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.
You can see the performance of the Sperandeo systems tested on the Russell 2000 constituent stocks during the 10 year period until February 2020. To produce the results I used Amibroker and the following test parameters:
Initial trading capital = $200,000
Capital per trade= $20,000 (Equal dollar transactions) and no margin or compounding.
Max. Open positions: 15
Commissions: $0.01 per share
Volume filter: Limit position to 10% of trading volume