Day Trading the Three Bar
Reversal Pattern
The 3 bar chart pattern is one of the more common trading
setups. The reason it’s so common makes it an easy target for
newbie traders when they do their scans. The problem with the
3 bar reversal strategy when it comes to day trading is the
setup can be found all over the place. So, in order to reduce
the potential number of trades on an intra-day basis, we are
going to apply a few requirements to this setup to filter out
the noise.
1. The stock must be trending hard in one direction
2. The low or high of the three bar formation must occur on
the middle candlestick
3. The third bar must close above the high of both the
first and middle candlestick (the requirement of the
formation is only that it closes above the high of the
middle bar, but we are tightening this rule a bit to
increase the odds in our favor)
As you see the picture below you will notice the painfully
obvious the trend has reversed based on the closing of the
third bar. That’s the entire point, we want to have a clear
sign that the trend has reversed in order to reduce the number
of false signals.
Example of when a 3 Bar Reversal Strategy works
Let’s first establish a baseline of when the 3 bar reversal
pattern works. For this example since we are day trading we
will use the 5-minute time frame to identify the setup. The
below chart is of First Solar (FSLR) from 2/20/2013. The
stock made a low and then reversed sharply. The third bar in
the formation closed above the high of both the middle bar and
the first bar. Again, the 3 bar reversal strategy only
requires a close above the high of the middle candlestick, but
we are looking for a close above the first and second
candlestick for insurance. In this particular setup, you
would have purchased FSLR on the close at $36.03 which was 1
penny above the high of the first candlestick at $36.02.
While the 3 bar reversal pattern does not have a specific exit
trigger you can use a simple moving average or a price target
to book your profits. A guiding principle is you want to
maintain a 3 to 1 reward to risk ratio for all of your trades.
Let’s have a little fun and stretch the boundaries for the
setup. What if instead of simply identifying the setup on one
day, what if we look for setups that occur over a two-day
period. This way we can honor the rules as defined for the 3
bar reversal, but wait for the third bar to occur on the next
day. This way you can take advantage of the increase in
volume and volatility that occurs on the open.
In our next example we will review a 3 bar reversal pattern
for Royal Gold (RGLD) that developed over 2/20/2013 and
2/21/2013. You will see from the image RGLD had a gap down in
the morning, traded flat for most of the day and then closed
near the low. Then the stock had a gap up in the morning to
close above the highs for both the first and second
candlestick. This then triggered a rally of over 2% by 10am
once RGLD exceeded the high set on 2/20/2013.
False Buy Signals using the 3 Bar Reversal Pattern
Day trading is really a test of wills as of late with the
number of active participants trying to fake each other out on
a daily basis. The 3 bar reversal is not immune to these
games. In the next few examples we will cover false signals
of the three bar reversal pattern and how you can quickly cut
your losses.
One reason the 3 bar reversal strategy will have a number of
failures is due to the lack of volatility. When the market is
really choppy the formation is nothing more than a pause in
the action that does not result in any major upswing. For
example, if we look at RGLD from 2/7/2013 you will quickly
notice the stock was range bound from 10:30am until the
close. At 1pm RGLD presented a three bar reversal pattern
after a minor pullback. The third candlestick then closed
above the high of both the first and middle candlestick. This
gave the impression that a rally was brewing. Well two small
dojis later and the stock rolled over. At this point you as a
day trader have to acknowledge you are on the wrong side of
the market. You will want to place your stop below the low of
the middle candlestick.
Pros
The 3 bar reversal pattern can be easily found on the chart
and can generate quick returns. As a day trader you will have
no trouble finding these patterns in any type of market.
Also, unlike other trading setups which are more prevalent in
the morning or afternoon, you will find the three bar reversal
pattern throughout the day.
Cons
The 3 bar reversal pattern used by itself can generate a
number of false signals. Adding in additional confirmation
items such as volume and volatility will increase the odds the
market will go in your favor.
