Short-Term Pattern: 3L-R

11/09/05 11:29:20 AM

by Paolo Pezzutti

Michael Harris' price pattern is useful to profit from short-term reversals.

Security: N/A
Position: N/A

Following my article about the GAP2H pattern, here is another short-term price pattern proposed by Michael Harris, the author of the book Stock Trading Techniques Based On Price Patterns (2001). The price pattern approach is very interesting. When certain technical conditions occur, players in the market in the short term react in a way that most of the time is repetitive, providing statistical characteristics of predictability. With this, I do not want to say that the pattern analysis solves all the issues. It is an additional tool to understand the nature of markets and players' behavior. Of course, you need a vast statistical base to make assumptions. It is not enough to randomly generate patterns to verify their profitability. You should have specific concepts you want to test in order to provide you with additional confidence about their implementation in a trading system or methodology.

The 3L-R is a short-term bar pattern strategy. The price pattern is formed by four consecutive daily bars. We are not concerned with all price points (open, high, low, close) for each bar. This is because the objective is to determine when three consecutive lower lows are followed by a high above the high of the three preceding bars. In fact, this pattern requires three lows followed by a reversal (3L-R). In particular, the rules call for buying the next day on the open if:

-Yesterday's low is lower than the low of two days ago
-The low of two days ago is lower than the low of three days ago
-Today's high is greater than the high of three days ago.

The opposite is true for short trades.

These rules describe only the concept of the pattern. They must include the risk and money management parameters. The author proposes to use a profit target and a percentage stop-loss.

The methodology is not mechanical and you can adapt it. The pattern is based on a valid concept that you can reuse. For example, you could also consider using it on an intraday time frame. In particular, the exit rule should be based on a trailing stop to lock in profits in a fast moving market, should the pattern be successful. In addition, the stop-loss could be defined differently, for example placing it below the lowest low of the formation.

The strategy goes long and short, but it does not reverse. The pattern is not very common, but it has its validity. Traders who are following a downtrending market suddenly find themselves caught by the sudden up move. This would add additional momentum to the upside in the coming sessions.

Modifications you might want to apply could include a reverse strategy, adapting the exit rules to your trading style. Let's see the pattern in action.

FIGURE 1: TEXAS INSTRUMENTS DAILY. The Texas Instruments daily chart displays the 3L-R pattern. It is a four-bar short-term reversal pattern.

Graphic provided by: TradeStation.

In Figure 1, you see the daily chart of Texas Instruments. In this case, as an example I proposed a pattern that triggered a short trade. The pattern starts on day 1. The next day (day 2) you have a higher high than the previous day's high. On day 3 (yesterday), you have another higher high. Today (day 4 in Figure 1), you have a low, which is lower than the low of day 1. The next bar (tomorrow), you go short at the open. In the figure, the methodology proposed has an exit strategy based on a 7% profit target and a 7% stop-loss.

After the entry, prices continued to move to the downside more than 1 point in the next four trading sessions -- not bad for this trade. At this point, I would have tried to lock in my potential profits. For example, you could partly close the position and trade to the break-even point, or you could use a trailing stop. What happened the next day is very common in the markets. Prices went back to test the high of the formation and verify the determination of the bears. The first day of October, the resistance level test failed with an excellent Turtle Soup pattern (see my May 2, 2005, article on the subject). The next day, a breakaway gap to the downside resumed the downtrend that in six sessions brought prices down more than 4 points. After 15 days in the trade, the profit target was finally hit. In this case, the pattern was successful, but it took several days -- not exactly a short-term trade.

The price pattern illustrates an example of a trading method implementation. It is up to you to tailor the methodology to include it in your trading tools library. The concept is valid in any market and, based on it, you can further develop the logic in order to adapt it to your own needs and trading style.

Paolo Pezzutti

He is the author of the book "Trading the US Markets - A Comprehensive Guide to US Markets for International Traders and Investors" - Harriman House (July 2008)