About
Victor Sperandeo, commonly known as “Trader Vic”, is a US trader, index developer, and financial commentator based in Grapevine, Texas, United States. He serves as the President and CEO of Alpha Financial Technologies, LLC (AFT), is a founding partner of EAM Partners L.P., and serves as the President and CEO of its general partner, EAM Corporation.
Sperandeo traded in commodities, particularly in the energy and metals sectors. He is renowned for having 'predicted' the stock market crash of 1987 during an extensive interview in the 21st September 21 issue of Barron's. On October 16, one trading session prior to Black Monday, Sperandeo shorted the Dow (DJIA) and made 300% as the index fell by over 20%.
The 1-2-3 pattern
This is a reversal pattern often seen when a longer term trend is broken. Victor Sperandeo popularized it in his book "Trader Vic: Methods of a Wall Street Master". This book offers more market perspectives than specific trading tactics but the few trading setups discussed in the book are enlightening.
Few things in a trader’s life are more annoying than a trend reversal or a failed breakout. These are so common that a number of trading setups, such as Victor Sperandeo’s 1-2-3 reversal pattern and the 2B rule, have been developed to take advantage of the inability of markets to follow through after breaking out (or down) beyond a previous price extreme.
Writing about the 1-2-3 trend reversal in his second book, Principles Of Professional Speculation, Sperandeo notes that there are three conditions involved in a true change of trend.
A trendline is broken.
The stock has stopped making “higher highs in an uptrend, or lower lows in a downtrend.”
Prices must break out above a previous “minor rally high” in a downward market or below a previous minor selloff low in an upward market.
At the point where all three of these events have occurred, there exists the equivalent of a Dow Theory confirmation of a change of trend.
The first indication that the trade may be in trouble is from the so-called 2B rule, a special case of the second condition.
A 1-2-3 formation is a well known chart pattern which crops up regularly across most liquid markets. Unlike some chart patterns such as a head and shoulders, which are subjective in nature, a 1-2-3 formation can be accurately defined by an objective set of rules. The 1-2-3 pattern is also a form of Failure Swing where price swings back towards the broken trendline and fails to get back to the prior trend, reverses and establishes the trend change. It conforms to Dow Theory.
The 123 reversal chart pattern is a three-swing price formation that indicates a potential reversal in trend. It is formed by three price swings or waves with three swing points, which is where the name of the pattern comes from. There is nothing special about the chart pattern, apart from the fact that the price swing is no longer making the expected higher high (in an uptrend) or lower low (in a downtrend). However, the change in price structure can help predict a potential reversal.
As with any trending market, the market makes higher highs in an uptrend and lower lows in a downtrend. But when the trend is about to reverse, the price deviates from that structure, making a lower high (in the case of a potential bearish reversal from an uptrend) or a higher low (in the case of a potential bullish reversal from a downtrend).
Important points
The 123 chart pattern appears frequently in the price action and is often a reversal signal.
The 123 setup consists of three pivot points.
The confirmation of the 123 reversal pattern lies at Pivot Point 2. The target when trading a 123 formation is at a distance equal to the size of the pattern, applied beyond Pivot Point 2. Your stop loss should go beyond Pivot Point 3.
The 123 reversal trading pattern has the structure of a double top or a double bottom.
The 123 chart pattern combines well with an oscillator – the RSI Histo for example.
Combining price action techniques comes in handy when using 123 setups.
The 123 setup could also work as a continuation pattern.
As a continuation setup, the confirmation of the pattern lays at Pivot Point 3.The target in a 123 continuation forex trade lays at a distance equal to the size of the pattern, applied beyond Pivot Point 3. The stop loss order should go beyond Pivot Point 2.
The 123 continuation chart pattern has the structure of a triangle, a wedge pattern or a flag pattern.
Trading strategy
Because a 1-2-3 formation can be objectively defined, it forms an excellent base on which to build a trading system. There are an infinite number of ways of doing this, but here are some common examples:
1-2-3 breakout trade entry
Example of a sell trade using the 1-2-3 pattern
1-2-3 Traders' Trick Entry (TTE)
The Traders' Trick Entry is a term coined by Joe Ross. This method allows the trader to enter at an earlier point in the formation's development. The idea is to "beat the crowd" with minimal risk.
The #3 point is referred to "potential" because subsequent bars can confirm or negate it.
A protective stop loss could be placed just below (for longs) or above (for shorts) the potential #3 bar.
The initial target might be the #2 point or a fixed number of ticks. If there is a breakout at the #2 point then a portion of the position could be left to run with a trailing stop based on subsequent bar formations.
See the diagram below showing both types of entry.
Divergence with oscillator
1-2-3 Reversals are powerful end of trend confirmations worth highlighting. For a 1-2-3 top, the market hits a new high labelled as point 1, and sells off to point 2. It then reverses again and trades higher without taking out point 1. This is labelled as point 3. The trade entry trigger is when price trades down through point 2. The measuring objective is the distance between points 2 and 3 projected below the break down at point 2.
On the other hand, at a 1-2-3 bottom as depicted in the example above, the market hits a new low at point 1, and trades higher to point 2. It then reverses again and trades down without making a new low below point 1 at point 3. The trade entry trigger is when price trades back up through point 2.
There is a sequence of events which takes place to confirm the end of the trend. The first is Divergence, where the price makes a new low in a downtrend or a new high in an uptrend — but the oscillator does not. The second is the Trend Line Break, and the third event is the 123 Reversal.
The example above highlights the End of Trend Confirmations. To see Divergence, almost any oscillator can be used including the RSI, RSI Histo, Stochastics, MACD and Awesome Oscillator.
Performance of the 1-2-3 pattern
I found a website where the 1-2-3 system was tested. The test parameters were:
Initial trading capital = $100,000
Capital per trade= $15,000 (Equal dollar transactions) and no margin or compounding.
Max. Open positions: 10
Commissions: $0.01 per share
Volume filter: Limit position to 5% of trading volume
Long system: tested on the Russell 2000 constituent stocks
Short system: tested on the Russell 3000 constituent stocks
Long system test period was the 10 year period until November 2020.
Short system test period was the 1 year period until September 2022
Note: Backtest results are what you should expect in real time trading
The tests on the long and short systems were run on very different time periods and this makes comparisons between the two sets of results difficult. It would appear that the 1-2-3 pattern works better for short positions than long positions in terms of annual return and the payoff for the fewer short trading setups was higher.
The short system was also lower risk in terms of drawdown but the reward to risk ratio was marginally better for the long system. The author offers no explanation for the different test periods or different indices used to measure performance of the 1-2-3 pattern.
On balance, it would appear that the 1-2-3 pattern works best on short trades but that view is unlikely to be statistically robust. The short test system was tested in falling markets so the overall index trend was indeed its friend.
The 2b pattern
"In an uptrend, if prices penetrate the previous high but fail to carry though and immediately drop below the previous high, the trend is apt to reverse.The converse is true for downtrends." - Vic Sperandeo in "Trader Vic: Methods of a Wall Street Master"
The 2B principle gets its power from the large number of stop-loss orders in the area of the X (in the red circle). Many traders who bought the breakout will have their stop-loss orders there, so if prices fall below the blue line, those stops will be hit, driving prices back down with thust. If you enter a short as the breakout traders are bailing out of their positions, the burst of selling can propel your trade into profit so quickly that, before you can enter your stop-loss order, prices may have moved far enough in your favour to set your initial stop-loss at break even. The inverse is equally effective for 2B bottoms.
4 Simple Steps to Trade the 2B pattern
Step 1: Find the Pattern
The key to finding the 2B Pattern is to find a new higher-high or lower-low on your chart, followed by a second attempt that does make new higher-highs or lower-lows but it quickly FAILS and goes back in the opposite direction.
Step 2: Find the Entry Trigger
The entry is triggered LONG when the price moves above the highs of the failed breakout candle that tried to make a new lower-low.
Entry is triggered SHORT when the price moves below the lows of the failed breakout candle that tried to make a new higher-high.
Step 3: Place your stop-loss
We always use a protective stop-loss, which is placed below the lows for a LONG, or about the highs for a SHORT.
Step 4: Place your Profit-target(s)
We use profit-targets to lock in profit on each trade, and we use swing-highs for a LONG, and swing-lows for a short. Find the next major swing-highs (long) or swing-lows (short) and use those as your profit-targets.
Another name for the 2B is the"spring". Imagine the blue line in the graphic as a rubber band, the bigger the poke above the blue line i.e. candle that breaks and closes above/below the 2b level , the stronger the reversal trend if the breakout fails. This same principle works on failed triangle breakouts.
If you were unfortunate and bought the breakout, instead of putting a stoploss order at the X level, you might want to consider making it a stop-and-reverse order.
However, in order to avoid losses due to the pattern failing, as before you should use additional indicators to confirm the price action. As you know, we favour the RSI Histo indicator so that you can trade in the direction of price momentum and increase your odds of success. It's a genuine Swiss Army knife when it comes to confirming price patterns.
Concluding thoughts on Trader Vic methods
First, the reversal patterns are well defined and are therefore easy to implement on a chart. Good for beginners. Secondly, you can place pending orders to catch potential reversals thus saving you screen time - just set and forget. Lastly, these reversal patterns do fail but when they play out, the rewards are large. So it pays to take small losses either by starting with a small position or having a tight stoploss because if the trade goes in your favour, there will be opportunities to add to your winning position.
The only negative with these price patterns is that there is more manual work to be done on your charts than other strategies. But if that's your thing, enjoy!
In time, when you review other strategies, you'll recognise the original strategies they are based on which confirms there are few enduring strategies in financial markets.
Useful Stuff
Download "Trader Vic: Methods of a Wall Street Master" HERE
Download the RSI Histo indicator HERE
Comments