lows and lower swing highs, which is characteristic of a down-trending market. However, at some point, the current price swing up doesn’t manage to fall below the previous low, giving rise to a higher swing low — an indication that the downtrend might be in danger.

If the next swing high breaks above the preceding swing high, automatically implying a higher swing high, a bullish 123 pattern is confirmed, indicating that the prior downtrend has reversed, as the recent price structure is now that of a rising market — higher swing high and higher swing low.

The 123 reversal pattern bullish

As you can see, the features of the 123 chart formation are almost the same as with the double top and the double bottom chart patterns, except that the second swing high or low, as the case may be, does not reach the level of the previous high or low. In fact, if you disregard the idea of reaching the same level, the bearish 123 setup is indeed a double top chart pattern, while the bullish 123 setup is a double bottom chart pattern.

Here you can find all our Trend reversal trading strategies.

What is a 123 bottom?

A 123 bottom is the 123 chart pattern that forms in a downtrend, indicating a potential bottom of the downtrend and a reversal to an uptrend. It is the same as a bullish 123 pattern. In terms of structure, the pattern consists of three price swings with three swing points, labeled 1, 2, and 3. Then, there is a confirmation breakout move.

123 pattern (bottom example)
  1. First price swing and swing point 1: This is a downward price swing, in line with the existing downtrend. Where this swing ends marks the lowest and turning point of the downtrend, and it is labeled point 1. Generally, the beginning of every trend correction is a potential turning point. In a valid 123 chart pattern, the price would eventually break its previous trend line after making the swing point 1.
  2. Second price swing ending at the swing point 2: Next, the price makes an upward swing, ending at a point very likely to form outside of the previous trendline or channel. This point is labeled point 2. If this point is outside the downtrend line, there is a good indication that the trend might be ready to end and reverse, as that could mean that point 2 is higher than the preceding swing high.
  3. Third price swing and swing point 3: The third swing is a downward price move that is more like a retracement of the second swing. This swing ends at point 3, which is usually above swing point 1, indicating a higher swing low. In the worst-case scenario, point 2 would be at the same level as point 1, in which case the setup becomes a perfect double-bottom pattern. Pivot Point 3 moving close to Pivot Point 1, but not reaching it is an indication of a stronger 123 reversal pattern setup.
  4. Confirmation breakout: The 123 pattern is confirmed when the next price upswing breaks above the preceding swing high point, point 2. This indicates that the current bullish swing is automatically making a higher swing high than the preceding swing high, thereby giving the emerging price movement the characteristics of an uptrend — a higher swing low (point 3 > point 1) and a higher swing high (the recent wave rising above point 2). With this breakout, the pattern is confirmed, and a new uptrend is underway.
123 pattern breakout (example)

123 pattern strategy trading rules

There are rules for trading the 123 chart pattern. These rules involve trade entry, stop loss, and price target.

123 chart pattern trade entry

The 123 pattern is confirmed when the price breaks above or below (as the case may be) point 2. A trade is entered at the close of the breakout price bar or the beginning of the next bar after it. If the breakout bar is very tall, you may want to wait for a retest of the breakout level.

Some people use buy stop orders placed above point 2. This is not advisable as the price may spike above that level without breaking it (closing above it).

123 pattern strategy trading rules

123 chart pattern stop loss

As with any other strategy, you might use a stop loss order when trading the 123 chart pattern. Place your stop loss order below (in the case of a bullish setup) or above (in the case of a bearish setup) point 3. It may also be wiser to place the stop loss beyond point 1, especially if the market is highly volatile.

Sometimes, volatile market conditions can push the price to go beyond Point 3 for a short period, and it would reverse again to move as expected. Placing your stop loss beyond point 3 preserves it from getting triggered due to this volatility.

123 chart pattern profit target

As with many chart patterns, you can estimate your price target by measuring the pattern itself. Here is how you do it:

  • You measure the distance between point 2 and the midpoint of a line connecting point 1 and point 3
  • Project this distance from the breakout point to get the estimated profit target.
123 chart pattern profit target

However, you can also take partial profits by having multiple profit targets. For example, you can close half of your position at the estimated profit target and let the other half run if you are so upbeat about the emerging trend. Another thing is to use a trailing stop loss to lock in profits while you let the new trend run its course. You may use a moving average to track your trailing stop or simply use a percentage level.

123 pattern strategy example

The 123 chart pattern can be used to trade any market, including stocks, forex, commodities, and even Bitcoin. However, given that stocks have unlimited upward potential and limited downward potential, shorting stocks on the basis of technical analysis alone may not be advisable. For stocks, it is better to trade only the 123 bottom or the bullish 123 chart pattern, as in the chart below:

123 pattern strategy example

Notice the stop loss level and the profit target. But it might be wise to let profit run.

In other markets, such as forex, where you can go long and short as you want, you can also trade the bearish 123 pattern, also known as the 123 top. It is just the exact opposite of the bullish pattern. You use it to find shorting opportunities when a bearish trend is emerging.

123 pattern reversal strategy (backtest)

Let’s go from theory to practice and make a backtest with proper trading rules. The 123 pattern reversal strategy is not among the easiest to backtest because it has somewhat subjective rules.

123 bullish reversal backtest

Our first backtest has the following trading rules (bullish reversal):

  • Today’s low must be lower than yesterday’s low
  • Yesterday’s low is lower than the low three days ago
  • The low two days ago is lower than the low three days ago
  • The high two days ago is lower than the high three days ago

We put in a time exit of N-days and we backtested the strategy on the gold price (the ETF with the ticker code GLD). The results are summarized in the table below:

123 pattern reversal backtest

The first column shows the results for the N-day exit. For example, an exit after 20 days has a profit factor of 2.22. The equity of exiting after 20 days looks like this:

123 bullish reversal backtest

123 bearish reversal backtest

Our second backtest of the day has the following trading rules:

  • Today’s high must be higher than yesterday’s high
  • Yesterday’s high is higher than the high three days ago
  • The low two days ago is lower than the low three days ago
  • The high two days ago is lower than the high three days ago

Let’s backtest again using GLD and exit after N-days:

123 pattern bearish reversal

The table indicates that the bearish reversal indeed shows a weaker performance compared to the bullish reversal. Below is the equity curve when we exit after 20 days:

123 pattern bearish reversal backtest

Can the strategy be improved?

We are not oracles, and we are pretty sure there are traders out there who can improve the strategy. Do you have any ideas on how to improve it?

If so, please comment below or drop us an e-mail.

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123 pattern reversal strategy – conclusion

The 123 pattern reversal strategy is very popular among traders, yet just a tiny few traders have backtested the strategy. In this article, we made trading rules in an attempt to make a backtest of the strategy. The result is somewhat promising for the gold price (GLD) and we are confident it can be improved by adding another parameter.

FAQ:

How does the 123 pattern form?

In an uptrend, the pattern signals a potential bearish reversal when the current price swing fails to make a higher high. Conversely, in a downtrend, it indicates a potential bullish reversal when the current price swing fails to make a lower low. A 123 bottom is a variation of the 123 pattern that forms in a downtrend, suggesting a potential reversal to an uptrend. It consists of three price swings with three swing points and is confirmed by a breakout move.

What are the trading rules for the 123 pattern strategy?

The 123 pattern reversal strategy is a three-swing price formation indicating a potential trend reversal. It consists of three price swings with three swing points, suggesting a change in market direction. Trading the 123 pattern involves entry at the breakout of point 2, stop loss placement below (for bullish setup) or above (for bearish setup) point 3, and setting a profit target by measuring the pattern itself.

How can I estimate the profit target for the 123 pattern?

The 123 pattern can be used to trade various markets, including stocks, forex, commodities, and Bitcoin, providing flexibility in application.Measure the distance between point 2 and the midpoint of a line connecting point 1 and point 3, then project this distance from the breakout point to get the estimated profit target.

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