The lower highs and lower lows pattern signals a downtrend. Is this likely to continue or reverse?
In almost all markets, the lower high and lower low pattern signals a short-term reversal. We develop multiple lower high and lower low trading strategies.
The lower highs and lower lows pattern
The pattern is pretty self-explanatory, but let’s show it on a chart:
The chart has two lower highs and lows in a row. The second candlestick marks a pretty strong reversal. As you’ll see in this article, this is a short-term reversal pattern.
Is lower high and lower low a reversal or trending pattern?
Let’s test the pattern on three different asset classes: the S&P 500 (SPY), the gold price (GLD), and long-term Treasuries (TLT).
Trading strategy 1: one bar lower high and lower low:
This is the result in S&P 500 (SPY):
The first column shows the holding period in days. The first row shows that if we exit on the next day’s close the average is 0.09%. If we exit after two weeks (ten trading days), the average increases to 0.47%. For comparison, the average gain for a random two-week period is 0.44.
Clearly, the longer the holding period, the better the result. This is expected because of the long-term tailwind by owning stocks.
We also see a declining number of trades the longer the holding period. This is because the pattern seems to happen in “clusters” and thus we get many signals in a short period of days.
This is the result in the gold price (GLD):
This is the result in long-term Treasuries (TLT):
The results indicate that the lower highs and lower lows pattern is a reversal pattern.
But the pattern is in the plural form, not singular form: lower highs, not lower high. Let’s see what happens if we use a two-day pattern.
Trading strategy 2: lower high and lower low two days in a row:
In this backtest we go long at the close of the second day when both the low and high have made lower readings than the previous day for two consecutive days.
We start with the S&P 500:
Perhaps as expected, we can see that the average gains improve slightly.
Let’s test the gold price (GLD):
Let’s see what happens in long-term Treasuries (TLT) when we use the two-day pattern:
Using a two-day pattern doesn’t help in TLT, either.
The lower highs and lower lows pattern that works
Let’s make a final test.
Short-term reversals work best in the stock market, and we make a final twist to our strategy:
We go long at the close of the third consecutive lower low and lower high. We sell after n bars:
Both the average gain and profit factor increase. Perhaps even better, the max drawdown is pretty low at 9.9% if we hold for just one day (exit at tomorrow’s close).
Conclusion about the lower highs and lower lows pattern:
Out tests reveal that the lower highs and lower lows pattern is a typical short-term reversal pattern that works well in stocks.