Trading the 1-2-3 Correction Pattern: A Day Four Strategy with Protective Stops

Trading the 1-2-3 Correction Pattern: A Day Four Strategy with Protective Stops 

Content Details 

Summary: This article details a trading strategy for the 1-2-3 correction pattern, focusing on entering the trade by buying 1/8 above the day three high and placing an initial protective stop near the day three low. It covers the definition, stages, practical application, risks, and indicators to use for this strategy, with examples using SPX. 

Target Audience: Intermediate to Advanced traders 

Expanded Response 

Quote: When filled, your initial protective stop should be near the day three low 

Definition: A 1-2-3 correction is a chart pattern used in technical analysis to indicate a potential market reversal. It consists of three consecutive lower lows or two lower lows and an inside day, followed by a strategic trading setup on the fourth day. 

Stages

Lower Low 1: The market makes an initial low. 

Lower Low 2: The market declines further, creating a second, lower low. 

Lower Low 3 or Inside Day: The final stage is either a third, lower low or an inside day, where the trading range is within the previous day’s range. 

Example in SPX: As of now, the current price of SPX is 4300. Suppose the SPX drops to 4280 (Lower Low 1), then to 4260 (Lower Low 2), and finally to 4250 (Lower Low 3). The high on day three is 4265. On day four, the strategy involves buying at 1/8 above this high, which is 4265 + (1/8) = 4265.125. If filled, the initial protective stop should be set near the day three low, at 4250. 

Practical Application: 

Trading Strategy: 

Identify the Pattern: Look for the three consecutive lower lows or the two lower lows with an inside day. 

Confirm the Pattern: Use technical indicators to confirm the pattern. Volume should typically decrease with each low. 

Enter the Trade on Day Four: Buy 1/8 above the high of day three. In the SPX example, this is 4265.125. 

Set Initial Protective Stop: Place the stop-loss near the day three low, at 4250 in the SPX example, to manage risk. 

Monitor and Adjust: Monitor the trade and adjust stop-loss levels as the market moves in your favor. 

Risks

False Signals: The pattern may not always result in a reversal. 

Market Conditions: Ensure the overall market conditions are conducive for a reversal. 

Volume: Low volume might not confirm the pattern. 

Indicators for Identifying and Trading a 1-2-3 Correction: 

Moving Averages: Use short-term moving averages to identify the lows. 

Relative Strength Index (RSI): Check for oversold conditions. 

Volume: Volume should ideally decrease with each consecutive low. 

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