As with most trading strategies, trading with trend reversal/continuation patterns is based on the levels formed directly by the price. To understand every point discussed in the article, let’s first provide definitions for the terms to be used here.
Pattern is a chart model of the price movement. Level – in this case, it refers to the level, where the price might reverse (meaning a local or a global trend change). Support/resistance – the term is used to describe the levels and the areas located below or above the current price.
It should be noted from the start that reversal pattern and trend continuation pattern relate to a purely trend trading, which cannot be applied under the conditions of the sideways market movement. The “1-2-3” pattern is called that because the chart model is formed by three areas, but the “Ross Hook” pattern (the chart model of trend continuation) is formed by two points (see the picture 1).
This picture clearly shows that the chart models are drawn based only on the price movement chart and don’t use all kinds of indicators able to bring errors into identification of patterns and generation of signals.
Additionally, this indicator-free trading strategy is not a lagging one, unlike any indicator-based trading system.
“1-2-3” reversal pattern
As mentioned earlier, we need three points to draw the “1-2-3” reversal pattern:
- Point 1 is the extreme resulted from the trend movement. Point 1 is the highest/lowest point formed at the end of the trend.
- Point 2 is the first local high/low after the Point 1 is formed.
- Point 3 is another local high/low; in this case, the price doesn’t break out an extreme level towards the trend (Point 1).
- The segment 1-2 should be longer than the segment 2-3.
Trend continuation pattern – “Ross Hook”
The “Ross Hook” is a trend continuation pattern named after Joe Ross, who proposed to use this pattern just in such interpretation as we use it nowadays. This pattern consists of two points (local high and low) located in the middle of the trend.
A prerequisite for searching the “Ross Hook” is the “1-2-3” reversal pattern during the initial stage (incipient trend). Search for this pattern is shown on the right side of the picture 1. This pattern is a good signal for adding to previously opened positions towards a trend. If we can see the price breaking out the point 2 towards the trend (there is an established trend), there comes a time to search for the “Ross Hook” pattern.
Formally, it’s easy enough to identify this pattern: Point 1 is the first extreme formed after breaking out the point 2 towards the trend (of the “1-2-3” pattern). The point 2 is the result of the price pullback, but without breaking out the point 3 in the trend direction (of the “1-2-3” pattern). In the further development of trend movement, each local extreme will be considered as point 1 of the “Ross Hook” pattern, and the extreme resulted from the price pullback will be considered as point 2 (see the right side of the picture 1).
Trading with patterns
As in any manual trading strategy, the main thing is not only to enter the market by the signal received in due time, as well as to exit a trade in time, without holding a trade for too long risking to lose own profit fully or partially. Trading with reversal and trend continuation patterns is no exception in this regard.
A conservative entry into the market is that a trader places a pending order above the local high/low level (RH stands for the “Ross Hook”; the term was taken from the theory of the pattern itself) by spread value or does it manually by opening a position with a market order. This applies to trading with the trend continuation pattern, which is “Ross Hook”.
When trading with the “1-2-3” reversal pattern, a conservative entry is made if the red point 2 level is broken out towards the trend (see the left side of the picture 2).
Aggressive entry into the market for both patterns is made when the price breaks out the trend line (next to the red squares) towards the established trend (see the right side of the picture 2).
Knowledge of the reversal and trend continuation patterns, as well as ways to enter the market, doesn’t guarantee a successful trading without knowing the market exit conditions. Therefore, it’s necessary to decide on the market exit strategy (lock in profit or loss).
Again, the entire trading process and Take Profit and Stop Loss levels are tied up in the price movement chart and don’t need special indicators.
First, let’s consider the conditions for making a profit.
There are two options to lock in profit when trading based on the “1-2-3” pattern: the minimum and stage-by-stage Take Profit level (see the picture 3).
The minimum Take Profit level is determined by taking the value of the segment 1-2 and extending that distance from the point 3 (see the left side of the picture 3). Knowing that the “1-2-3” chart model is formed at the trend beginning, it doesn’t always benefit traders to get the minimum profit and therefore profit can be locked in stages. The right side of the picture 3 shows how one can lock in profit in stages when trading with the “1-2-3” pattern. The Fibonacci grid is drawn using the segment 1-2 in such a way that 0% coincides with the point 1 and 100% coincides with the point 2 (0% and 100% relates to the Fibonacci grid). Thus, trading lot of an order is roughly divided into three parts.
We should close the first part of order when the price reaches 161.8% and move Stop Loss to breakeven; we should close its second part at 261.8% and move Stop Loss to breakeven at 161.8%; and its third part should be closed at 423.6% of the Fibonacci grid or the price itself will close each part of order at breakeven levels (by the way, the latter happens much more often).
As for locking in losses, we would advise you not to be greedy and close all your open trades right after breaking out the level at the point 3 in the trend direction (see the left side of the picture 4).
Locking in profit when adding to the positions opened with the “Ross Hook” pattern. In this case, the process can be divided in two components as well. The first way is to lock in profit at the target levels of the “1-2-3” reversal pattern (see the right side of the picture 3), and the second way is also based on the Fibonacci grid (see the picture 5):
In order to determine properly the target levels for the trend continuation pattern, it’s also necessary to draw the Fibonacci grid, as in the case with the “1-2-3” pattern. The targets of the price movement may be identical in both cases.
Locking in losses
If the conservative entry into the market implies breakout of the point 1 of the “Ross Hook” pattern, locking in losses should be done after breakout of the reverse level – the point 2 forming this pattern (see the right side of the picture 4). No matter how nice this trading strategy seems to you, it’s still best to filter each signal.
Since the trend reversal and continuation patterns are based on the levels, we suggest using the order book as a signal filter.
Using the order book to develop a trading system
There is no a perfect trading strategy and even the one that yields only profit. Someday, signals from any trading strategy can lead to drawdowns and loss of your deposit, so every signal needs an additional filter. In this case, we suggest using the order book as a filter. Note the picture 6. This picture shows the interests of both bulls and bears exactly at the point where the “bearish” signal is formed by the trend continuation pattern – “Ross Hook”.
We would like to call your attention to the fact that areas of the best interests of both bulls and bears exactly match the points of the pattern formation. Therefore, knowing the sentiment of most market players, one can determine for oneself whether the given trading signal will be profitable or have your positions gone into a drawdown.
The analysis of the manual indicator-free Forex trading strategy, which is based on the signals of the “1-2-3” reversal pattern and the trend continuation pattern (“Ross Hook”), revealed the effectiveness of its application, since this trading strategy provides not only entry and exit signals, but also has an effective filter of these signals in the form of the book of orders and positions.
We should note the simplicity of the market entry conditions and closing trades. This trading strategy is intuitive and can become one of the trading strategies suitable for a newbie trader, without having to be experienced in sophisticated indicators.
One only needs to be able to see high/low levels. Using such a filter as the book of orders and positions will ensure that traders work efficiently and profitably, because they will always be well informed about market events. Besides, they will know the sentiment of players in the market and thereby be aware of whether it makes sense to open a trade, in which direction a trade should be opened, or perhaps whether they need to refrain from trading at all.