Section 7:

Bullish Reversal Patterns

 

Bullish reversal patterns predict the reversal of an existing bearish trend and the beginning of a new bullish trend. Nevertheless, bullish reversal patterns go against the grain of an existing bearish trend. This makes bullish reversal patterns a little more nuanced and delicate in their application.

Bullish reversal patterns emerge when existing bearish trends grow old, when the fundamental drivers of the trends have run their course. The bullish reversal patterns reveal equaling levels of demand for or supply of a stock; sellers complete all of their selling and buyers begin to see value.

The bullish reversal patterns point to an end of a bearish trend and the beginning of an opposite bullish trend. The reversal patterns provide entry points, offer price targets, and even suggest the time horizon in which the price target might be achieved.

The probabilities of bullish reversal patterns playing out as expected are less than the probabilities associated with trading bullish continuation patterns. The lower probabilities associated with trading bullish reversal patterns stem from the fact that the patterns go against the existing bearish trends. It’s vital, therefore, to manage risk in the event that a bullish reversal pattern doesn’t play out as planned.

123 Bottom

 

Definition:

The 123 bottom is the most common bullish reversal pattern. The requirements for the 123 bottom are rather common, causing the pattern to frequently appear in existing bearish trends. Many 123 bottoms reach the first two conditions, but never confirm. The 123 bottom, therefore, can be somewhat deceiving. That’s why it’s imperative that the pattern confirms before placing trades.

The 123 bottom starts when a stock sharply reverses higher after an extended bearish trend. This sharp rebound is the first requirement of the pattern, or part 1. The second requirement is for the stock to halt its rally attempt at short-term resistance, which is part 2 of the pattern. Part 3 of the pattern forms when the stock stages another sharp rebound, but from a relatively higher level than in part 1. The 123 bottom confirms when the stock breaks above short-term resistance as defined in part 2.

Nuance:

A basic definition of a bearish trend is lower lows. A basic definition of a bullish trend is higher lows. The 123 bottom seeks to identify when a pattern of lower lows ends and a new pattern of higher lows begins.

Another way to think of a 123 bottom is as a very short-term cup and handle, only the 123 bottom occurs at the end of a bearish trend.

The 123 bottom occurs in most bearish trends, but it rarely confirms. When it does confirm, it’s best to take a very short-term approach to trading the 123 bottom. Taking profits quickly is generally a good idea after entering a 123 bottom.

Application:

A 123 bottom is confirmed once the stock breaks above the horizontal resistance level as defined in part 2 of the definition. An entry can be taken as soon as the stock crosses its short-term resistance. This resistance will often act as support in the days following a breakout.

A 123 bottom is rejected if the stock fails to break above resistance or falls below the relative low traced in part 3. A drop below the relative low in part 3 reveals a very short-term pattern of lower lows, which is a bearish indication.

Figure 7.1

Example:

Shares of Goldman Sachs (GS) traced a 123 bottom over the course of three weeks as shown in Figure 7.1. The pattern began when the stock rebounded from $160, tracing part 1. The pattern continued to unfold when GS reached up to but rolled over from the $180 level. This was part 2 of the pattern and served as short-term resistance. Part 3 of the pattern was formed when GS pulled back to near $170, which was $10 higher than the low in part 1. The pattern was confirmed one week later when GS broke above resistance at $180, and aggressively trended higher.