Trading A 1-2-3 Trend Reversal
The S&P 500 SPDRs (SPY) 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 it's exchange-trade 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 towards 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 sell-off low, then the 1-2-3 trend reversal has completed.
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 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.
Vic 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 it's second phase, demonstrating the inability to regain its upward momentum.
In order to minimize losses, a stop loss should accompany your order, being strategically placed just above the preceding high of 138.19. Traders can set stops anywhere form about .15 to .35 cents higher for this set up. 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. 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, that the "3" has moved beyond the low established by "1," 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 thrid 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 begin to rise, a trader should abandon the trade near the intial entry point at the peak of the second phase.
Now 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. To summarize, 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.