Three outside down patterns in candlestick trading can only occur when the market is in a period of positive gains. This pattern signals that a reversal in the current trend is taking place. The first candle will continue the momentum with the second and third candles creating the reversal process.
With the market in an uptrend, the first candle in a three outside down pattern continues this positive outlook. The second candle opens higher than the previous day’s close and closes lower than it’s open. The final candle remains bearish and closes lower than the second.
Knowing how to identify this trend correctly and what it means for the market can pay dividends in your investing portfolio. Once you’re familiar with spotting the pattern, you’ll want to determine the best ways to utilize it to maximize profits and minimize any potential losses.
Below, you’ll find the complete guide to identifying this pattern to gain practical knowledge so you can implement it into your investing arsenal.
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Table of Contents
How to Identify Three Outside Down Pattern in Candlestick Trading?
To provide you a better clarity on accurately identifying the three outside down pattern, let us take a quick look at the construction of this pattern and its key characteristics.
Construction of Three Outside Down Pattern
Rather fittingly, three candles make up the construction of a three outside down pattern. Since this bearish pattern signals a reversal in the current market trend, it must begin during an uptrend.
The first candle has a green or white real body (i.e. bullish), showing that the upward trajectory shows no signs of slowing. The second candle is red or black (i.e. bearish) and fully covers the first candle. The price change is the first indication that the bears have taken control to reverse the trend.
The final candle in the three outside down pattern is another red or black (i.e. bearish) candlestick that closes even lower than the second candle. The bears have gained further control at this stage and continue to drive the price down.
Characteristics of Three Outside Down Pattern
Described below are some of the key characteristics of the three outside down pattern –
- Uptrend: An uptrend within the market must be taking place to form an acceptable three outside down pattern.
- First Candle: The first candle maintains the current upward trajectory of the security, giving confidence to buyers (bulls).
- Second Candle: The second candle opens higher than the first candle’s close and closes lower than the opening of the first candle, fully encompassing the candle and starting the reversal. The first two periods together are what’s known as a bearish engulfing.
- Third Candle: The final candle essentially confirms this bearish engulfing while remaining bearish and closing lower than the low of the second candle.
How to Interpret the Three Outside Down Pattern?
The psychology behind this pattern is relatively simple. Think of the first candle as the bulls maintaining control and the last two showing the bears taking over.
The first candle continues what has already been taking place in the market. An increase in price leads to continued confidence in buying. The second day will open higher, but the bulls will gain control and drive the price lower than the open of the first day.
Some bulls may see this reversal as a new trend and cut their losses.
The final day of a three outside down pattern reveals maintained control from the bears and a new low.
The selling signal is even stronger as the pattern is completed.
How to Improve the Reliability of the Three Inside Down Pattern?
Using the Moving Average Convergence Divergence (MACD) is a reliable method to confirm your trade hypothesis from a three outside down pattern. The MACD is a momentum indicator that takes two moving averages and shows the relationship to the price of a security.
You can determine the MACD by:
- subtracting a 26-day exponential moving average (EMA) from a 12-day EMA, creating a MACD line on the chart.
- Along with this MACD line, a 9-day signal line is plotted, which can help to signal changes in the trends.
Simplified, the MACD shows if the trends are strengthening or weakening.
Using the MACD in relation with the three outside down candlestick pattern gives you an added layer of confirmation.
If you achieve a three outside down pattern and your MACD agrees, then it is likely that the trend change is occurring.
Trading Three Outside Down Pattern with Short Selling
As noted above, three outside down is a reversal candlestick pattern, and its appearance on the price chart of a security indicates an upcoming bearish reversal. Hence, it is a great tool to inform your short-selling decisions.
Described below are several important steps and considerations that you should account for when using the three outside down patterns for identifying short-sell trades.
Market Environment
Short selling can be taken advantage of in both bull and bear markets.
Ordinarily, a bear market will be the ideal market for selling short since they make a profit from the price drop in a security. This price drop is why a three outside down pattern is so useful if you are planning on selling short.
The market had been in an uptrend, but with the signal that this position may reverse, you can sell to entry and buy when the price drops.
Identify and Confirm Trade Opportunity
A trader will see that the market has been in a consistent uptrend, which will keep short-sellers away.
Once a short seller notices the bearish engulfing, it will tip them off to the idea that the market could be taking a downturn. Depending on the risk they’re willing to take, they can enter at the engulfing or wait for further confirmation from the third candle.
They can also use the MACD to strengthen further the notion that the market could be taking a downturn.
If the MACD agrees that a downturn is likely, then they will have a strong positioning to sell short.
Determine Trade Entry, Stop Loss and Take Profit Levels
Again, depending on the risk that a trader is willing to assume, they can enter the trade after the bearish engulfing or wait a couple of periods for the exchange to be further confirmed.
If they wait, they could be sacrificing more substantial potential profits, but they are bolstering against a false positive.
Traders can also use the MACD, which will signal buy and sell opportunities. This signal arises when the MACD line falls below the signal line, which could indicate selling. When the opposite occurs, this can signify your take profit level, or buy level, banking your profit.
Generally, if you’re entering the market after the third candle confirms a bearish trend, then you can place your stop loss above the high of the first, second, or third candle. Where you put it, determines your risk level.
Traders like to deal with at least a 1:2 ratio for risk/reward, meaning that the profit needs to be at least twice as much as the potential loss.
Execute and Manage Trade
If you execute a short sale and the market doesn’t continue that downtrend that you were expecting, you may want to consider repurchasing the security before your stop loss hits to minimize your loss.
Advantages and Limitations of Trading Three Outside Down Patterns
Now that we have discussed the basics around the three outside down pattern, let us briefly touch upon several advantages and disadvantages of trading this pattern.
Advantages of Trading Three Outside Down Pattern
Listed below are several key advantages of trading the three outside down pattern –
- The third candle acts as a solid confirmation for an upcoming reversal in the price trend.
- The larger the bearish engulfing, the stronger the change. This characteristic of this candlestick pattern further helps with trade confirmation.
Limitations of Trading Three Outside Down Pattern
Listed below are several key limitations of trading the three outside down pattern –
- The three outside down candlestick pattern is generally not sufficient to inform trading decisions as a stand-alone indicator.
- For reliable trading, you will need to rely on other technical indicators or trading tools in addition to the three outside down pattern.
Candlestick Pattern Opposite of Three Outside Down
As you may have guessed, the pattern opposite of the three outside down is the three outside up pattern. This pattern takes place after a downtrend and helps identify a potential bullish reversal in the market.
- The first candlestick confirms the downtrend that has taken place within the market recently.
- The second candle opens lower than the close of the first candle but closes higher than the first candle opened.
- The final candle continues the upward climb and closes higher than the second candle closes.
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Conclusion
The three outside down pattern is a reliable indicator that a current uptrend may be reversing. Remember that with all securities, there is no 100% reliable answer, so adding other forms of analysis to assist this pattern will increase the odds of making a sound decision.
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