Introduction to the 123 Rule
In technical trading, trendlines visually represent market trends. When a trendline is breached, it signals potential trend termination. Interestingly, this "broken" trendline can later aid in identifying new trends through the 123 Rule.
While Dow Theory forms the foundational framework for market analysis, Victor Sperandeo's Professional Speculation Principles refined trend confirmation techniques by simplifying trendline applications—culminating in the 123 Rule for detecting trend reversals.
Core Components of the 123 Rule
Trendline Break:
- The upward trendline is broken downward (or the downward trendline is broken upward).
Failure to Make New Extremes:
- Prices test but fail to surpass prior highs (in uptrends) or lows (in downtrends).
Confirmation Break:
- In downtrends: Price breaks above the previous rally’s high.
- In uptrends: Price breaks below the prior pullback’s low.
When all three conditions are met, a trend reversal becomes probable. Entry points emerge after Step 3 confirmation.
Flexibility in Application
- Sequence Variations: Steps may occur in any order (e.g., 2-1-3 or 3-2-1), but Step 3 must finalize the reversal.
- V-Shaped Reversals: Some reversals skip Step 2 entirely (e.g., sharp "V" recoveries without retesting highs/lows).
Practical Challenges & Solutions
1. Validating Step 2 (Non-Exact Tests)
When prices form near-but-not-at prior extremes:
- The connecting line between the new high/low and the prior extreme should ideally maintain a slope ≤30°.
- Example: If testing a downtrend’s low, the subsequent higher low’s slope exceeding 30° suggests Step 2 may be invalid.
Note: The 30° threshold is heuristic; adjust based on market context.
2. Identifying Step 3 Breakout Levels
- With Step 2: For uptrends, locate the lowest point between the prior high and the tested high.
- Without Step 2: For uptrends, use the low immediately preceding the prior high.
Combining 123 Rule with Reversal Patterns
When the 123 Rule coincides with candlestick reversal patterns (e.g., head-and-shoulders), prioritize the reversal pattern—it often provides clearer profit targets.
Limitations
The 123 Rule isn’t infallible. False signals occur when trends resume post-break. Thus:
- Use it for short-term reversals.
- Confirm major trend shifts with additional indicators (e.g., volume, momentum oscillators).
FAQ
Q1: Can the 123 Rule predict the magnitude of a reversal?
A: No—it only signals reversal likelihood. Measure targets via support/resistance or Fibonacci extensions.
Q2: How reliable is the 30° slope guideline for Step 2?
A: It’s a practical reference, not absolute. Backtest with historical data to calibrate for your asset.
Q3: Does the Rule work across all timeframes?
A: Yes, but higher timeframes (daily/weekly) reduce noise and false signals.
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Q4: What if Step 3 fails after entry?
A: Set tight stop-losses below (uptrend) or above (downtrend) the breakout point to minimize losses.
Final Notes
The 123 Rule excels in simplicity but demands disciplined validation. Pair it with risk management tools to enhance efficacy.