Pattern 1-2-3. Is It as Good as It is Believed to Be?

The article will focus on the formation well-known among traders – the 1-2-3 pattern.

Its description as “reversal points” can be found in the book “Long Term Secrets of Short-Term Trading” by Larry Williams.

It is believed that the formation of this pattern predicts a market reversal.

Trading on the basis of 1-2-3 pattern can be carried out on any timeframe and on the charts of any financial instrument. The structure of the model is not complicated, that’s why it’s popular among traders.

Let's check the effectiveness of the signal’s work on this pattern using historical data.

The 1-2-3 pattern is graphically interpreted as a zigzag: impulse - correction - impulse. The beginning of the first impulse will be marked by point 1, and its completion by point 2. Point 3 is the completion of the correction and it should be at the level between points 1 and 2. With the renewed motion, the price crosses the level of point 2, and at this moment the pattern formation ends.

Since the model belongs to reversal patterns, it will occur at the end of a trend, in case of sharp price fluctuations, at the end of the correction of the current trend, and within the borders of a sideways trading range.

Bullish 1-2-3 pattern looks like in Picture 1 – after point 3 (local minimum) the price rises. A bearish 1-2-3 pattern looks as displayed in Picture 1 (after the formation of the third peak, the price breaks down):

Event detection method

We will use the ZigZag indicator to search for minima and maxima when constructing 1-2-3 formations in our research.

On the chart, the indicator displays lines that connect local minima and maxima that outline trend direction. The following indicator contains three parameters. They define the working of ZigZag and which minima and maxima it will consider. Changing parameters influences the degree of the indicator’s sensitivity to price movement. If you increase the values for calculation, the number of local minima and maxima will decrease. Thereafter, fewer lines will be displayed and theoretically fewer formations will be formed, but larger in size (price movements will be larger).

There is one drawback of the ZigZag indicator: it is recursive, which makes it possible to unambiguously judge its lines only up to the penultimate one. The last line will form and change its position until a new line appears.

Still, the ZigZag indicator suits well to spot a 1-2-3 formation. Here, to receive a signal to open a position, the last indicator line is not needed. The main thing is that the price should exceed the level of top 2 (for the 1-2-3 bullish pattern).

We will define the pattern on charts the following way (for the 1-2-3 bullish pattern):

• Searching for a bearish trend (successively decreasing low)
• The ZigZag indicator is forming bottom “1”;
• Then the price corrects up to top “2”;
• The price changes direction to point “3”;
• ZigZag is forming bottom “3”;
• The price is moving in the direction of a new bullish trend, breaks the level of top “2”;
• The pattern is formed – we are making a deal.

An important condition of the bullish 1-2-3 pattern:

• The formation of the pattern begins with the identification of a bearish trend (that is, the price declines from a level higher than the top of "2").
• Bottom “3” should be between the extremes “1” and “2”.

The algorithm above describes the conditions for the formation of a bullish 1-2-3 pattern. For a bearish pattern, the situation is mirrored.

In our research we will take a ZigZag with parameters 5.3.3 (for small formations) and with parameters 12.5.3 (for large formations). The second group of parameters are set in the ZigZag indicator by default.

We will test trading signals generated by the 1-2-3 pattern on a large volume of various financial instruments and in the context of two timeframes.

Let us point out the conditions for opening and closing a trading position.

Opening positions

After the pattern is formed, a new position is opened at the moment of opening a new candlestick:

• The bullish 1-2-3 pattern – a signal to buy;
• The bearish 1-2-3 pattern – a signal to sell.

Closing positions

In all situations, the lifetime of a position is 5 or 10 candlesticks.

Let us start testing after defining all conditions and setting up the necessary parameters.

Analysis of the obtained results

The results are first estimated by the size of the values selected.

ZigZag with parameters 5.3.3 (small formations)

For the H1 (1-hour) timeframe:

For the D1 (daily) timeframe:

Total: 2,124,495 candlesticks and 21,679 events.

ZigZag with parameters 12.5.3 (large formations)

For the H1 (1 hour) timeframe:

For the D1 (daily) timeframe:

Total: 2,124,495 candlesticks and 10,146 events.

As expected, the number of events decreased with the enlargement of formations.

Next, let's see what is the total share of events in the total number of initial candlesticks for the two timeframes.

ZigZag with parameters 5.3.3 (small formations):

ZigZag with parameters 12.5.3 (large formations):

Based on the results of the grouping, we can make a conclusion that regardless of the types of financial instruments, the distribution of events is approximately the same, namely: in the first case - between 0.98 and 1.03% and between 0.46 and 0.49% in the second. That is, the 1-2-3 pattern isn’t formed very often on the charts. And larger formations are less common than smaller ones.

Now let's refer to the results of processing trading signals received as a result of formed formations.

We will evaluate the results according to two criteria:

• Momentum (m) – reflects the average percentage of the increment of quotations of financial instruments at the moment of fixing positions, in %. A positive momentum value indicates a positive profit of signal processing, a negative momentum indicates a loss.
• SPP - share of profitable positions, %.

ZigZag with parameters 5.3.3 (small formations)

Momentum in % and Share of profitable positions in % in the context of holding periods, timeframes and types of financial instruments:

The parameters for 6 out of 8 Momentum values are negative.

ZigZag with parameters 12.5.3 (large formations)

Momentum in % and Share of profitable positions in % in the context of holding periods, timeframes and types of financial instruments:

Parameters for 4 out of 8 average Momentum values are positive.

At the same time, there are some features to be highlighted.

To do this, let us visualize the results in the form of Momentum distribution (m) relative to each considered parameter (position holding period, timeframe, type of the financial instrument):

The diagrams above display Momentum distributions depending on the considered parameters. Each diagram consists of two parts: a “box” and “tails” or “whiskers”. 50% of the observed values are placed in the box, the remaining 50 are represented by tails. The end of the lower tail represents the smallest of the observed values, the end of the upper tail – the largest value. The cross shows the average value.

Analysis of the results allows us to draw the following preliminary conclusions:

• for small formations, the average value of the Momentum when fixing positions at the 5th candlestick is located higher than the average value of fixing at the 10th candlestick, which indicates that closing positions at the 5th candlestick is less unprofitable; for large formations, fixing positions at the 10th candlestick is more profitable compared to the 5th candlestick;
• in both cases, the average Momentum value on the hourly timeframe is located higher than on the daily timeframe, which indicates a greater profitability of working with the signal on hourly charts;
• the greatest Momentum in case of small formations is noted when trading indices; in case of large formations – when trading Stocks.

Let us have a look at the results in terms of the timing of holding positions, timeframes and types of financial instruments.

Let’s set up the following designation:

“H1/5” – fixing a position at the 5th candlestick when working on a 1-hour timeframe;

"H1 / 10" - fixing a position at the 10th candlestick when working on a 1-hour timeframe;

“D1 / 5” - fixing a position at the 5th candlestick when working on a 1-day timeframe;

"D1 / 10" - fixing a position at the 10th candlestick when working on a timeframe for 1 day,

SPP - share of profitable positions, %.

ZigZag with parameters 5.3.3 (small formations):

ZigZag with parameters 12.5.3 (large formations):

Let’s summarize the results using diagrams:

ZigZag with parameters 5.3.3 (small formations)

ZigZag with parameters 12.5.3 (large formations):

We have the following results:

• Signals from small formations show the best Momentum of 0.00003% on a 1-hour timeframe when fixing a position at the 5th candlestick.
• Signals from large formations show the largest Momentum of 0.217% on a daily timeframe when fixing a position at 10th candlestick.

So, on the one hand, the signal Momentum of the 1-2-3 pattern is positive, which confirms the hypothesis that the 1-2-3 pattern belongs to reversal formations. On the other hand, the Momentum value is so small that it looks more probable that the pattern is neutral.

Detailed results are presented in the appendix:

XLSX (0.14 MB)Application ti the article 'Pattern 1-2-3. Is it as good as people think' eng.xlsx