Among candlestick patterns, patterns that include three candlesticks are held in high regard among the candlestick pattern traders. Both three outside up and three outside down patterns are reversal patterns. In this article, we will discuss in detail these two patterns. We will also find examples of these patterns in candlestick charts.
We will also learn about their characteristic features, when and how they can be found, how to trade them and their pros and cons.
Learn The Basics: Guide to Candlestick Patterns
Three Outside Up Candlestick Pattern
What is the Three Outside Up Candlestick Pattern?
The three outside up is noticeably a reversal pattern. Appearing in a downtrend, preferably at the end of the downtrend, this candlestick pattern consists of three consecutive candles that form this pattern. The first candle is red which is a part of the prevailing downtrend. The next two candles are green candles indicating a bullish reversal.
In the figure above, we can see a schematic diagram of the three outside-up candlestick patterns. As mentioned above, we have three consecutive candlesticks here.
The first one is red and the other two consecutive angles are green. They have been marked with a circle for understanding. The next green candle after the pattern actually validates the reversal pattern.
Features of Three Outside Up Patterns
This candlestick pattern is a three-candlestick bullish reversal pattern. This pattern indicates the end of the prevailing trend from an existing bearish trend.
Hence, this pattern will start with a red candle which is a part of the existing trend and tries to take the market lower.
The first candle is a short-bodied red candle. It is short-bodied because there is in-fighting going on among the bulls and bears while the first candle is being formed. There must be a prevailing downtrend for this trend to appear.
The second candle is a large green candle. This signifies that the bulls have taken control of the situation. The first candle must be contained with the body of the large second green candle. Thus, the second candle is an engulfing candle.
This feature is important to justify the fact that from that point onwards the bulls will take control and defeat the bears hands down. This situation is indicative of the bullish reversal uptrend.
The third candle is also a green candle. This candle is indicative of the upcoming bullish reversal trend. The third candle has a tighter close than the second candle. But the third candle must close higher than the large second candle. The third candle actually starts a bullish reversal.
How to Find the Three Outside Up Candlestick Pattern?
Firstly, a trader needs to look for a strong bearish trend.
Secondly, there should be a small red candlestick down the trend which may turn out to be the first candle of this pattern.
The second candle has to be a large green engulfing candle. The large body of the second candle must contain the body of the first candle. That is why the second candlestick is an engulfing candlestick.
The third green candle is closing above the second candle, which practically starts the bullish reversal. As already mentioned, the third green candle must close above the second green candle.
Reversal starts after the third candle if the pattern is valid. We can see from the chart above, that the downtrend ends and the uptrend starts from this pattern. Though the reversal may not last long, the reversal happens for a valid pattern.
How to Trade the Three Outside Up Pattern?
The three outside up pattern provides easy entry and stop-loss. But as we already know, before trading an asset, a trader must confirm the market condition overall. Unless the trade can be confirmed from other indicators, at least one other indicated, a trader should not commit any position.
Once the trader decides to do the trading, the trader must confirm the pattern first. When at the end of the existing bearish trend the three candlesticks form the three outside up pattern is formed, the trader buys the stock just above the high of the third candle. That can be done only on the fourth candle, the candle after the third candle of the pattern, In the diagram above, the trader buys the stock above the high of the third candle, as marked by the green line.
The stop loss was maintained below the swing low, which is just below the low of the second candle. It is a very simple setup.
The profit target is not fixed. It depends on the trader. Profit can be taken when the price reaches the 1:2 risk/ reward ratio or based on a predetermined profit percentage target, or wait till the trend is broken.
Example of a Three Outside Up Pattern
Here is an example of three outside-up patterns. This is a chart of Wal-Mart stores. In this chart, we can see that the second candle is the bullish engulfing candlestick. The third candle crosses the immediate resistance line.
It must be noted that if the reversal pattern has to continue, the price must break through resistance zones. The price chart shows that the price moved up after the reversal was confirmed.
But when the price faced strong resistance, as shown by the red line, the bulls were rejected and the price came down as a result.
Further on the way, the bulls started to push the price upwards slowly but surely. Later we find that the price broke through the resistance line. That is important for a reversal to continue. The price must face the resistance and break through it.
Three Outside Down Candlestick Pattern
What is the Three Outside Down Candlestick Pattern?
This candlestick pattern is also a three-candle reversal pattern. Commonly found at the end of a bullish trend, this candlestick pattern indicates a bearish reversal. Similar to the three outside up, the second candle is an engulfing candle. The first candle is green and the other two candles are red candles.
Features of Three Outside Down Candlestick Patterns
The three outside-down patterns has some features which separate them from other patterns.
Firstly there has to be an existing uptrend. Secondly, there must be a small green candlestick at the top.
Once the small candle is found, the trader should look for a bearish engulfing pattern. A bearish engulfing candlestick after the small bullish candle. The arrangement should be such that the body of the second candle should be large enough to cover the whole length of the body of the first candle.
This indicates the end of the prevailing bullish trend. We can find that in candlestick charts. A new opposite trend may start once this candle is followed by a third bearish candle.
The third bearish candle must close below the second bearish candle. This is an essential feature of the three outside down patterns.
We should also note that the stronger the second candlestick is, the stronger is the reversal pattern.
If all these features are there, we may find a bearish reversal trend from this pattern. The pattern will form an immediate top in the bullish trend.
How to Find the Three Outside Down Candlestick Patterns?
We find this pattern on the top of a bullish trend. The small bullish candlestick found at the top is the last bullish candle after which the bearish reversal starts.
How to Trade the Three Outside Down Patterns?
Trading a three outside down pattern is not very difficult. Once the pattern is found at the top of a bullish trend, the trader should simultaneously confirm the reversal pattern from other indicators.
The short or sell position should be taken just below the low of the third candle. The trade entry is shown in the diagram above. The stop loss is kept just above the high of the second candle.
The trade exit will depend upon the trader. It can be done based on any predetermined percentage, a fixed risk/ reward ratio or at the next bullish trend.
Example of a Three Outside Up Pattern
Here is a real example of three outside down pattern formations on the Ashoke Leyland chart. After forming a top, the reversal pattern occurs and the price comes down sharply.
We may expect a similar kind of result in another chart if we trade this pattern. In this chart, we can see that the three outside down pattern has given a lot of profit to the trader. It may or may not happen in other cases, but a valid three outside pattern is good for trade.
Accuracy of Three Outside Up and Three Down Patterns
Both of the above patterns are three candle reversal patterns. In a chart, candle reversal patterns are seen often. But we need to know their efficiency before we commit to any position.
These patterns are found often in candlestick charts and provide good trading opportunities. But though often found, these patterns do not give good profit margins always. Statistical data says, on average, a net profit of approximately 5% can be had over the long term.
Hence a trader should not trade only these patterns. it is advisable to trade other patterns as well along with these patterns.