Trading A 1-2-3 Trend Reversal

03/13/12 01:53:38 PM

by Ron Walker

Spotting a trend reversal is as easy as 1-2-3.

Security: SPY
Position: N/A

The Standard & Poor's 500 SPDR's current corrective course of action could take the shape of a 1-2-3 trend reversal. The 1-2-3 trend reversal was popularized by Victor Sperandeo in his book, "Trader Vic: Methods Of A Wall Street Master." If the pattern sets up, it would mean more downside for the S&P 500 and its exchange traded fund (ETF), SPY.

The pattern sets up in three phases. The "1" of the 1-2-3 trend reversal represents the initial trendline break. The "2" of the 1-2-3 trend reversal is characterized by the attempt of prices to rally back up to test the preceding high, prior to the trendline break. The "2" sets up when prices fail to make a higher high, and a lower peak is established and then begins slipping back down toward the low made after the initial trendline break. The "3" symbolizes a move beyond the extreme low made after the initial trendline break.

If prices carry through, moving beyond the preceding selloff low, then the 1-2-3 trend reversal has completed.

FIGURE 1: SPY, HOURLY. SPY is attempting to fill the gap in a V-shaped recovery that could produce a lower high. A lower high and plunge back below the low establish after the trend break at the pivot point would complete a 1-2-3 trend reversal.

Graphic provided by: StockCharts.com.

A 1-2-3 trend reversal may be under construction on SPY's hourly chart. Figure 1 shows an hourly chart of SPY. Note that SPY recently put in a peak just above 138. The initial trendline break occurred just above 137, with prices falling to about the 134 level after a nasty gap lower. From there, SPY began a recovery, attempting to claw its way back up to fill the gap and to test the preceding high of 138. A gap fill would occur just below 137 area. There is also resistance just below that at the 50-period exponential moving average (EMA).

So whether SPY fills the gap or just attempts to fill it is irrelevant; the only thing that matters is that it meets the criteria of the second phase by setting up a lower peak. If a lower high sets up, and then prices turn lower and head south, the pattern could play out.

Sperandeo notes the best way to trade the 1-2-3 criterion is to trade before the third condition is met. In this case, that means that short positions should be taken in SPY as the second condition is being met as SPY moves into its second phase, demonstrating the inability to regain its upward momentum.

In order to minimize losses, a stop-loss should accompany your order, strategically placed just above the preceding high of 138.19. Traders can set stops anywhere from about 15 to 35 cents higher for this setup. A trader can add to the position once prices cross below 134.36, ushering in the third condition and completing the 1-2-3 trend reversal. This level is also called a pivot point, which is a line in the sand, marking the birth of a new downtrend on the hourly chart, with the completion of a lower high and a lower low. A break below this pivot point should cause prices to countinue to decline.

It is important to note that once all three phases of the 1-2-3 trend reversal have occurred -- that is, the "3" has moved beyond the low established by "1," and it marks a key pivotal point that should be acted upon.

By establishing a position before the third condition is met and adding to that position as it crosses the pivot point, a trader can make a commitment with the assurance of being right from the start. If a stock or ETF doesn't behave as it should, you will be stopped out with a small loss before you plunge in and add to the position. If prices do not perform as they should, after falling below the pivot point marked by the third phase, it will send a danger signal that the 1-2-3 trend reversal pattern may have been a false move.

If prices fail to resume the decline after breaking below the pivot point, and instead begin to rise, a trader should abandon the trade near the intial entry point at the peak of the second phase.

While prices have temporarily ticked back above the 134.36 level, there is now sound evidence that the path of least resistance for SPY is to the downside.

A successful 1-2-3 trend reversal on the hourly chart will require a lower peak on SPY, remain below 138.19, and then a move back below 134.36.

Ron Walker

Ron Walker is an active trader and technical analyst. He operates an educational website dedicated to the study of Technical Analysis. The website offers free market analysis with daily video presentations and written commentaries. Ron is a video pioneer, being one of the first to utilize the internet producing Technical Analysis videos. His website is thechartpatterntrader.com


Website:	thechartpatterntrader.com
E-mail address:	thechartpatterntrader@gmail.com

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Trading A 1-2-3 Trend Reversal

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