Lower Highs And Lower Lows Pattern Trading Strategy (Setup and Backtest Analysis)

The lower highs and lower lows pattern signals a downtrend. Is this likely to continue or reverse? What is the meaning of a lower highs and lower lows pattern?

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 – trading rules

What do lower lows and lower highs mean? The pattern is pretty self-explanatory, but let’s show it on a chart and look at this setup on the chart:

We describe the trading rules both in plain English and by using a chart:

Trading Rules

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Is lower high and lower low a reversal or trending pattern? Is lower highs and lower lows bullish or bearish?

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

If one daily bar has a lower high and lower low, we enter at the close and exit after 1-10 bars. We use the optimization function in Amibroker.

This is the result in S&P 500 (SPY):

The lower highs and lower lows pattern - strategy 1
The lower highs and lower lows pattern – strategy 1

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 of 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):

The lower highs and lower lows pattern - gold
The lower highs and lower lows pattern – gold

We see the same pattern in the gold price as in the S&P 500: the long-term upward drift makes a longer holding period better.

This is the result in long-term Treasuries (TLT):

The lower highs and lower lows pattern - TLT/bonds
The lower highs and lower lows pattern – TLT/bonds

During the period, interest rates have fallen, thus making TLT rise in value. This has resulted in better returns the longer the holding period, just like the two other asset classes.

The results indicate that the lower highs and lower lows pattern is a reversal pattern.

But the pattern is in the plural form, not the 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:

The lower highs and lower lows pattern - strategy 2
The lower highs and lower lows pattern – strategy 2 (backtest)

Perhaps as expected, we can see that the average gains improve slightly.

Let’s test the gold price (GLD):

The lower highs and lower lows pattern - strategy 2 (gold backtest)
The lower highs and lower lows pattern – strategy 2 (gold backtest)

An extra weak day doesn’t help much in the gold price!

Let’s see what happens in long-term Treasuries (TLT) when we use the two-day pattern:

The lower highs and lower lows pattern - strategy 2 (TLT/bonds backtest)
The lower highs and lower lows pattern – strategy 2 (TLT/bonds backtest)

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 backtest.

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:

Three consecutive lower low and lower high
Three consecutive lower low and lower high

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.

However, we suspect other patterns and indicators offer better rewards for such a short holding period. Please have a look at our free trading strategies or monthly Trading Edges.

FAQ:

What does the lower highs and lower lows pattern signify in trading?

The lower highs and lower lows pattern is a technical analysis pattern that signals a short-term reversal in the market. It is characterized by consecutive candlesticks with lower highs and lower lows, indicating a potential shift in momentum.

Is the lower highs and lower lows pattern more likely to continue or reverse in trading?

The lower highs and lower lows pattern is primarily considered a reversal pattern in trading. This pattern signifies a shift in the prevailing trend, suggesting that the existing upward momentum is losing strength, and a potential reversal to a downtrend is underway.

What are the trading rules for the lower highs and lower lows pattern?

The trading rules for the lower highs and lower lows pattern involve meticulous pattern identification, strategic entry points, optimization through backtesting, consideration of confirmation signals, and a continuous commitment to risk management. Traders should tailor these rules to their specific preferences and market conditions for a well-rounded trading approach.

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