Trading the 1-2-3 Reversal Pattern Using the Fibonacci Tool
The 1-2-3 pattern is a commonly traded pattern in forex, used to trade market reversals. The truth is that this pattern can be applied to trade other assets as well, and so it will find application in the binary options market in a variety of ways. These will be demonstrated in this article.
The 1-2-3 reversal pattern is based on Fibonacci numbers. The pattern gets its name from the price pattern’s actions, moving and breaking off at three key areas which are determined by these Fibonacci numbers, before undergoing the full reversal.
For the binary options market, the use of the 1-2-3 reversal pattern will entail the following steps:
- Tracing and identifying the pattern
- Identifying a binary options trade type
- Trading the pattern
Tracing and Identifying the 1-2-3 Pattern
Binary options platforms do not carry the sort of charts that will help the trader to make the correct trade decisions. It is therefore advised that the trader gets a chart program. Free chart programs are given by most forex brokers. It is advocated that the cTrader charts are used. The cTrader is a more superior charting program to the MT4 for a number of reasons. Some of those will be used to make trade decisions using this strategy.
The 1-2-3 reversal pattern occurs in two directions because the markets are bi-directional. This pattern can therefore form in a downtrend or in an uptrend.
1-2-3 Pattern in Uptrend
When the 1-2-3 pattern forms in an uptrend, the expected direction of reversal would be downwards. In this situation, it can be used to trade the PUT option. As price moves in an uptrend, the price action will attain a high that forms point 1 of this pattern, before turning south to an area of support that is known as point 2. Price experiences another upward move to a point known as 3. This point is not a random price level, but rather is determined by the Fibonacci numbers.
Historical chart studies have shown that this area corresponds to the 38.2 or 50% retracement level of a line drawn from point 1 to point 2. It is also important to point out that the point 3 price level is always lower than the price level at point 1. The price action is expected to undergo a full reversal from point 3, even going below the point 2 support line.
Take a look at the chart above. This shows how the SELL trade was set up on the charts. First, the trader must allow points 1 and 2 to form, then trace the Fibonacci retracement levels using the Fibo retracement tool available on your charting platform. The tool is traced from point 1 to 2 to see where the points would form. Using the tool, we pull out the end of the trace to properly show the Fibo retracement levels.
Now here is why we recommended the cTrader platform. You can actually setup an email alert using the appropriate function on this platform, and this will tell you when the price has hit a lower high at a Fibo level to form point 3. From here, it is vigilance all the way. More alerts can be setup to indicate when the breakout has occurred, and also when the price has pulled back to the broken neckline for the trade to be initiated.
1-2-3 Pattern in Downtrend
When the 1-2-3 pattern is formed in a downtrend, the expected direction of reversal would be upwards. In this situation, the 1-2-3 reversal can be used to trade a CALL option. The downtrend experiences its lowest point at a price level which is known as point 1. It then heads upwards to find resistance at a price level known as point 2. From this area, price is expected to resume the downward move to the Fibonacci retracement levels of either 38.2% or 50%, when the Fibonacci retracement tool is drawn from point 1 to point 2. This Fibonacci level represents point 3, which is at a higher price level than point 1. It is from point 3 that the price is expected to undergo a full upward reversal.
Identifying Suitable Trade Types
It is possible to use the 1-2-3 reversal pattern to trade the following trade types:
- Call/Put on European-style binary options
- Buy/Sell on American style binary options exchanges
CALL or BUY
The call trade is a trade which aims to follow the upward movement of the price of an asset. As such, it is only logical to use it to trade the upward reversal of a 1-2-3 pattern which has formed in a downtrend. However, we need to understand that binary options could be traded European-style using any of the registered European/UK-based brokers, or could be traded American-style, using exchanges such as Cantor Exchange and NADEX.
When trading a European-style binary option, all that needs to be done is for the trader to set a CALL trade when the resistance line drawn horizontally across point 2 has been broken by the upward price reversal. This is shown on the snapshot below.
The breakout is confirmed if a candlestick goes above the line, and closes ABOVE it. For best results, allow the price action to attempt to return to the broken resistance line so as to get the best possible entry price and facilitate greater success rates. The broken line will usually start to act as a new support. The trade entry should occur once price level touches this line during the attempted pull back.
For the American-style options, the principles of entry are the same. However, the nomenclature and structure of the trade is different. This trade is known as a BUY, and the trader has to choose the number of contracts to trade, with each contract priced at between 0 and 100. The contract settles at 0 (for a loss) or at 100 (for a profit). The price of the contract is deducted from 100, and multiplied by the number of contracts the trader has purchased to come up with the final profit sum.
PUT or SELL
The trade is set just as the CALL trade, but this time in reverse. After the price action must have broken the support line drawn horizontally with the line tool across the point 2 support, allow it to pullback to the broken support line which is now functioning as a resistance line. Once the price touches this line, the PUT trade can be set there.
For the American style options, this is a SELL trade, where the price is fixed between 0 and 100. If the trade ends in profit, the selling price of the asset is added to 0 and the total figure (0+price of asset) is multiplied by the number of contracts that were sold for the deal. For instance, if you expect the price of USD/JPY to fall from the present price of $112.80, and you sold 12 contracts of USD/JPY at the opening price of $52, and the USD/JPY falls to 112.12 by trade expiry, then the profit is (0+52) X 12 = $625.
Although trading 1-2-3 reversal patterns using Fibonacci retracement levels is a good binary options trading strategy it is not easily mastered and can be quite challenging for novice traders. We recommend using a signal service to confirm your trades. Many of the existing signal services use Fibonacci levels and 1-2-3 pattern in their signal calculations.Published in Free Strategies