Implementing the 1-2-3-4 Pattern for Short Selling 

Content Details 

• Summary: This article explains how to use the 1-2-3-4 pattern for short selling, including the placement of a sell short order and setting an initial protective stop. It details the steps for identifying the pattern and executing the trade, with a focus on risk management strategies. 

• Target Audience: Intermediate to advanced traders with a good understanding of technical analysis and looking to enhance their short-selling strategies. 

Expanded Quote on 1-2-3-4 Pattern for Short Selling 

Quote: "On day four only, sell short 1/8 below the day three low. Your initial protective stop should be near the day three high." 

Expanded Response: 

Definition: The 1-2-3-4 pattern is a short-selling strategy where a trader sells short 1/8 below the low of the third day on the fourth day. The initial protective stop is placed near the high of the third day to manage risk. 

Stages: 

• Day 1: The first day marks the beginning of the pattern with an initial high. 

• Day 2: The second day features a higher high, confirming upward movement. 

• Day 3: The third day sets another higher high, forming the final peak of the pattern. 

• Day 4: On the fourth day, a sell short order is placed 1/8 below the low of the third day, and an initial protective stop is placed near the high of the third day. 

Example in SPX: As of now, the current price of SPX is 4400. Suppose the low of the third day is 4350 and the high is 4450. On the fourth day, a trader would place a sell short order at 4349.875 (4350 - 1/8) and set an initial protective stop at approximately 4449.875 (4450 - 1/8). If the price drops below the entry level, the short position is initiated, and the stop-loss is in place to limit potential losses. 

Practical Application: This strategy is particularly useful in volatile markets where quick reversals can occur. By placing the sell short order slightly below the third day's low and setting a protective stop near the high, traders aim to capture the beginning of a downward move while managing their risk. 

Trading Strategy: 

• Identify the Pattern: Look for three consecutive higher highs over three days. 

• Place Sell Short Order: On the fourth day, place a sell short order 1/8 below the third day's low. 

• Set Protective Stop: Place an initial protective stop near the third day's high to limit potential losses. 

• Monitor the Trade: If the order is executed, continuously monitor the position and adjust the stop as needed. 

• Take Profits: Consider taking profits as the price moves downward, or set trailing stops to lock in gains. 

Risks: 

• False Signals: The pattern may occasionally produce false signals, leading to potential losses if the price does not reverse as anticipated. 

• Market Conditions: Ensure that the broader market conditions support the short-selling strategy to avoid trades during strong bullish trends. 

Indicators for Identifying and Trading the 1-2-3-4 Pattern: 

• Relative Strength Index (RSI): Identify overbought conditions that may support the likelihood of a reversal. 

• Moving Averages: Use moving averages to confirm the overall trend direction and potential entry/exit points. 

• Volume Indicators: Confirm the pattern's reliability with volume indicators such as On-Balance Volume (OBV). 

• Bollinger Bands: Use Bollinger Bands to gauge market volatility and set appropriate stop-loss levels.