1 - 2 - 3 Formations

This technical analysis indicator is a combination of several ideologies at work. Perhaps best know as the Ken Robert's 1-2-3 top or bottom, this chart pattern is no more than a simplified Elliot wave move. I do not recommend trading on this pattern alone, but in conjunction with the other trading techniques covered in this section, it is worth having a basic understanding of what a 1-2-3 formation represents.

Not to take a cheap shot at the Ken Roberts course, because it is how I was introduced to this wonderful game, but Ken Roberts is a marketing genius, not a trading genius. What a 1-2-3 formation represents is a possible reversal of trend in a market. A more credible interpretation of this chart pattern comes from Elliot Wave analysis. Which I don't use or recommend due to the various ways wave counts can be interpreted and manipulated, but please feel free to investigate either approach more on your own. Many traders have had success using both these schools of thought. A 1-2-3 formation works well when it is also a head and shoulders reversal pattern, which is the only way I would trade this type of chart set up.

When using a 1-2-3 top or bottom chart formation it is highly recommended that you confirm this possible reversal with a stochastic reading and a violation of a trendline. When this pattern presents itself on a chart and stochastics are pointing in a supporting direction, this can be a valuable chart pattern.

The first blue rectangle represent the 1st shoulder, the head represented by the red circle and the 2nd shoulder - which should always be lower than the 1st - by the other blue rectangle. A major trendline was also broken as stochastics confirmed a move towards lower prices.

Elliot Wave analysis keys off of the idea that markets move in a five wave sequence. A 1-2-3 formation is simply the first three waves of the naturally occurring five wave pattern. The first wave represents a change in market balance, or the initial reversal of the prevailing trend. The second wave, or minor pullback, is a correction of the first wave and is often represented in the market place by profit taking and one last attempt to re-establish the trend that has just been reversed. To add credibility to this chart pattern, look for a second wave retracement that is at least 50% ( in time and price ) of the initial wave one reversal. The third wave, if the formation is to hold true, will exceed the initial trust of the first wave and is representative of the following occurrences in the trading pits. Traders who missed the initial reversal will now look to initiate positions and those who tried to re-establish the previous trend must now cover their positions which will only add strength to the third wave now in progress. For the above reasons, the third wave is usually the greatest in terms of price movement and time duration. Also, according the Fibonacci phenomonem, the market will grow by 1.618 times the previous wave. Meaning in theory, the price movement of wave three should be 1.618 times that of wave one.

Just to finish the story, a wave four retracement or correction will follow the end of wave three. And finally, a wave five to a new high or low will complete the initial stage of a reversal. These patterns have a tendency to get sloppy and less predictable after this point. There are many books on the Elliot Wave phenomenon that will explain this occurrence in greater detail. Like I said earlier, after the initial five wave move, I feel there is too much room for manipulation in the Elliot school of thought for it to be consistently successful.

Here is a complete move lower that was started witha 1-2-3 top formation. Supported by a break lower in the prevailing uptrend line and a retest of that same trendline - which became resistance after it was broken as support. Wave 3 or the middle wave down was the longest and a new low was achieved after a correction. A text book price move that could have been captured using all these methods in conjunction.

My philosophy has always been that you must be constant in your trading approach and methods. The market will be the variable in the equation. Control what you can because no one has ever controlled the markets. A constant and a variable will line up much more often than two variables.

Trend Lines | Stochastics | 1-2-3 Formations | Pulling the Trigger

 

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