Forex Strategy: Learn To Trade The 123 Reversal

forex strategy, forex educationI was a newbie trader once. All I did was search the Internet for a good Forex strategy. Actually, all I was interested in was trading entries. I thought if I could pick the right direction every time, I could make a million bucks out of my measly $8000 trading account. I looked at hundreds of different strategies, well, entries. I even spent some money on a few of them. I read all about discipline, trading psychology, taking your “hits”, risk management, trade management, controlling your emotions – but I rejected all that. I had a good handle on my emotions and was a disciplined individual (most of the time.) All I needed was my magic bullet, my crystal ball, my time machine and then I’d be a trader. I didn’t care about anything but finding an entry strategy.

Let me tell you now. I started doing that in 2004. In 2009, I was still doing that, but my $8000 account was now about $500 and I still couldn’t make money. It’s a good thing I didn’t quite my day job. ;) Then I met Casey at Winner’s Edge Trading and he slapped me around and made me realize that the entry was about 5% of the deal and all the stuff I rejected was the other 95%. All that I had learned in those five years came back to me in a flash (I guess I was paying closer attention to it than I realized) and I became a profitable trader in just a few months. I joined Casey’s team at Winner’s Edge soon thereafter as the Asia Session Trading Room Moderator.

I said all that to say this: I’m going to show you my favorite strategy with lots of examples, but I’m not going to stop with just showing you how to do the entries. As I mentioned, entries are only a small part of a successful trading strategy. If you get the entry right half the time (that seems statistically possible, doesn’t it) and you get the other things right, you can still make a potload of money as a trader. You see, losing is part of your job. If you don’t take your loses, you’ll never make it as a trader. I know that sounds wrong because we’re taught all our lives that we should be winners. But, unless you own the aforementioned crystal ball or time machine, you will never be 100% correct on the direction of the market. The market breathes in and out and will go down while it’s going up and then go sideways for a while. It’s fairly unpredictable. What is predictable are human emotions. When the market is going in their direction, many (most) are experiencing greed – look how much I’m making, gotta get it all. When it’s going against them, they are experiencing fear – when will it stop? should I get out? That’s the reason why I like to trade on pure price action. I still use some indicators, though. They can give you a feel for the direction of the market. But only the price action can show you how our emotions are affecting the market.

What is a 123 Reversal?

A 123 Reversal is simply a picture of that emotion on a candle chart. Let’s talk first about a 123 high. That’s what I call a 123 reversal that happens at the top of an uptrend. In the Forex market, everything that happens in an uptrend can happen in a downtrend as well because currencies are traded in pairs, one against the other. So, for example, an uptrend in the EUR/USD currency pair is actually just the Euro trading higher and higher against the US Dollar. At the same time, the US Dollar is in a downtrend against the Euro. That may be different in futures or equities markets because many uninitiated traders think that you can only trade long (buy) and can’t conceive of going a trade in which you sell to open.

 

Strong_Uptrend_w_Volume

The first element to look for in a 123 high is a strong uptrend. 123 reversals happen all the time in the context of trading ranges and consolidations but don’t follow through because the market is trading in a range. The uptrend should be at least one and a half times the size of the 123 pattern (which we’ll look at shortly) because this trend will help define your target. The trend should be fairly
strong without a lot of retracements and pauses. The stronger the better. If you follow trade volumes on your chart, you should also be seeing strong volume (I like volume as and indicator – even though the volume may not be an actual representation of the volume on a pair, it does give you some indication of collective opinion of your broker’s traders. Which is a good reason to get your charts from a big broker even if you don’t trade there.)

To the left you see a potential setup happening. This is a strong uptrend with volume. You can see this right now (12/6/2013 @ 10am NY Time) on a GBP/JPY hourly chart. You will see that this is not yet a 123 high, but it’s definitely got a good start.

The picture shows an hourly chart, but a 123 reversal can occur on any time frame since it’s showing you the emotions of traders and not necessarily depicting a particular event. I prefer to look at them on an hourly chart or higher, but that’s because they happen too fast for me on the lower time frames.

The next element to look for is an exhaustion high point – this is point number 1 of your 123. Something like a pin bar or an engulfing bar. Although it doesn’t have to be as extreme as a pin bar, that would serve to demonstrate a very strong exhaustion or euphoria point and would give me more confidence. I especially like to see this happen at a historical resistance level. That just gives it more legitimacy.

Potential_high_at_historical_resistanceAgain, to the left you can see the same uptrend I showed you earlier, but this time I included some of the candles to the left. You see this pause (it’s just a pause right now, we’ll have to see if it turns into anything more than that) happening right at a historical area of congestion.

After the high point, your next job is to look for a pull-back. It can happen on the same candle, but I prefer to see it on subsequent candles. It just looks better to me that way. If it appears to be happening on the same candle, drop down to the next lower time frame and see how it looks down there. Sometimes I find that it’s better looking on the lower time frame. This will be the number 2 point of your 123.

Next you’re looking for a new high, but it must be a lower high than the number 1 point. If the next high exceeds the point 1 high, then your 123 high is blown and you can move on and look elsewhere. Again, I like to see a pin bar or engulfing bar here, but it’s not necessary. I like to see volume confirmation, but there’s usually much less enthusiasm for this high than the number 1 high.

 

123_high_that_is_about_to_be_blown

To the left you will see what was a potential 123 high that is about to be blown. This was looking like a pretty nice pattern until the last few minutes when it started to test the number 1 high. This example is on the EUR/GBP H4 (4 hour / 240 minute) chart on 12/6/2013 around Noon NY Time.

Now you’ve got your initial 123 setup. Officially, your trade entry is a break of the number 2 point to the downside. Although, of all the possible 123 trade strategies, that’s my least favorite because it requires you to risk the most pips and therefore requires you to trade with the smallest size.  I actually take as many as three different positions on 123 reversals – but we’ll get to that later in our story.

 

Why do 123 Reversals occur?

As I’ve said, charts reflect the emotions of traders. Certain patterns occur regularly on charts. We’ve all seen head and shoulders patterns, various triangle and flag patterns and the more complex harmonic patters. The reasons these patterns continue to provide trading opportunities is that the emotions that caused these patterns are consistent and happen frequently. The patterns don’t always hold – sometimes they’re affected by other factors like news – but they are consistent enough that we can use them to make profits in the market.

The number 1 point occurs at a place where traders who were long in the market decide they need to secure the profits they made during the trend up. That’s why the initial trend is very important. It’s also why you should watch for this point at a place of strong resistance. It’s the place where traders will feel that the market may stall or turn. In other words, they fear they may lose the profits they’ve got in place. The surge in volume is due to the “not so smart” money finally recognizing the trend and jumping on the bandwagon (euphoria – “this trend could last forever, I gotta get me some”.) That surge in volume usually happens when a move has reached exhaustion. The volume is a signal that the smart money is passing on their holdings to the latecomers, leaving them “holding the bag”. This is the number one point.

Of course, after there are no more traders to buy up the positions the latecomers entered, the price starts to drop. As the price drops, the smart money sees an opportunity to possibly make a little profit on another pop to the number 1 high, but they are less committed because most of the longer term momentum indicators are still giving overbought indications and the market has just made a big up move. Eventually, all the latecomers that bought while the market was at the peak are experiencing fear. As the market continues to drop, they unload those positions to the smart money – who are more willing to buy as the price drops lower. Until there are no more folks wanting to sell. That’s the number 2 point.

Now that the latecomer sellers are gone, prices will start to move up again. The smart money folks bought from the latecomers, so now as it starts to go up again, the latecomers figure they got out too soon and start buying again, but since they were burned before, they are a little more wary, so fewer of them get involved this time. And of course, the smart money folks are more than willing to take their profits as the market goes up. But since there are fewer willing to buy this time, when the price peaks, it often doesn’t get as high as the number one point before it starts dropping again. This is the number 3 point.

As the market starts to drop from the number 3 point, the more educated, smart money traders recognize that this could be a reversal or the beginning of a trading range, but at the very least, they are willing to sell down to the number 2 point again – which is exactly what we will do. This causes prices to drop back to the number 2 point – often breaching the number 2 point by a few pips.

When do 123 Reversals occur?

As I mentioned before, 123 reversals most often happen at areas of support and resistance. They happen after a good strong trend. They can happen on any time frame on any instrument. On the shorter time frames (less than one hour), you have to watch continually or you will miss your opportunity. Often you can see one after a big news event.

That’s why I prefer to trade hourly or higher. I day trade periodically and will watch the 5 minute and 15 minute charts, but I have a short attention span, so I’ve got to be in the right frame of mind to do that. I know folks that do it on the 1 minute charts and make lots of pips daily doing it. I just can’t concentrate that much for that long. That’s why trading is such a personal thing. You have to know your strengths and limitations to be a profitable trader. I tried to trade like someone else, but I couldn’t be profitable that way. That’s one of the things I learned early on from Winner’s Edge.

I didn’t mean to digress into trader psychology, but in my opinion it’s the most important factor in trading success, so I thought it warranted a few words.

How do I trade a 123 Reversal?

I use three different entries for the 123. The first one is what I call “cheating the number 3 point”. The second is trading the “standard” break of the number 2 point and the third is to trade the retracement after the break of the number 2 point.  My favorite entry is cheating the number 3 point as this can be done with very little risk, fairly large trade size and works quite well.

How do I determine position sizes?

I’ll go into more detail about entries below, but I’ll take most of  the first 123 reversal position (cheating the number 3 point) off before the second entry point occurs. Also, the first position, while having a low risk in terms of pips – also has a lower probability of success. Because of these factors, I usually use about half my standard trade size on the first position. I then use half on the second entry and half on the third entry.

My trading rules state that I can only risk 2% of my account on any single trade setup. So each of my positions will risk 1% of my account. Calculate the number of pips for your stop loss on each position (we’ll talk about where to place stops a little later) and use a risk calculator to determine your trade size. Winner’s Edge Trading has a risk calculator- you can find it right here. Use it with our compliments.

How do I enter and manage the positions?

Example of an Ugly 15m EUR/USD 123 High

Example of an Ugly 15m EUR/USD 123 High

As I’ve mentioned several times, I use three different entries in trading 123 reversals. The first one I call “cheating the number 3 point”.  The completion of a number 3 point is the first indication that a 123 reversal may be occurring. Officially, it’s not a 123 reversal until it breaks the number 2 point so that’s why I call this entry a “cheat”. When I see the first two points and see price pop to the number 3 point and start to drop, I start anticipating the entry. As soon as price breaks below the highest candle at the number 3 point, I take a short entry with a stop loss just above the number 3 point. Since the number 2 point is a fairly significant support level, I close about 90% of the position at the number 2 point and set the stop to break even (the entry point) on the remaining 10% of the position.

Trade Entries for the ugly 123 High

Trade Entries for the ugly 123 High

The second entry is the “standard” trade strategy for the 123 reversal. In fact, once you have a number 3 point, you can put a pending short a few pips below the number 2 point. How far below the number 2 depends upon the time frame you are trading. When trading the hourly time frame, I usually put the order 5 pips below the point. Be sure to make allowance for the spread. Since you’re most likely looking at a Bid chart, then you won’t have to take spread into account. If you’re trading a 123 low you will be placing a pending long and you will have to allow for the spread. Remember that on the longer time frames, the spread may actually fluctuate  before the entry is made.

As I mentioned, the risk is greater on the second entry. You need to place your stop a few pips above the number 1 point. You will most likely see the price bounce right after your entry and it may consolidate some before dropping, so don’t sweat it, just ride it out. You should target the consolidation from where the uptrend began. That’s why I suggest that you be sure the uptrend is at least one and a half times the size of your 123 pattern. That will give you a good risk-reward ratio.

Example of a 123 Low on GBP/JPY H1

Example of a 123 Low on GBP/JPY H1

After the price drops below the consolidation at the number 2 point, it most likely will pop up in a retracement (the market likes to let off steam after breaking a significant barrier like the number 2 point – traders taking profits.) That retracement will give you your opportunity for your third position. Watch for the price to pop and then drop just below the low of the highest candle in the retracement. That’s your short entry. Place your stop above the retracement for a nice tight risk and target the same place as the second position, the consolidation from which the initial uptrend came. This is likely to be the most profitable position of all three of them with it’s small stop loss.

And there you have it. Remember that everything I said about a 123 high applies in reverse to a 123 low. I always thought it was confusing when writers tried to address the opposite direction trades right in amongst the other trades so I tried not to do that.

Entries on a 123 Low GBP/JPY

Entries on a 123 Low GBP/JPY

Remember that not all 123 reversals will look perfect. In fact most of them won’t be perfect. Not all 123 reversals will give you an opportunity for all three positions either. That’s OK. You can just trade the second position if there’s just not enough reward to risk on the fist position. You’ll get used to finding them and they’ll just jump of the screen after a while.

Be sure to stick to the rules and don’t take profit too early or you will kill the profitability of this strategy. And remember not to freak out if the trade goes against you and/or stops out. That’s part of the job. You will take losses so be prepared for that. And please leave comments and questions below.

 

 

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  • Sean

    Thanks Eric. Excellent point on decorum. Congratulation on your Forex success. Haven’t been all that successful myself. May I ask what, besides fibs and S&R levels, how else are you finding your Forex success ? Thank you.

  • Eric Lambert

    I for one don’t think you should be speaking or writing that filthy language here my lad. The Forex can make you or anyone else more money than you know what to do with but first you need to change it from being about making money and instead focus on the art of capturing pips. When I started doing that pal, I went from zilch per month in pips to 2000+ or more pips every month. If you can do well in one area of the Financial markets then you can do it anywhere or you should be able to eventually that is. Ill put it to you this way when you can read the charts and use the tools correctly and draw your lines and fibs correctly, you are in business. By the way it sounds like maybe the Forex screwed you rather than the other way around otherwise you wouldn’t be so pissed would you pal?
    Good day sire and Merry Christmas and a Happy New year.

  • http://www.winnersedgetrading.com caseystubbs

    Harry, I think it is great that you are sharing your thoughts on this discussion, but can you elaborate and perhaps share some of your wisdom as to why Futures would be a better option?

  • Pythagoras From Cyprus

    Thanks for a simple and yet a clever way to reduce overall risk.

  • HarryJohnsonthe3rd

    Screw Forex. Futures are the way to go.

  • Chris

    Hi Dave! Happy to hear that you have found something that matches your trading style :) Dont forget though that I have nothing against trading reversals on a lower time frame if this is actually with the trend on your trend definition chart. I’ll explain more in today’s trading room :) Cheers!

  • http://twitter.com/IsItCoffeeYet Tim Black

    Thanks Dave. It’s good to hear from you. Sorry we missed each other in TX. We should be back there in a few months.

    As I mentioned, I think trading is personal. You have to find out what works best for you. Just remember, not every trade is a winner. Just because you don’t win on a trade it doesn’t necessarily mean you did something wrong. If you followed your rules, then it was a successful trade. :)

  • http://twitter.com/IsItCoffeeYet Tim Black

    Thanks Mike. I’ll try to find some good examples (winners and losers) to share in future posts. Sometimes a good 123 comes along, but you can only get 1 or 2 of the possible entries. One thing I should have mentioned in the article – especially on the #1 entry – be sure there is enough profit in the trade between the entry and the number 2 point. I will bypass the first entry if there isn’t enough profit. That doesn’t negate the second and third entries.

    Tim

  • Dave Hanna

    Hey, Tim, thanks for the clear and logical explanation. This will be very helpful – I’ve recently come to the conclusion that I can do better trading reversals (contrary to Chris’s advice!) than breakouts, but I didn’t have any sort of well-defined entry strategy. This makes a great deal of sense.

  • Mike Glavin

    Thank you for sharing this strategy with us. Really appreciated. I’ve been working on something similar for several months now. The difficulty Ive had is how to manage the risk and so I like your idea of using your second position to mitigate some of the risk for the whole trade setup. I would love to see some actual examples of how you successfully traded this approach.