Last Updated on 18 November, 2020 by Samuelsson
The candlestick chart was first used by Japanese rice traders in the 18th century and later became popular among Japanese financial market traders. It wasn’t until the 1990s that the candlestick chart became popular among Western traders. Ever since Steve Nison popularized its use in the Western trading world, a few candlestick patterns have been found to have high predictive quality, and the three outside up pattern is one of such patterns.
The three outside up pattern is one of the most reliable candlestick patterns that can tell you about a potential price reversal. One good thing is that the pattern is not difficult to identify if you know it since it appears quite commonly on the price chart, and you can easily formulate a strategy to trade it.
Continue reading to learn the following:
- What the three outside up pattern is
- The anatomy of the pattern
- How to interpret it
- The psychology behind the pattern
- How to use it in swing trading
- Steps for creating a trading strategy with the pattern
What is the three outside up trading pattern?
The three outside up trading pattern is a pattern that forms on the candlestick chart over three trading session. It consists of three candlesticks and is typically formed in a downtrend or an extended downward price swing in an uptrend, where it may indicate a potential price reversal to the upside.
The pattern is an extension of the bullish engulfing pattern or the bullish reversal day pattern. On the daily timeframe, the pattern is formed over three trading days after a prolonged downswing, with the first two trading days looking like a bullish engulfing or bullish reversal day formation. The third candlestick that completes the pattern is a bullish candlestick that confirms the potential reversal.
Some traders formulate their swing trading strategies with this candlestick pattern alone or in combination with other trading tools owing to its reliability. We will discuss in detail how you can use the pattern in your trading, but let’s dissect the anatomy of the pattern first.
The anatomy of the three outside up trading pattern: how to identify the pattern
Basically, the three outside up pattern consists of three candlesticks, and as you know, each candlestick represents a trading session, which can be a full trading day, week, or month, or even an intraday time session like 4 hours, 1 hour, 30 minutes, or any timeframe. Using the daily timeframe, for example, the pattern forms over three trading days with three candlesticks:
- The first candlestick is a small bearish candlestick (the trading day closes lower than the open price) in line with the preceding downswing.
- The second candlestick is a large bullish candlestick (the trading day closes higher than the open price) that opens below the close price of the first candlestick and closes above the open price of that first candlestick, so it completely engulfs that first candlestick.
- The third and final candlestick that completes the pattern is a bullish candlestick that closes above the close of the second candlestick.
As you may have observed, for the pattern to be considered well-formed, the following conditions must be met:
- The pattern must be formed in a prolonged downswing
- The open price of the second session’s candlestick is lower than the close price of the first session.
- The close price of the second session’s candlestick is higher than the open price of the first session.
- The close price of the third session’s candlestick is higher than the close price of the second session’s candlestick.
Another thing to note is that the strength of this pattern is increased by the size of the engulfing second candlestick. The bigger the engulfing second candlestick, compared to the first bearish candlestick, the more significant the pattern will be. Look for the pattern in a downtrend, a pullback in an uptrend, or the downswing in a ranging market.
Interpreting the three outside up pattern
The three outside up pattern has a strong bullish implication as it forms after an extended downward price movement. It is seen as a reliable reversal setup, and most smart traders add it to their trading arsenal. The formation indicates a buying opportunity in the market, which can be traded alone or when supported by another analysis.
This pattern is formed during a long downswing. This is how it occurs: The market has been falling for a while and suddenly comes to a halt with the appearance of a bullish engulfing candlestick, indicating a potential bullish reversal. But prior to the engulfing bullish candlestick, the last bearish candlestick in the downswing is not as big as the other bearish candlesticks before it, which is an early indication that the downswing has lost momentum.
This last bearish candlestick is considered the first candlestick in the pattern. The fact that the second candlestick opens below its closing price before turning to move steadily upward during the trading session and ending with a closing price that is well above the first candlestick’s open price shows that the downswing would have continued but buyers stepped up their game and shifted the momentum to their side. What you have is a long bullish candlestick that is pointing to a possible reversal.
Finally, the third trading session confirms the reversal suggested by the first two sessions when it closed as a bullish candlestick, with its closing price higher than that of the second trading session. Since this pattern occurs in a downswing, it strongly indicates a possible upward reversal in the price direction.
As a matter of fact, many traders consider the pattern a reliable trade signal on its own. Even if the bullish engulfing candlestick in the second session is seen as a fluke, the third session closing higher than the second session shows that the price is actually determined to head upward. The pattern is more significant if it happens at a known support level — it means that a rebound has occurred. But do you know why the bullish reversal could happen at that level?
The psychology behind the three outside up pattern
Now, let’s take a look at sentiments behind the three outside up pattern and why it is likely to occur at a known support level. As you already know, the market is made up of buyers, who are also called the bulls, and sellers, who are also called the bears. Sellers drive a downward price movement, while buyers push the price up.
Looking at what happed during the three trading days (sessions) that form the pattern, the first day ends with a small bearish candlestick that, even though it looked like a continuation of the downswing, actually showed that the bears are getting exhausted. The weakening bear’s momentum emboldened the bulls to step up and take control, which is confirmed by the long bullish engulfing candlestick that formed the next trading day.
This larger candlestick tells a lot about the shifting market sentiments — after a long period of domination by the bears, the bulls are finally taking control and beginning to dominate, signaling that the price movement in the foreseeable future is to the upside. What follows on the third trading day is another bull’s domination, which further confirms that the bulls have taken control of the market direction.
Interestingly, like other bullish reversal candlestick patterns, the three outside up pattern tends to form around a known support level, and the reason is simple. A support level is often a demand zone — a price level where there are many buy limit orders. Aside from the buy limit orders, some traders who are on the sidelines are monitoring the level to know how the price reacts at that level.
So, when the price falls to a strong support level where there are many buy limit orders, the already exhausted bears may not be able to clear all the buy orders at that level to push the price further down, so the price stagnates. Seeing that the bears couldn’t push any lower, the buyers on the sidelines flood the market with their buy market orders, which push the price up. What you get is a tall bullish engulfing candlestick, followed by another bullish candlestick the next trading day, which closes above the close price of the engulfing candlestick.
The momentum is now with the buyers (the bulls). Only a few sellers are still willing to sell at this point because the price has gotten so low for them to want to sell any lower. As a result, the bulls don’t have any serious resistance on their way. They easily take out the few sell limit orders in the market and keep pushing the price up in search of sellers to fill their orders. This gives rise to a price reversal.
Using the three outside up pattern in swing trading
The three outside up trading pattern can be very effective in swing trading, but you will need to understand how to use it effectively in different market conditions. Before we look at the different market conditions, let’s first discuss some of the tools you can use to trade this candlestick setup.
The trading tools you can combine with the pattern
There are tools that are used in price action trading which can be very useful in trading the three outside up pattern. The common ones include:
- Trend lines
- Support and resistance levels
- Long-period moving averages
Trend lines are very helpful in identifying the direction of the trend so that you don’t trade against the trend. With the three outside up pattern, you are interested in an uptrend. Apart from spotting the trend direction, trend lines can also act as dynamic support or resistance levels, where the price is likely to reverse.
When the market is in an uptrend, you attach the trend line to the lows of the pullbacks (downward price swings) so it acts as a rising potential support level for future downswings. If the price makes a pullback to the trend line in the future, look for the three outside up pattern there. A pattern that occurs there is more likely to play out very well.
Support and resistance levels
It is important to identify support and resistance levels when trading a price action setup because setups that form around those levels are more likely to play out well. The three outside up pattern is a bullish setup, so it makes sense to look for it around a support level.
However, in an up-trending market, the resistance levels would often become support levels when the price climbs above them. Whatever the case, when the price falls to a supporting level, look for signs of a price reversal, especially the three outside up pattern. When you see the setup there, it has a high probability of success.
Long-period moving averages
A long-period moving average, such as the 200-day or 100-day moving average, can help you to identify the direction of the long-term trend in a stock. But more importantly, it can serve as a dynamic support level that improves the odds of any bullish reversal setup, including the three outside up pattern.
When the market is trending upward, the moving average is below the price bars and sloping upwards. If the price makes a decline to the level of the moving average, watch out for the three outside up pattern. A pattern that forms there will likely yield a profitable outcome.
Swing trading different markets
You can use the three outside up pattern in combination with any of the tools discussed above to swing-trade in different market conditions. Let’s take a look at the different conditions one by one and how you can swing-trade them with the three outside up setup
A market in an uptrend
When the market is trending upward, the upswings will be bigger and more prolonged than the downswings. So, in an uptrend, swing traders normally focus on the upswings and try to capture them one at a time. Interestingly, the three outside up pattern can help them to do that more effectively.
To swing-trade an uptrend, wait for the price to pull back to a trend line, long-period moving average, or support level. Then, watch out for the three outside up pattern, and if you see one, place a buy trade at the open of the next day after the pattern has completed.
A ranging market
In a ranging market, the price is moving sideways between two already established boundaries. The upper boundary is the resistance zone, while the lower boundary is the support zone. When the price reaches the lower boundary, it bounces off and heads upward, and when it reaches the upper boundary, it finds it difficult to break the resistance and turns downward.
You can use the three outside up pattern to anticipate when the price is about to head upward after hitting the support level. Here is what to do:
- Confirm that price is in a range and mark the boundaries
- Wait for the price to hit the lower boundary
- Look for the three outside up pattern and enter a trade on the completion of the pattern
- Put your take profit just before the upper boundary of the range
A downtrend reversal
Some swing traders use the three outside up pattern to spot a potential reversal of a down-trending market, but we don’t advise you to do this if you are a beginner. What they do is to watch how the price reacts after it has fallen to a well-known support level. If the price can break below the support level, they watch for the three outside up pattern, which is a strong reversal setup.
If the pattern forms, they go long on the next candlestick and place their stop loss below the support level. Once the price moves in their favor, they move their stop loss to breakeven. Their take profit is set at the nearest resistance level.
Creating a trading strategy with the three outside up pattern
Here is how you can formulate a trading strategy with the three outside up pattern:
- Study the three outside up pattern in your price chart, using the price history
- Play around with some of the trading tools like moving averages and trend lines discussed above
- Note the situations where the pattern worked and where it failed
- Find the things the successful setups have in common as well as the things the failed setups have in common
- Formulate a strategy based on your findings and write the rules down
- Test your strategy
- Make the necessary modifications
Learning to how to swing-trade stock
While you can teach yourself how to trade by studying all the books and other trading resources you can find online, you may end up wasting too much time without learning the important stuff that can make you a profitable trader. The easier way to learn swing trading is to enroll in a swing trading course.
If you simply intend to make money from trading stocks without bothering to learn how to analyze the markets to find the stocks to trade and all those hard stuff, you can subscribe to a reliable swing trading signal service that would tell you which stocks to buy and when to open and close your trades.
Here you can find our Candlestick archive with many articles covering the subject.