The Three Outside Up candlestick pattern is a potent bullish reversal signal used by traders to identify potential trend changes in the market. This pattern is a combination of three candles that reflect a shift in market sentiment from bearish to bullish, providing traders with a reliable indication of an upward price movement. Understanding the structure and significance of the Three Outside Up pattern is crucial for traders who want to make informed decisions in the financial markets.
What is the Three Outside Up Candlestick Pattern?
The Three Outside Up candlestick pattern is a three-candle formation that appears after a downtrend, signaling a potential reversal to the upside. It’s a variation of the Engulfing pattern, where the second candle engulfs the first one, but with an added third candle to confirm the reversal.
This pattern is highly valued for its reliability, as it not only indicates a change in market direction but also provides a strong confirmation that the new trend is likely to continue.
Components of the Three Outside Up Pattern
The Three Outside Up candlestick pattern consists of three distinct candles:
- First Candle: A bearish (red or black) candle that continues the existing downtrend.
- Second Candle: A large bullish (green or white) candle that completely engulfs the first candle’s body. This indicates a shift in market sentiment, as the bulls have taken control from the bears.
- Third Candle: Another bullish candle that closes higher than the second candle, confirming the upward reversal.
How to Identify the Three Outside Up Pattern
To accurately identify the Three Outside Up pattern, traders should look for the following criteria:
- Location: The pattern must occur after a downtrend, ideally after a sustained decline, which makes the reversal signal more significant.
- Engulfing Candle: The second candle must engulf the entire body of the first candle. The wicks or shadows are less important, but the body of the second candle should be larger than the first.
- Confirmation Candle: The third candle must close higher than the second candle, reinforcing the bullish sentiment and confirming the reversal.
Formation of the Three Outside Up Candlestick Pattern
The Three Outside Up candlestick pattern is formed by three consecutive candles that indicate a bullish reversal in the market. Here’s a detailed breakdown of its formation:
- First Candle:
- Bearish Candle: The pattern begins with a bearish (red or black) candle. This candle is part of the prevailing downtrend, reflecting ongoing selling pressure in the market. The size of this candle can vary, but it typically represents a continuation of the bearish sentiment.
- Second Candle:
- Bullish Engulfing Candle: The second candle is a bullish (green or white) candle that completely engulfs the body of the first bearish candle. This means the opening price of the second candle is lower than the close of the first, and the closing price of the second candle is higher than the open of the first. This engulfing action signifies a strong shift in market sentiment, where buyers overpower sellers.
- Third Candle:
- Confirmation Bullish Candle: The third candle is also bullish and closes higher than the second candle. This candle confirms the reversal initiated by the second candle, solidifying the shift from a bearish to a bullish trend. The third candle’s close above the second candle’s high is critical for confirming the strength of the new upward trend.
Key Characteristics of the Formation:
- Gap Consideration: The Three Outside Up pattern does not necessarily require gaps between the candles, but the second candle must engulf the first candle completely, without considering the shadows (wicks).
- Volume: The formation is more reliable when accompanied by increasing volume, especially during the second and third candles. This rising volume indicates stronger buying interest and adds credibility to the reversal.
- Location: The pattern should appear after a clear downtrend. Its effectiveness as a reversal signal is heightened when it forms at a support level or following an extended period of bearish movement.
The Three Outside Up pattern’s formation is a clear indication of a potential bullish reversal, making it a valuable tool for traders looking to capitalize on changes in market direction.
Significance of the Three Outside Up Pattern
The Three Outside Up candlestick pattern is significant because it demonstrates a decisive change in market sentiment. Here’s why this pattern is considered a strong bullish reversal signal:
- Engulfing Strength: The second candle’s ability to engulf the first candle shows that buyers have gained substantial control, overpowering the sellers.
- Confirmation: The third candle acts as a confirmation, reducing the likelihood of a false signal. It indicates that the bullish momentum is strong enough to continue pushing prices higher.
- Market Psychology: The pattern reflects a shift in market psychology, where traders who were previously selling are now buying, contributing to the trend reversal.
Trading the Three Outside Up Pattern
Traders often use the Three Outside Up pattern as a signal to enter long positions. Here’s how to trade this pattern effectively:
1. Entry Point
The ideal entry point for a trade based on the Three Outside Up pattern is at the close of the third candle. This ensures that the pattern has fully formed and the bullish reversal is confirmed.
2. Stop-Loss Placement
To manage risk, traders typically place a stop-loss order below the low of the first candle in the pattern. This provides a safety net in case the reversal fails and the downtrend resumes.
3. Profit Target
Setting a profit target can be done using various methods, such as identifying key resistance levels, using Fibonacci retracement levels, or aiming for a risk-to-reward ratio of at least 2:1.
4. Volume Confirmation
Volume is a critical factor in confirming the Three Outside Up pattern. An increase in volume during the formation of the second and third candles adds credibility to the pattern, indicating strong buying interest.
Combining the Three Outside Up Candlestick Pattern with Indicators: RSI, MACD, and Bollinger Bands
While the Three Outside Up candlestick pattern is a powerful bullish reversal signal on its own, its effectiveness can be significantly enhanced when combined with technical indicators like RSI, MACD, and Bollinger Bands. Using these indicators in conjunction with the Three Outside Up pattern allows traders to confirm signals and make more informed trading decisions.
1. Three Outside Up and RSI (Relative Strength Index)
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements, ranging from 0 to 100. It’s typically used to identify overbought or oversold conditions in the market.
- Confirmation of Bullish Reversal:
- When the Three Outside Up pattern forms while the RSI is in the oversold zone (below 30), it strengthens the bullish reversal signal. This combination suggests that the market is not only showing a reversal pattern but is also recovering from an oversold condition, making a price rise more likely.
- Avoiding False Signals:
- If the RSI is in the overbought zone (above 70) when the Three Outside Up pattern forms, traders might be cautious, as the market could be overextended, reducing the reliability of the reversal.
2. Three Outside Up and MACD (Moving Average Convergence Divergence)
The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD consists of the MACD line, the signal line, and the histogram.
- Signal Confirmation:
- A bullish crossover on the MACD (when the MACD line crosses above the signal line) occurring simultaneously or shortly after the formation of the Three Outside Up pattern serves as a strong confirmation of the bullish reversal. This crossover indicates increasing upward momentum, aligning with the reversal signaled by the candlestick pattern.
- Divergence Analysis:
- Positive divergence between the MACD and the price (where the price makes lower lows but the MACD makes higher lows) further enhances the reversal signal provided by the Three Outside Up pattern. This suggests that the downtrend is losing strength, and a bullish reversal is more likely.
3. Three Outside Up and Bollinger Bands
Bollinger Bands are a volatility indicator consisting of a middle band (typically a 20-day simple moving average) and two outer bands that are two standard deviations away from the middle band. Bollinger Bands help traders identify overbought or oversold conditions as well as potential price reversals.
- Band Interaction:
- If the first candle of the Three Outside Up pattern closes near or below the lower Bollinger Band, and the subsequent candles close within or above the bands, this indicates that the price is reversing from an oversold condition, adding credibility to the bullish reversal signal.
- Squeeze and Expansion:
- A Bollinger Band squeeze (when the bands are close together) followed by an expansion (when the bands begin to widen) during the formation of the Three Outside Up pattern suggests that volatility is increasing, which can lead to a significant price move in the direction of the reversal.
How to Trade Using the Combined Signals
When trading the Three Outside Up pattern combined with these indicators, consider the following strategy:
- Identify the Pattern: Spot the Three Outside Up pattern after a clear downtrend, ideally near a support level.
- Check RSI: Ensure the RSI is in the oversold zone or moving upward from oversold levels. This supports the likelihood of a strong bullish reversal.
- Confirm with MACD: Look for a bullish crossover on the MACD or positive divergence between the MACD and price. This adds momentum confirmation to the reversal signal.
- Observe Bollinger Bands: Confirm that the pattern is interacting with the Bollinger Bands, especially if the first candle is near the lower band, suggesting a reversal from an oversold condition.
- Enter the Trade: Consider entering a long position at the close of the third candle of the Three Outside Up pattern, provided the indicators align to confirm the bullish reversal.
- Set Stop-Loss: Place a stop-loss below the low of the first candle to manage risk.
- Monitor the Trade: Use additional indicators like trailing stop-losses or moving averages to manage the trade as the price moves in your favor.
Three Outside Up vs. Other Candlestick Patterns
It’s essential to compare the Three Outside Up pattern with other bullish reversal patterns to understand its unique advantages and when it might be more effective.
Three Outside Up vs. Bullish Engulfing
- Structure: Both patterns involve a large bullish candle engulfing a smaller bearish candle. However, the Three Outside Up adds a third candle that confirms the reversal, making it more reliable than the Bullish Engulfing pattern.
- Confirmation: The third candle in the Three Outside Up pattern serves as additional confirmation, which is absent in the Bullish Engulfing pattern. This extra confirmation reduces the risk of false signals.
Three Outside Up vs. Morning Star
- Structure: The Morning Star is a three-candle pattern similar to the Three Outside Up, but it begins with a long bearish candle, followed by a small-bodied candle (Doji or Spinning Top), and ends with a bullish candle. The Three Outside Up starts with a bearish candle and is followed by two bullish candles, with the second candle engulfing the first.
- Psychology: The Morning Star pattern reflects a more gradual shift in sentiment, while the Three Outside Up shows a more aggressive and decisive change in market sentiment, making it a stronger reversal signal in certain situations.
Three Outside Up vs. Three White Soldiers
- Structure: The Three White Soldiers pattern consists of three consecutive bullish candles, each closing higher than the previous one, and does not require an engulfing action. The Three Outside Up pattern, however, starts with a bearish candle and includes an engulfing action in the second candle.
- Trend Strength: The Three White Soldiers pattern indicates a strong and continuous uptrend, while the Three Outside Up signals a reversal from a downtrend to an uptrend. The latter is more significant for identifying the exact turning point in the market.
Advantages of the Three Outside Up Candlestick Pattern
- Strong Reversal Signal:
- The Three Outside Up pattern is a robust bullish reversal signal. The presence of three candles, with the middle one engulfing the first, and the third confirming the reversal, makes it a highly reliable indicator of a trend change.
- Clear Market Sentiment Shift:
- This pattern clearly indicates a shift in market sentiment from bearish to bullish. The engulfing action of the second candle shows that buyers have taken control, and the third candle confirms that the new trend is likely to continue.
- High Reliability:
- Compared to simpler patterns like the Bullish Engulfing, the Three Outside Up offers greater reliability due to its three-candle formation, which includes a confirmation candle. This reduces the likelihood of false signals.
- Versatility Across Time Frames:
- The Three Outside Up pattern can be applied across various time frames, from intraday to daily and weekly charts, making it useful for different trading strategies, whether short-term or long-term.
- Ease of Identification:
- The pattern is relatively easy to identify, even for beginners. Its distinct three-candle formation makes it straightforward to spot on a chart, reducing the chances of misinterpretation.
- Confirmation with Volume:
- When accompanied by increased volume during the second and third candles, the Three Outside Up pattern becomes even more reliable. The rising volume confirms strong buying interest, reinforcing the reversal signal.
- Applicable to Various Markets:
- The Three Outside Up pattern is not limited to a specific market or asset class. It can be used effectively in stocks, forex, commodities, and cryptocurrencies, making it a versatile tool for traders.
Limitations of the Three Outside Up Pattern
While the Three Outside Up pattern is a reliable bullish reversal indicator, it is not without its limitations. Here are a few considerations:
- False Signals: In highly volatile markets, the Three Outside Up pattern may produce false signals, especially if the third candle does not follow through with substantial upward momentum.
- Context Matters: The effectiveness of the pattern can vary depending on the broader market context. It’s essential to consider other technical indicators and market conditions before making trading decisions.
- Time Frame: The pattern may work better on certain time frames than others. It’s often more reliable on longer time frames, such as daily or weekly charts, where the price action is less likely to be influenced by short-term noise.