The Three Outside Up candlestick pattern is one of the most powerful and reliable reversal signals that traders use to predict potential upward price movements in the markets. This pattern plays a crucial role in both short-term and long-term trading strategies, offering traders a clear indication of a shift in market sentiment from bearish to bullish.
In this comprehensive guide, we will explore the details of the Three Outside Up pattern, its formation, and how traders can use it effectively to capitalize on market opportunities.
What is the Three Outside Up Candlestick Pattern?
The Three Outside Up candlestick pattern is a bullish reversal signal that appears in a downtrend. It consists of three distinct candlesticks: a bearish candle, followed by a bullish candle that fully engulfs the first bearish candle, and a third bullish candle that confirms the reversal. This pattern suggests that the bears (sellers) are losing control and that the bulls (buyers) are beginning to dominate the market.
Key Characteristics of the Three Outside Up Pattern
To fully understand the Three Outside Up candlestick pattern, it’s important to break it down into its components:
- First Candle: A bearish candle, typically a red or black candlestick, which represents the continued downward movement of the asset.
- Second Candle: A bullish candle that engulfs the first bearish candle. This candle indicates that buying pressure has started to outweigh the selling pressure, signaling a potential reversal.
- Third Candle: A bullish candle that closes higher than the second, confirming that the trend has shifted from bearish to bullish.
This pattern is often observed at or near a support level, where the price tends to find stability before reversing its direction. Traders typically look for this pattern as an opportunity to enter long positions or to make adjustments to their portfolios in anticipation of a potential price increase.
How the Three Outside Up Pattern Forms
The Three Outside Up pattern forms in a downtrend, signaling a potential reversal. Let’s take a closer look at the formation of each candle:
- Bearish Candle (First Candle): The pattern begins with a bearish candle, which indicates the continuation of the downtrend. This is where the sellers are still in control, pushing the price lower.
- Bullish Engulfing Candle (Second Candle): The second candle is a bullish candle, which completely engulfs the body of the first bearish candle. This indicates a shift in market sentiment, with the bulls starting to take control and pushing the price higher. The fact that the second candle fully engulfs the previous candle suggests that the selling pressure is fading and buying interest is increasing.
- Confirmation Candle (Third Candle): The third candle is also a bullish candle and closes above the high of the second candle. This confirms the bullish reversal and indicates that the market has shifted from a bearish trend to a bullish one. The confirmation candle strengthens the signal and gives traders more confidence in the reversal.
Significance of the Three Outside Up Pattern
The Three Outside Up pattern is a strong bullish reversal signal, especially when it appears after a prolonged downtrend. The significance of this pattern lies in its ability to signal the end of a bearish trend and the beginning of a bullish one. This pattern indicates a shift in the market’s psychology, from pessimism and fear (selling) to optimism and hope (buying).
When traders observe the Three Outside Up pattern, it can suggest that the downward momentum is losing steam and that the market is primed for an upward move. As a result, this pattern is often used by traders to enter long positions, riding the anticipated uptrend.
How to Trade the Three Outside Up Pattern
Understanding how to trade the Three Outside Up candlestick pattern effectively can greatly improve your chances of success in the markets. Here are some essential steps to follow when trading this pattern:
1. Identify the Downtrend
The Three Outside Up pattern is most effective when it occurs during a downtrend. The first step is to identify a strong bearish trend, characterized by a series of lower highs and lower lows. The pattern’s reliability increases when it appears after a sustained period of downward movement.
2. Wait for the Confirmation
While the Three Outside Up pattern itself is a strong indicator of a potential reversal, it’s crucial to wait for the third candlestick to confirm the shift in momentum. The third candlestick should be a bullish candlestick that closes above the high of the second candlestick. This confirmation is vital to ensure that the reversal is not a false signal.
3. Entry Point
Once the confirmation candle has closed, traders can enter a long position at the opening price of the next candle. This provides traders with an opportunity to capitalize on the anticipated uptrend. It’s also important to monitor the price action closely after the entry point to adjust your position if necessary.
4. Place Stop Losses
As with any trading strategy, managing risk is crucial when trading the Three Outside Up pattern. Place a stop loss just below the low of the third candlestick to protect your position in case the market doesn’t reverse as expected. A stop loss is an essential tool to help limit potential losses if the market moves against you.
5. Set Profit Targets
Once you’ve entered the trade, it’s important to have a profit target in mind. A good rule of thumb is to target the next significant resistance level or a predetermined risk-to-reward ratio. Setting profit targets allows you to lock in profits when the market moves in your favor and helps to avoid greed-driven decisions.
Best Timeframes for the Three Outside Up Pattern
The Three Outside Up pattern can be observed on any timeframe, but it is generally more reliable on higher timeframes (such as the 4-hour or daily charts) as the signal tends to be more significant and less prone to noise. However, traders who prefer shorter timeframes, such as the 15-minute or 30-minute charts, can also benefit from spotting this pattern in day trading.
Four-Hour and Daily Timeframes
On 4-hour or daily charts, the Three Outside Up pattern indicates a major shift in market sentiment and provides a stronger signal for reversal. This makes it ideal for swing traders or those who prefer to hold positions for several days.
15-Minute and 30-Minute Timeframes
On shorter timeframes, the Three Outside Up pattern can provide quick, actionable signals for day traders. However, the pattern may be more prone to false signals in these timeframes, so it’s crucial to use it in conjunction with other technical indicators for added confirmation.
Common Pitfalls to Avoid When Trading the Three Outside Up Pattern
While the Three Outside Up pattern is a reliable reversal signal, it’s important to be aware of potential pitfalls that traders should avoid:
1. Trading in a Range-Bound Market
The Three Outside Up pattern is most effective in trending markets, especially during downtrends. It’s less reliable in range-bound or sideways markets, where price movement is erratic and unpredictable. Always ensure that the market is trending before acting on this pattern.
2. Ignoring Confirmation
Many traders make the mistake of entering a trade as soon as the pattern appears, without waiting for the confirmation candle. Without confirmation, the reversal signal may be false, leading to unnecessary losses. Always wait for the third bullish candle to close above the high of the second candle before entering a position.
3. Overtrading
Some traders may become overenthusiastic when they see the Three Outside Up pattern and trade every instance they spot. However, not every occurrence of this pattern will lead to a successful trade. Use proper risk management techniques and be selective about the trades you take.
Conclusion
The Three Outside Up candlestick pattern is an excellent tool for traders who wish to capitalize on bullish reversals in the market. This pattern, when properly identified and confirmed, offers a strong signal that the trend is shifting from bearish to bullish. By combining this pattern with other technical indicators and sound risk management practices, traders can improve their chances of success in the markets.
As with any trading strategy, it’s essential to be patient and wait for the right conditions before entering a trade. By mastering the Three Outside Up pattern, traders can add a valuable tool to their trading arsenal.
For more information and detailed strategies, check out Three Outside Up Pattern Trading Guide.