The idea that “trend is your friend, trade with the trend” is good, but excessive confidence never did anyone any good. Trends tend to unfold very quickly against the backdrop of a gradual profit-taking by large players. You can, of course, bet on euphoria, depletion of the life cycle of the trend, but without signals from the technical analysis identifying such situations can be extremely challenging. A group of counter-trend trade patterns, including the 1-2-3 pattern we have discussed in detains, can provide us with such signals. Today we will talk about another very popular graphic configuration – Three Little Indians.
The article covers the following subjects:
Three Indians Pattern: History and Description of the Model
For the first time, I encountered this pattern in Linda Raschke’s Secrets of Top Trading Performance, although I later realized that I had used it in my trading long before that. For example, in harmonious trading there is a very similar pattern Three Movements, and in candlestick analysis there are the Three Mountains and Three Rivers. We will talk about the variations of the pattern in our subsequent articles, but now I will try to explain its economic essence.
Obviously, sooner or later, a trend is exhausted. In the bullish market there are fewer and fewer buyers who are ready to buy the asset at current prices and, vice versa, on the bearish market – sellers who believe in the continuation of the south-bound movement. Large players are waiting for a signal to a change in the trend and, as soon as it comes, they begin to close the previously formed positions. Three consecutive extremes – the little Indians – appear in the chart. In this case, the inability of the bulls to move quotes much higher indicates their weakness and launches a wave of sales.
To identify the pattern, several methods are used: visual (it involves visual search of three peaks successively formed in the conditions of an upward trend); linear (the first two Indians draw a line, its intersection with the chart allows to determine the place where the third extremum will be located); and the culmination method (the pattern is considered formed if the quotes after the completion of the third peak have returned to the highest level of the second Indian).
The pattern trading is diverse and suitable for both aggressive and conservative traders. The former can act in accordance with the previously described test systems. They must be prepared for numerous losses, which are then easily cancelled out by one successful transaction. The position is opened at the closing of the test bar of line 1-2, provided that it is located below this diagonal resistance. Simply put, there must be an unsuccessful test of the line of the first two Indians. The protective stop order is narrow and is at a level a few pips above the current high. A trader must understand what they are risking because they act against the trend.
In the case of peak trading, the entry point is at the highest level of the second Indian bar, the stop order is at the previous extremum. This approach is ideal for conservative traders who tend to win time and carefully prepare for each trade.
The pattern occurs quite often, so it’s not easy to tradewithout a filter system. These may include divergence on indicators, and the minimum depth of rollback, but personally I’m more impressed by the combination of several graphic configurations, or a so-called pattern in a pattern. In the case of the emergence of the derivative and main Three Little Indians patterns, the risks of reversal increase.
As for exit points from the position, you can use both the profit factor, harmonious trade methods, and the emergence of reverse patterns. We have talked about these methods earlier.
Three Movements, Three Mountains, Three Rivers: Candlestick Patterns and Filters
A combination of patterns, harmonious trade, indicator and candlestick analysis increases the efficiency of strategy development.
A novice trader in their search of the Holy Grail would browse the entire Internet, enroll for courses, become an avid visitor of webinars, and download tons of books. In fact, all they need is to find one or several working models, carefully study them along with money management rules, adjust the filter system and start trading. If the experience turns out to be successful, you can use it all your life, if it doesn’t – adopt a new strategy. Work on the pattern involves not only its detailed study, but also the creation of a set of rules that increase the efficiency of trade. We talked about them in the materials on 1-2-3 pattern, it’s time to talk more about the Three Little Indians.
I was once a little surprised to see different names for seemingly identical graphic configurations. In harmonious trade, there are Three Movements, in candlestick analysis – Three Mountains and Three Rivers. A little later I realized that the identification of the model by different authors strengthens its analytical significance. If different people see the same patterns in the chart, the extrapolation principles will work. The question is how to make them effective.
Constructed on the basis of Japanese candlestick analysis’ Three Mountains and Three Rivers, unlike the pattern created by Linda Raschke, Three Little Indians can be used as a kind of filter. For these graphic configurations, three consecutive extremes are not enough. It is required that at the top of the last high or low, a candlestick reversal pattern is formed. Whether it’s a Hammer, a Hanged man, a Morning or Evening Star, Bullish or Bearish Engulfing, or another pattern.
We cannot really say that there is no such thing in Western technical analysis. I, for example, am always happy to find a so-called “pattern in a pattern”, which is when a derivative pattern appears in the parent graphic configuration. This is what happened around the formation of a large third Indian and is, in my opinion, a very serious signal for the reversal of the previous trend.
Despite the fact that Three Little Indians, as, indeed, the previously described 1-2-3, Expanding Wedge, and other patterns, represent the price action, i.e., trade without indicators, traders can very well use combined strategies. With this approach, the calculated indicators, whether MACD, Stochastic Oscillator, Relative Strength Index or others, serve as filters. They do not signal the opening of the position, they only allow you to sort out potentially profitable trades. As a rule, divergence – the discrepancy between the dynamics of the indicator and the instrument – is used. In the case of EUR/USD, the peaks of the currency pair chart are growing (resulting in the formation of the Three Little Indians), while the MACD highs, on the contrary, are declining. The discrepancy in their movement allows the trader to enter the market with more confidence.
The pattern Three Movements is part of the harmonious trade system, therefore requires clear correlarions based on Fibonacci numbers. Rollbacks and projections should correspond to the levels 38.2%, 50%, 61.8%, 78.6%, 127.2% and 161.8% (or otherwise) to be considered a working model. Otherwise it should not be traded.
In my opinion, the market is not so harmonious so as to seek the target point (the point of formation of the next Indian) at the level of only 161.8% based on a correction of 61.8% from the previous wave. Thus, you could miss profitable trades. Another thing is to use combinations of significant numbers and ratios.
Broadening Wedge reversal pattern based on Three Indians
Trading against the trend is often compared to a try to stop an approaching tram. At best, your nails will be harmed. Nevertheless, all trends reverse sooner or later. You just need to know the signs to save your limbs. Finally, everything can turn out like in a fairy tale: you extend your hand and the tram stops. One of these signs is a deeper, compared to the previous one, correction in the current trend. Big traders showed their will to break it and are trying to find out whether their opponents have enough power to extend the present move. If they have run out of power, it is time to go ahead for a counter attack and impose your own conditions.
In the previous articles, I explained in detail Three Little Indians reversal pattern and its varieties, without any regard to the rollback depth. If we take it into account, we’ll get a completely different view on trading with this pattern. If the second Indian is followed by a deeper correction than the first one, it builds the ground for emerging Broadening Wedge pattern and makes the trend more likely to reverse.
Remember, wedges, as a rule, suggest a higher volatility, that is a more intensive fight between sellers and buyers. To identify Broadening Wedge correctly you need to repaint the marking: the correction extreme after the first high becomes point 1, the second Indian – point 2; following it rollback – point 3, the third high in the bullish market (low in the bearish one) – point 4. Now, you only need to wait until point 5 emerges that must be lower than point 3, provided the original uptrend (it will be higher, if the trend is downward).
Trading with Broadening Wedge pattern based on Three Little Indians is the same as the application of it based on 1-2-3 pattern. Traders use Fibonacci grid applied to wave 4-5, besides, rollbacks to the levels of 23.6%, 38.2% and 50% suggest considering sales on the price rebounds from the resistance levels; as in the example of GBP/JPY. Conservative approach suggests going short if the quotes go back to the previous price levels (if the price reaches 50% and goes back to 38,2%, then we sell). Protective stop order is set in the zone of the retracement high. Remember, if the currency pair reaches 78.6% and 88.6%, Broadening Wedge becomes a continuation pattern.
Trading with this pattern is easily combined with other technical tools, both indicators and price action patterns. For example, if traders think that Fibonacci levels are not a sufficient signal to enter a trade, they can also apply Three Indians during a correction to open short positions. The pattern should preferably emerge close to an important resistance level. Asin the case with AUD/USD, when the price went back to the low of the second Indian bar, trader could press SELL. The stop order was set above the retracement high.
Broadening Wedge, based on either 1-2-3, or Three Little Indians is a strong reversal pattern. If you use it in applied trading, you can make it far more efficient. Then, you won’t be afraid of extending your arm to stop the approaching tram.
Three Indians reverse the Trend: A Harmonious Approach
Any trend will end, sooner or later. Deeper corrections, as compared with the previous ones, and a currency pair’s inability to hold above a certain level for a long time say that the dominant strength, either bullish or bearish, is exhausted. As a result, there appears a set of several extremums which is called Three little Indians in technical analysis. We have mentioned the pattern in our blog many times, but the question of the last maximum/minimum’s identification remains open.
A classic approach, whose founder is Linda Raschke, the author of the best-seller “Street Smarts: High Probability Short-Term Trading Strategies”, suggests a visual identification of the third Indian. The trading strategy is supposed to form as soon as the quotes have returned to the previous extremum. However, there are some other methods which allow opening a position much earlier – once the currency pair bounced from an important resistance level. For example, a modern approach determines the third extremum using the trend line plotted through the two first extremums. In an example with USD/CHF, it proved to be quite efficient: the uptrend reversed after the Three little Indians pattern formed.
Three little Indians pattern in USD/CHF chart, modern approach
The third method links the pattern to harmonious trading. The level of the third Indian is computed using 1.272 factor, which is nothing more than a number in the Fibonacci sequence. The following formula is applied to the bullish market:
ER3 = ER1 +1,272*(ER2 – ER1), where
ER1, ER2, and ER3 are the currency rates at the first, the second and the third extremums
The pivot point for the bearish market is computed in the same way:
ER3 = ER1 – 1,272*(ER2 – ER1).
An example with USD/CAD proves that the modern approach wouldn’t have been favourable to a trader: the pair never reached the analytical line drawn through the first and the second Indians. The calculation showed where the important support level, transformed into resistance afterwards, was.
Harmonious approach to Three little Indians pattern
To benefit from the Three little Indians pattern, one didn’t have to wail till USD/CAD quotes returned to the bottom of the second extremum at 1.3255. A short position could be opened two figures higher – at the breakout of support at 1.3455. Further retracements would allow building up short positions. A stop order was supposed to be placed at the top of the market. Only when the pair returned to that level, one could understand that the pattern hadn’t worked out and the uptrend would most likely continue.
Strategy of work using Three little Indians pattern
Some other tools of technical analysis can be used to confirm the efficiency of a potential trade. If Pivot points are close to the calculation level, a trader becomes more confident about opening a position. The same applies to divergence formed in the currency pair’s and MACD’s chart: both in the case when the market reversed because of Three little Indians and afterwards, it helped open short positions in USD/CAD.
Complex trading strategy based on Three little Indians pattern
One may be sceptical about calculation levels or harmonious trading in general, but they often provide what is necessary – the result. Identifying the third Indian mathematically won’t take much time, but the return will certainly compensate for the efforts.
Powerful forex Pattern Combination Strategy
The old ways are the best ways. There have appeared lots of price/action patterns over the last years and their developers promise huge profits. However, they all need to be thoroughly tested. Unlike those “new arrivals”, such patterns as Three little Indians, 1-2-3 or Ross hooks are time-proven. And they continue showing excellent performance on various time frames and currency pairs. A reversal of the EUR/USD’s uptrend is the best proof of classic price/action patterns’ efficiency.
Let’s remember that the bulls in the main currency pair felt extremely optimistic at the beginning of 2020. The USA and China announced a cease-fire in the trading war, which was supposed to have a positive effect on China’s and Eurozone’s efficiency. Bloomberg’s experts made a forecast of $1.16 for 1 euro at the end of the year. However, technical analysts raised an alarm as early as at the very beginning of January: there appeared 3 raising maximums on the daily chart of EUR/USD, a reversal pattern known as “Three little Indians”. Bulls’ inability to move quotes above the last peak, the third Indian, is a clear sign of their weakness. Aggressive strategies imply that the return of a pair to the peak of the second Indian is a reason for opening a short position. A protective stop order is placed a bit higher than the last extremum.
Three Indians in EUR/USD chart
What’s more, following Three little Indians, the 1-2-3 pattern appeared on the daily time frame. It’s a pattern where the second peak is lower than the first one. The buyers don’t have the strength to update the previous peak, which is another sign of their weakness. A classic approach to the 1-2-3 pattern implies going short at the breakout of the diagonal support line drawn through point 2. A protective stop order is placed a bit above point 3. If the quotes return there, the bulls aren’t as weak as they could seem at first.
1-2-3 pattern on EUR/USD chart
A trader may doubt that an uptrend will reverse if only Three Little Indians or only 1-2-3 appears in the chart, but a combination of those patterns is much more persuasive. Next, the process of money-making becomes a mere question of technics. Following the popular price/action patterns on the daily time frame, there appeared a few Ross hooks which allowed building up a short position. Let me remind you that a breakout of the latest minimum after which a slight retracement took place is a reason for selling EUR/USD. A stop order is placed traditionally a bit above the last peak.
Ross hooks in EUR/USD chart
Any trading system is incomplete if a trader doesn’t know when to close a trade. In the example of selling the EUR/USD, harmonious trading is here to help. A target at 113% according to the Shark pattern is placed near the level of 1.08. Thus, when entering at 1.12 (Three little Indians), 1.115 (1-2-3 pattern), 1.1085 and 1.099 (Ross hooks), the profit could have been 1,225 points (400+350+285+190). With a 1:100 leverage, a deposit could have increased manyfold within 1.5 months!
Shark in EUR/USD chart
Still, one needs to know how price/action patterns work. And it’s not an impossible task even for a beginner trader. The LiteForex blog provides a variety of trading strategies and opening a trading account is enough for using them in practice.
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