In this article we will explain a trading strategy that combines the use of Bollinger Bands and the 1-2-3 pattern, a very powerful chart pattern used by many traders in a variety of markets. It is a simple strategy as we shall see below, however, it requires mastery of a number of theoretical concepts that we will explain below.
The 1-2-3 maximum that originate in the upper bollinger band or moving average line (center line of the Bollinger Bands) and the 1-2-3 minimum which originate in the lower bollinger band or the moving average line, provide excellent signals that indicate possible changes of direction in the market. Because the 1-2-3 pattern occurs in virtually every market and any time frame, this strategy can be applied to trade in a variety of instruments and time frames, including short, medium and long term.
It works well in any time interval and market that is dynamic enough to swing from side to side while on trend, or to swing with enough volatility within a price range to generate good opportunities.
For example, we can see the 1-2-3 pattern in combination with Bollinger Bands (standard configuration) on a graph that shows a clear downtrend:
- Most of the 1-2-3 pattern remain within the Bollinger Bands.
- The 1-2-3 pattern is completed near the upper Bollinger Band or near the 20-period moving average of the same indicator.
- The arrows indicate the market entry points, which are down the point 3 of the 1-2-3 pattern. In this case, these entry points are located in a level before what is recommended by the classical strategy to trade with these price formarions. In other words, this system uses Bollinger Bands to generate an early market entry based on the 1-2-3 pattern.
- In a market downtrend, the price must reach or exceed the upper Bollinger Band, or the price must meet or exceed the moving average of 20 periods before the 1-2-3 formation to become a legitimate pattern from which you can enter the market according to the classic rules of this price formation.
- In a market uptrend, the price must meet or exceed the lower Bollinger Band, or the price must meet or exceed the moving average of 20 periods before the 1-2-3 formation to become a legitimate pattern from which you can enter the market according to the classic rules of this price pattern.
- The entry occurs 2-3 bars after point 3 of the pattern. This depends largely on the risk tolerance of the trader. The earlier you enter the market after point 3, the higher the risk as the pattern is not yet fully confirmed.
- Stop loss: For an uptrend, the stop loss is placed below the point 3 of the 1-2-3 pattern. For a downtrend, the stop loss should be placed above the point 3 of the pattern. Regarding the level of stop loss with respect to point 3, it depends on the time frame used, eg in short-term intervals, the stop loss recommended should not exceed 10 pips away in relation to point 3.
- Take Profit: Occasionally, from a 1-2-3 pattern may originate strong movements, so the trader can use traling stops to follow the price. Another option is to place Take Profit objective in a significant support or resistance level, or in levels determined by pivot points or Fibonacci levels. The trader can also wait a 1-2-3 pattern in the opposite direction of the position, although it must be remembered that these patterns might be the start of trends changes.
Examples of the trading system with Bollinger Bands and the 1-2-3 pattern