Last Updated on 24 January, 2023 by Samuelsson
In the candlestick chart, individual candlesticks — which, as you know, represent a unit trading session — can form recognizable patterns either alone or in groups of two or more, and these patterns not only tell you about what has happened in the market but also give you a clue about what the market may do next. The Three Outside Down trading pattern is one of such candlestick patterns and is considered to be among the most reliable patterns.
The Three Outside Down trading pattern occurs quite commonly in the price chart and is very easy to identify if you know what you are looking for. It can tell you about a potential bearish reversal, so you can develop a trading strategy with it.
In this post, you stand to learn the following:
- What the Three Outside Down pattern is
- How to identify it
- What the pattern can tell you
- The psychology behind the pattern
- How to use the pattern in your trading
- Steps for creating a trading strategy with the pattern
What is the Three Outside Down trading pattern?
The Three Outside Down trading pattern is a candlestick pattern that forms over three consecutive trading sessions. It is a bearish reversal pattern that consists of three candlesticks and is typically formed at the end of an uptrend or an extended price rally in a downtrend, where it may signal a potential price reversal to the downside.
The Three Outside Down pattern is an extension of the bearish engulfing pattern or the bearish reversal day pattern. As a matter of fact, some traders and chartists refer to it as a “confirmed bearish engulfing pattern.” Looking at the pattern on the daily timeframe, you will notice that it is formed over three consecutive trading days following a prolonged price rally, with the first two trading days looking like a bearish engulfing or bearish reversal day pattern. The third trading day that completes the trading pattern ends as a bearish candlestick, thereby confirming the bearish engulfing signal formed in the preceding two days and indicating a potential downward reversal.
With this pattern, you can formulate an exit strategy for your long positions in stocks since it signals a possible downward reversal or deep pullback. While we don’t advise new traders to take short positions on stocks, if you are experienced enough to go short on stocks and have a margins account, you can formulate some strategies for trading short positions with this pattern. Interestingly, those strategies also work very well in other markets, such as the forex and commodity markets where you can easily trade in either direction.
Before we discuss, in detail, how you can use the pattern in your trading, let’s first explain how you can identify the pattern, what it tells you about the market, and the psychology behind it.
Three Outside Down Backtest
A backtest is an evaluation of the performance of a trading strategy that uses historical data. In the case of the Three Outside Down candlestick pattern, a backtest can be used to evaluate the pattern’s effectiveness in predicting bearish reversals in the market.
The Three Outside Down pattern consists of three candlesticks in a row. The first candle is a long white candle, followed by a black candle that closes lower than the first candle’s close. The third candle is a black candle that opens below the prior two candles’ lows, and closes even lower than the prior two candles’ close. This pattern is interpreted as a strong bearish signal, suggesting that the price trend is about to reverse.
To evaluate the accuracy of the Three Outside Down pattern, a backtest can be performed. In a backtest, the performance of the pattern is tested by running a simulation on historical data. The backtest looks for instances of the Three Outside Down pattern in the past and measures how often it successfully predicted a bearish reversal.
We have conducted a backtest of the Three Outside Down pattern and 75 other candlestick patterns. The results showed that the Three Outside Down pattern was one of the most reliable reversal signals, accurately predicting bearish reversals approximately 70% of the time. This high rate of accuracy makes the Three Outside Down pattern a valuable tool for traders looking to enter bearish positions.
How to identify the Three Outside Down pattern
Look for the Three Outside Down pattern in an uptrend, a price rally in a downtrend, or the upswing in a ranging market. It is more likely to occur around a resistance level. The pattern comprises three candlesticks; each candlestick is a graphical representation of the price movement during a trading session, which can be a full trading day, week, or month, or even an intraday timeframe like 4 hours, 1 hour, 30 minutes, or any timeframe.
So, if we’re to use the daily trading session, for example, the Three Outside Down pattern forms over three trading days as follows:
- The first trading day ends as a small bullish candlestick (the trading day closes lower than the open price) in line with the price rally preceding it.
- The second trading day forms a large bearish candlestick (the trading day closes higher than the open price) that opens above the close price of the first candlestick and closes below the open price of that first candlestick; hence, the second day’s bearish candlestick completely engulfs the first day’s bullish candlestick.
- The third trading day, which completes the pattern, forms a bullish candlestick that closes below the close of the second day’s candlestick.
Certain conditions must be met before a valid three outside pattern formation is established. The conditions include:
- The pattern must be formed in a prolonged price rally (uptrend or pullback in a downtrend)
- The open price of the second day’s candlestick is higher than the close price of the first day’s candlestick.
- The close price of the second day’s candlestick is lower than the open price of the first day’s candlestick.
- The close price of the third day’s candlestick is lower than the close price of the second day’s candlestick.
One more thing to note is that the strength of the Three Outside Down pattern is increased by the size of the second day’s bearish engulfing candlestick — the bigger that engulfing candlestick, compared to the first day’s bullish candlestick, the stronger the trade setup.
What does the Three Outside Down trading pattern tell you?
The Three Outside Down trading pattern is one of the most reliable reversal candlestick patterns, and since it forms after an extended price rally, the pattern has a bearish implication. Experienced traders use the pattern as one of the tools in their arsenals when looking for shorting opportunities in the market, and they often combine it with key resistance levels.
Appearing during an upswing in price, here is how the pattern is formed: A price rally suddenly comes to an end with the appearance of a bearish engulfing candlestick, which signals a potential price reversal to the downside. However, if you critically look at the price action prior to the engulfing bearish candlestick, the preceding candlestick, which is the last bullish candlestick in the price rally, is not as big as the other bullish candlesticks — this an early sign that the price rally has lost momentum.
This last small bullish candlestick is considered the first candlestick in the Three Outside Down pattern. The second candlestick, opening above the closing price of that bullish candlestick before turning downward during the trading session and closing well below the first candlestick’s open price, indicates buyers are exhausted and sellers are taking control, shifting the momentum to the downside. At the end of the trading day, you have a long bearish engulfing candlestick that indicates a possible downward reversal.
On the third trading day, the potential price reversal suggested by the preceding two day’s price action is confirmed when the day closes as a bearish candlestick, with its closing price lower than that of the second trading day. Occurring in an upswing, the formation signals a possible price reversal to the downside.
Even if you consider the bearish engulfing candlestick on the second trading day a poor reversal signal, the third session closing below the second day’s close indicates that the downward price reversal may be serious. The effect of the Three Outside Down pattern is more significant if it occurs at a known resistance level — many traders consider the pattern a reliable trade signal on its own.
But what is the psychology behind the pattern?
The market psychology behind the Three Outside Down pattern
As you already know, bulls push the price up, while bears push it down. These two are always fighting to control the market, and in the process, they generate specific candlestick patterns, such as the Three Outside Down pattern, which shows who is likely dominating the market at that point.
Taking a closer look at the pattern, you will notice that the first trading day’s candlestick is bullish, in line with the ongoing price rally. But it is quite small compared to other bullish candlesticks in that upswing, which indicates that the bulls are getting exhausted. The next day, the bulls threw in everything they got by opening the day with a gap but were overpowered by the bears as they forced the day to close lower than the previous day’s open, showing a shift in sentiment. The next day, the bears’ domination continued, confirming the shift in momentum.
Now, like most bearish reversal candlestick patterns, the Three Outside Down pattern is more likely to form around a strong resistance level, and here is why: There are many sell limit orders around a strong resistance level, essentially making such level a supply zone. In addition to the sell limit orders, there are traders waiting to flood the market with sell market orders once the price reaches the resistance level. All these contribute to the selling pressure that overwhelms the bulls at that level, leading to the bearish engulfing candlestick and the confirmation bearish candlestick after it.
How to use the Three Outside Down pattern in your trading
The Three Outside Down pattern can be an effective tool in your swing trading arsenals. But you may have to combine it with other trading tools that can help you to identify the price trend and important price levels. In fact, the Three Outside Down pattern is best used as a trade trigger when the other factors that set up a high-probability trade are present. As you should know, the key factors for a good trade setup include:
- The trend
- An important price level
- A trade trigger
With the Three Outside Down pattern as your trade trigger, you will need other tools for identifying the trend and key price levels with huge supply.
The trading tools you can use
Some of the important tools you can use alongside the Three Outside Down trading pattern include:
- Trend lines
- Support and resistance levels
- Long-period moving averages
You can see the Three Outside Down pattern in an uptrend, a pullback in a downtrend, and the upswing in a range-bound market. In a trending market, you need trend lines to delineate the direction of the trend so that you don’t trade against the trend. Apart from spotting the trend direction, trend lines can also act as dynamic support or resistance levels, where the price is likely to reverse.
With the Three Outside Down pattern, you should be more interested in downtrends, so you attach your trend line to the highs of the pullbacks (price rallies) where it can act as a descending potential resistance level for future price rallies. When the price makes a pullback in the future, it is likely to reverse around the trend line, so a Three Outside Down pattern that occurs there is more likely to be accompanied by a bearish reversal and the continuation of the downward trend.
Horizontal resistance levels
When trading a price action pattern, such as the Three Outside Down pattern, it is important to identify support and resistance levels since they are usually the levels where the price is likely to reverse. The Three Outside Down pattern is a bearish reversal signal, so the best place to look for it is around a resistance level. A Three Outside Down pattern at a resistance level has a high probability of success.
Long-period moving averages
Another tool that can help you identify the direction the trend direction is a long-period moving average, such as the 200-day or 100-day moving average. A long-period moving average can also serve as a dynamic resistance level where price rallies in a downtrend are likely to reverse, so the Three Outside Down pattern is likely to occur there.
In a down-trending market, the moving average is sloping downward and mostly stays above the price bars. When the price makes a pullback, it is likely to reverse around the moving average level. Hence, a Three Outside Down pattern that forms there will likely yield a profitable outcome.
Some trading strategies you can use with the Three Outside Down pattern
As we stated earlier, you can use the Three Outside Down pattern to fashion some trading strategies that suit your trading styles. The pattern may be used to find shorting opportunities or to know when to close an open long position. Let’s take a look at some of the uses.
A reliable exit strategy
As a beginner trader in the stock market, it may not be wise to go short on stocks. You may wish to limit yourself to taking only buy setups, like the three outside up pattern. However, you should also know how to identify the Three Outside Down pattern so that you may close your position when the pattern occurs since it is a very potent bearish reversal pattern.
Shorting rallies in a downtrend
If you have the capacity to go short on stocks or you are trading the forex or commodity market, the best way to trade the Three Outside Down pattern is to short rallies in a downtrend. In a downtrend, the downswings are impulse waves, which are bigger and longer lasting, while the upswings (rallies) are pullbacks. The aim of a swing trader in a downtrend is to ride down the downswings when the pullbacks reverse.
So, what you do here is to wait for the price to pull back to a resistance level, trend line, or long-period moving average and look for the Three Outside Down pattern. When you see one, go short at the close of the candlestick that completes the pattern
Shorting the upper boundary in a range-bound market
Another good way to use the Three Outside Down pattern is to use it to find shorting opportunities in a range-bound market. In this case, you look for the pattern around the upper boundary of the range, which is the resistance zone. Your aim is to ride the next downswing, and the Three Outside Down pattern signals the beginning of a new downswing.
Predicting a potential trend reversal
In the forex or commodity market, some traders may use the Three Outside Down pattern to trade a potential trend reversal, especially when combined with reversal chart patterns and a strong resistance level. Attempting to predict the market top is very risky, especially for stocks, which have unlimited upward potentials and limited downward potential.
Steps for developing a swing trading strategy with the Three Outside Down pattern
Here is how you can formulate a trading strategy with the Three Outside Down pattern:
- Research: Study the Three Outside Down pattern in the historical price data on your price chart. Combine it with moving averages, resistance levels, and trend lines discussed above. Observe the situations where the pattern worked and where it failed and find the things that are common in each group.
- Develop a strategy: Formulate a strategy based on your findings and write the rules down
- Test your strategy: Back-test and front-test (demo trading) your strategy to know how well it performs and note the areas that need tweaking.
- Modify: Make the necessary modifications and test it again.
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