THREE-BAR REVERSAL PATTERN FOR DAY TRADING

According to Alton Hill, three-bar reversals are too common in intraday time-frames. To select the best three-bar reversal patterns for day trading, he wants the third bar in the pattern to close above the highs of the first two bars.

The diagram below demonstrates the difference between the usual three-bar reversal pattern and Alton Hill’s day trading version.

RULES FOR LONG

1. Bar 1 closes down
2. Low of Bar 2 is below low of Bar 1 (and Bar 3)
3. Bar 3 closes above the high of both Bar 1 and Bar 2
4. Buy at close of Bar 3

RULES FOR SHORT

1. Bar 1 closes up
2. High of Bar 2 is above high of Bar 1 (and Bar 3)
3. Bar 3 closes below the low of both Bar 1 and Bar 2
4. Sell at close of Bar 3

WINNING TRADE

This a 5-minute chart of ES futures. It shows the regular session. I included part of the previous section to show the up trend that ended yesterday. After our entry, the prices drifted up for the rest of the session.

1. The previous session ended with a strong bull trend.
2. The three-bar reversal pattern was also the right shoulder of a bullish head and shoulders formation. (You might have noticed that the head of the formation was a regular three-bar reversal pattern. In this case, it gave a better entry than our enhanced pattern.)
3. The last bar of the pattern closed above the highs of the two previous bars. That was our signal to buy.

LOSING TRADE

This is a 5-minute chart of E-mini Dow contract. Despite a strong signal bar, the pattern failed immediately after entry.

1. Although prices were dropping consecutively for seven bars, the increasing buying pressure is obvious as the bars show long bottom tails (shadows).
2. Tails developed at the top of the bars during the pullback upwards. Tails on both top and bottom of the bars are giving us mixed signals, implying that prices might be congesting soon.
3. If we ignored the above warning signs and shorted the three-bar reversal pattern, it is difficult to find a worse entry point.

REVIEW – THREE-BAR REVERSAL PATTERN FOR DAY TRADING

This modified three-bar reversal pattern is impressive. A simple rule has turned this commonplace pattern into a powerful setup.

In fact, this added rule is asking for confirmation of the pattern in advance. (Applying the technique of candle blending, if Bar 3 in a normal three bar reversal pattern has good follow-through in Bar 4, blending Bar 3 and Bar 4 would have resulted in this enhanced three-bar reversal pattern.)

You can easily combine this pattern with other indicators or price patterns to find high probability trade setups. The winning example is a great combination of a head and shoulders formation and a three bar reversal pattern.

However, due to the extra rule, the signal bar (Bar 3) tends to have a large range. As our stops are usually placed on the opposite end of the signal bar, the trade risk might be higher. We should either cut down our trade size or tighten the stop if possible. If you are unable to manage the risk, then skip the trade setup.

One last point to note is that if the middle bar of the pattern is an outside bar, be very careful. Outside bars often precede wild and unpredictable price action.