Forex Swing Trading Strategy: The 1 2 3 Reversal Price Action Trading Pattern

The 1 2 3 reversal is a price action trading pattern that can easily form the basis of a trading strategy.

It is a simple price pattern that is simple to spot on your charts and many swing traders will find it easier compared to other more advanced swing trading strategies and systems.

As with any trading strategy I talk about on my blog, location is important and the 1 2 3 reversal is no exception.

You can use this price pattern in a few ways including:

• Finding a trading position in the direction of the trend
• Being a counter trend trader and looking for quick hit reversal trades
• Being able to position inside of a full trend reversal from downtrend to uptrend and the opposite as well

Regardless of how you use it, you must fully understand the risks in trading as well as keep your risk parameters conservative so you can withstand any losing streak.

1 2 3 Reversal

You can see there is nothing complicated about this price pattern and the 1 2 3 reversal is simply a breakout of highs or lows after an impulse/corrective move in price.

Breakouts fail so the most important aspect of the 1 2 3 reversal pattern is what price does on and directly after the breakout.  You want to see price acceptance of the new high.  Of course there will often be a pullback after the breakout (Ross Hook), but that does not make this price pattern invalid.

In fact, the pullback after the breakout can be a way to add to your position.

1 2 3 Reversals – Daily Chart

This is a high level overview and while you may find this enough to trade, others will look for other variables to line up.

What’s important to notice is that the #3 point also becomes the #1 point as the first pattern resolves.  A break of the green dotted line can be your trading entry.

You can see at the last pattern very clearly – a price pullback does not make this trade invalid.

Rule Base The 1 2 3 Reversal Setup

It is easy to see anything you want on a chart.  Our eyes love to see patterns where they don’t really exist.

One technique you may want to use to determine if the potential 1 2 3 setups you are looking at is a possible trade, is to use a Fibonacci retracement zone.

There is NO magic in Fibs so don’t believe that this is the most important aspect of this reversal pattern.  What it can do is make sure that you are seeing a true pattern that has a real retracement as opposed to a simple consolidation pattern.

1 2 3 Reversal – Fibonacci

I set my Fib ratios to .382 and .786.  As long as price finds its way between these two ratios, I could potentially consider this a trade setup.

Another thing that needing a measured zone for price to pull back in to is it can help prevent you from entering a potentially over extended market.  Over extension will often lead to mean reversion and entering a trade just prior to mean reversion can make for a painful trade.

Entering The 1 2 3 Reversal Setup

One of the easiest ways is to just trade the breakout of the pattern.  I have not done any back testing on it but I don’t see how that would be an edge especially if you believe that most breakouts will fail.  Maybe they won’t just fail, but we’ve seen quick pops above/below #2 that could trigger you into the trade which all traders have probably experienced.

Another way to enter is to monitor price as it approaches swing #2.  See if you can find some type of consolidation on your trading time frame or even a lower time frame.  This will position you before the breakoutand if the breakout succeeds with momentum, you will find yourself in quick profits.

Other traders may want to enter near location #3 as it will give you a larger profit profile and you can be in profit before the breakout which means any failure of the breakout, won’t cost you as much.

Stop Loss Location

You can use somewhere below or above the #3 or use an ATR stop that measures the volatility of the market.  Just ensure you are not placing your stop loss too close to market action.  The main drawback of the 1 2 3 pattern is that stops can be fairly large depending on the length of the 2-3 leg.

Traders may, once they recognize the pattern on a higher time frame, drop to a lower time frame and look for the same pattern on a smaller scale.

You will get an earlier entry and a smaller risk profile as well.  You should consider using the same stop location as you would on the higher time frame chart.  With an earlier entry off the lower time frame 1 2 3 reversal, you will have an opportunity for a slightly larger position size.

Take Profit Targets

You can use the same pattern to exit the trade as well.  Consider a market in an uptrend and you’ve entered early on in the move.

1 2 3 Trade Exit

Once price takes out #1, you exit the trade regardless of the profits you have accumulated.  Traders may notice this is a violation of higher highs and higher lows you need for an uptrend.  That is correct.  You exit when you see price is no longer respecting the stair stepping trend direction pattern.

Another profit taking approach is to use Fibonacci extensions.

1 2 3 Profit Targets – Fibs

Managing Your Trade

There are many different ways to manage a trade from multiples of risk to price action patterns.  I like to keep things simple in regards to managing my trades with any trading strategy.

Being a risk manager is my first job.

1. Once I am in profit at 1R, I will bank a percentage of my profits.  The actual percentage will depend on the strength of price but anywhere from 25-35%.
2. Depending on the size of the trade, I may or may not move my stop to break-even.  It depends on how far price has traveled.  I don’t want a protective stop too close that it is hit by fluctuations in the market that don’t challenge the trade.
3. You can take further action at 2R and 3R or use Fib targets to scale out or exit fully at the 2.0 which is the length of 2-3 of the 1 2 3 reversal pattern

Hope this helps and please share this trading post!