Red-White-Red Pattern Trading

Trading with chart patterns can offer low-risk and highly profitable trade opportunities. Recurring patterns can be easily described and tested in terms of profitability. Also, the pattern presented here that refers to the Austrian flag could well replenish your holiday budget. This article shows how you can use it to your advantage.

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THE PATTERN

Price patterns are generally regarded as highly profitable investment strategies. You will hardly find a trading professional who does not in any way incorporate the conclusions resulting from the recurring patterns into his trading decisions.

The most commonly known price pattern is probably the candlestick pattern "Hammer". It describes the behaviour of the market on a given day and indicates where and how open/high/low/close are arranged on the price scale. This in turn allows conclusions to be drawn about market behaviour on the following day.

A hammer is a day in a downtrend which could lead to a trend reversal. The day begins weakly, new lows are formed in the course of trading, but then the reversal comes, the market makes up the lost ground and closes near the opening. The chartist doesn't care what this reversal of the market direction has initiated, the only important thing is that the market has moved away from its daily low and closes where it had opened. Figure 1 shows this candlestick pattern.

Figure 1: Hammer pattern. Figure 1 shows you twice the appearance of one of the simplest price patterns - the hammer. The market forms new lows in the course of the day, but can then recover and close in the vicinity of the opening. After the first hammer shown in red, the market could neither form a new high nor a new low. The pattern thus remains without consequences. The second hammer illustrates the idea of how it should work. The market continues to rise the day after the hammer, we go long at the high of the hammer and the initial stop is placed at the low of the hammer.

This means the following for the next day: If the market manages to rise further and exceed the previous day's high, then this is a strong bullish sign and we can consider a long position. However, if the market starts to fall again and forms new lows, then the intraday trend reversal of the hammer was a strengthening of the bulls that came too early. If you are already long, you should close the position at the bottom of the hammer at the latest.

So, a price pattern is nothing more than a good way to indicate exactly where to place the entry and the exit stops. With known stops, the position size can then also be selected correctly - and that is the basis of successful trading.

RED-WHITE-RED

The red-white-red pattern is a price pattern that comprises a total of three days, i.e. not only describes the market behaviour on one day, but also determines the exact sequence of the price development on three consecutive days. The first day of the price pattern is a bullish day, represented on the chart by a red candle. This negative day is followed by a short recovery after new lows, the market can close on day two of the price pattern above its opening. This day must be the lowest of the three days.  A negative day follows on the last day of the price pattern. The previous day's correction is over, but the bears are not so strong that they could push prices below the previous day's low, the market must trade above the low of the white candle all day, but close below its opening. Figure 2 shows several examples of this pattern. The two upper charts show the DAX30 index, the two lower charts the S&P500 index.

Figure 2: chart pattern Red-White-Red. Figure 2 shows the appearance of the price pattern in the DAX30 and S&P500 indices. The red-white-red pattern consists of a total of three days. The first and the last day close under their opening, the day in the middle forms the lowest low of the group of three and closes above the opening price. If the high of the last two days is exceeded, then after three days of indecision a further breakout upwards is to be expected. In combination with the right position size and a sound exit plan, this pattern can be used profitably for trading.

 
 
The idea behind the pattern is that, as the chart shows, after these three indecisive days and today's higher low, a turnaround is imminent. Whether this pattern is meaningful enough and how it could be traded is the subject of this article.

ENTRY

With the definition of the pattern you know the setup, however, in order to be able to earn money with this chart pattern, you still have to determine where exactly the position is to be taken, how large this position is to be and when the position, hopefully with an appealing profit, will be closed again. The price pattern itself, and this applies to all types of price patterns, is not yet a sufficient reason to jump into the market immediately and build up a position. First the market has to confirm the idea, so it has to show that it will follow the red, white and red pattern with the expected upward movement.

Only when the market exceeds the high of the last two candles, i.e. the bulls have clearly taken the helm again, has your time come to enter the market.

If the market rises above this point and thus forms a new high, you can no longer speak of selling pressure. After three undecided days, the market seems to have agreed on one direction again. In addition, the low of the white candle of the formation was confirmed by the new high as Swing Low.

Practically you can realize this entry by placing a stop-buy order valid for the following day on the high of the last two days. However, only enter the market if it has not already opened with a gap above the pattern.

POSITION SIZE

The dose decides whether the medicine is poison or remedy, Paracelsus already knew that, and it is similar for us traders when we have to determine how big the next position should be.

Before you think about how many stocks to buy, you have to think about where and when we will have to decide that our trading idea turned out to be wrong and that we have to close the trade with a loss. So, we need to define our initial stop and set the maximum possible point loss for that trade.

As an entry point, we had decided to go into the market as soon as we saw that new highs were being formed. If the new high turns out to be a bull trap and the market falls below the low of the white candle, then it is clear that the pattern did not work in this case and we have to close the position again. The spread between the high of the last two days (= entry point) and the low of the pattern (= worst case exit) is therefore the risk we take when trading this pattern.
In order to determine the number of shares to be bought from these two values, remember the old money management rule that says that you should never risk more than one percent of your trading account in a trade. The number of shares to be bought is therefore determined by the equation: Number of shares = 0.01*trading account / (Entry level - Exit level). Figure 3 shows this procedure once more.

Figure 3: Position size. The picture shows a possible entry into a long position at the high of the last two candles of the price pattern.  The worst-case scenario for the first day is when the market takes the old highs, then turns and falls below the low of the pattern. The low of the formation is the stop point for the long trade. The position size results from the risk of the trade (28.60 - 28.04 = 0,56€) and the account size. If you want to trade this pattern with a 10 000€ trading account, for example, you would risk 1 percent of your equity if you trade 10 000*1% / 0.56 = 180 shares.

 This ensures that you do not ruin your portfolio even in the event of several consecutive losing trades; on the other hand, the size of the position is large enough to also promote portfolio development in the event of a profit.

EXIT

I have shown you so far how the red-white-red pattern is recognized, how big the position should be, when you should enter the market and where the initial stop should be placed. This does not win any money, only the risk is under control. The next step is to show you how to keep the losses small, let the profits run, and trade this pattern with a positive result.

The entry is usually only a very small building block on the way to a successful trade, the money is earned with the exit, and so that is where our attention should be. If you test the presented approach yourself, you will quickly see that you can also combine this exit with other price patterns and entries.

Successful patterns can easily be detected seen on historical charts, but I would now like to show you a few examples in Figure 4 where this pattern would not have worked. These examples are much more important to develop the exit strategy than those where the pattern worked as planned. You learn what can happen from them, and in the next step you can determine the method with which you can get out of such negative examples with the least possible damage.

Figure 4: If it doesn't work. Figure 4 shows you four examples in which the price pattern was not followed by the expected sustained upward movement. Clockwise: In example 1, the market could only reach a high one day after the pattern occurred. It then stagnated at a high level. Figure 2 shows the case where the market passed the pattern on the first day, but then reversed and fell below the low of the configuration. Figure 3 shows a similar problem to Figure 1, the market cannot decide to go up. Figure 4 is similar to Figure 2, after two days the market turns and begins to fall. An intelligent exit should be able to limit losses in such situations.

 
The cases in which the market explodes after the appearance of the pattern are not difficult to trade (see Figure 2). Wait and count the money, but what if it doesn't go up? Always wait until we are stopped out at the bottom of the configuration or realize earlier that this time it will not be successful, and you better wait with small realized losses for the next chance?

We already had the first exit - the initial stop at the low of the configuration. The next exit deals with the case that we don't see the low of the pattern, but the market doesn't start to rise either. This means we would be trapped in the position. To avoid this, I close the position if it is not positive two days after the entry at the end of trading.

The purpose of this is to eliminate the time risk. The longer you are in the market, the higher the risk is that something will happen to your disadvantage. Originally, the idea was that the market would move strongly upwards after this formation. If it doesn't, something was wrong in our analysis and it is usually better to end the trade and realize small losses than to wait for luck and be exposed to the danger of being stopped with the worst case loss at the bottom of the configuration.

With these two exits, and tests on a basket of stocks from the Dow30 and DAX30 show this, you at least manage to survive. The strategy is not yet generating any profit, but the losses are limited. Now you can only improve.

The second exit further reduced the risk and addressed those cases where the market did not tend further upward. But there is still another risk before we consider taking profits.

What happens if the market rises for a few days, but then turns around and goes down again? Exit 3 is planned for this case. It becomes active from the third day of trading and closes the trade when the market drops back to the entry price. Nothing is won, but nothing is lost, and that is already a small victory.

With these three exits and the right position size you have the risk under control as far as possible, now we can think about how and when we realize profits.

The first profit taking exit is a simple profit target. The profit is automatically realized when the trade has taken three times the initial risk. The initial risk was the distance from the low of the white candle to the high of the last two candles in the pattern (Figure 3).

You can also work with a lower target. This increases the hit rate in sideways markets, as the target is repeatedly triggered by random movements, but prevents larger gains in trend phases. If you already have a trend-following strategy in place, this can be sensible, otherwise I wouldn't choose a target smaller than twice the original risk.

If the target is not reached within six days, I try to exit at the high of the previous day. This usually brings a few extra points of profit compared to closing the trade after a fixed period of time. Instead of waiting for a fixed number of days, you could also try to exit at the high of the previous day if no new high has been reached in the last one or two days. The exit at the entry price always remains active for the worst-case scenario. Figure 5 shows what these exits look like in practice.

Figure 5: Exits. Figure 5 shows various options to close the position. In the first case, the position is closed after four days at the entry price. This has prevented the exit at the bottom of the pattern. Example 2 shows a lucky case for the timed exit. Since the position was not in profit two days after the entry, it was closed. Example 3 shows how useful a profit target can be. The high opening was used for the exit as it was more than three times the original risk above the entry. In example 4, the position is closed after six days at the high of the previous day (clockwise). The position size was chosen so that the same money risk was taken for each trade (see Figure 3).

 CONCLUSION AND PERSPECTIVE

This article showed you a supposedly meaningful course pattern and a technique on how to trade with this pattern. This technique can be extended in many ways and combined with other patterns and entry ideas. The exits presented show how important it is to get the risk of a trade under control as quickly as possible. You need to be careful in your trades to end all those that do not develop as intended. This includes not only the losers, but also those cases where the market only evolves sideways after the expected breakout. Time is also a risk and if the trade does not develop as planned, it is usually best to realize small losses and wait for the next opportunity.

At the end of this article, do you really believe that the Austrian flag can predict the behaviour of the market? Or is it rather the sound exit plan and the right position size which are responsible for the profits?

Philipp Kahler

 Philipp Kahler studied electrical engineering and works in the financial industry. After working in proprietary trading for Bankgesellschaft Berlin, he now develops and manages portfolios for institutional clients.

Source: Traders' Mag