Three Outside Candlestick Patterns Explained: What They Are & How To Trade Them

 

What Is a Three Outside Pattern?

A three outside pattern is a 3-candlestick formation that may signal a reversal.  It is made up of one candle moving in the direction of the current trend, followed by a large engulfing candlestick moving against trend, and finally a third candlestick that continues the move against trend.

The three outside candlestick pattern has both bullish and bearish variations, called the three outside up and three outside down, respectively.  It is also similar to the three inside pattern.  But it is probably most accurate to describe it as an extension of the engulfing pattern.  For all of these, the second candlestick is essentially the apex of the potential reversal.

Of course, no candlestick pattern guarantees a particular outcome.  Instead, they offer clues as to what is going on in the market.

So the question is, what does a three outside really tell you?

What Three Outside Patterns Mean

Like many candlestick patterns, the name describes it fairly well.

And unlike some, English speakers do not use the Japanese name for it.  It is essentially a three candlestick pattern that includes an engulfing (or “outside”) candle.  Thus, “three outside.”  If it implies bullish pressures it’s a three outside up; if it implies bearish pressure it’s a three outside down.

(It would be great if all candlestick pattern names were this literal.)

In trading terms:

• During the first period, price continued the ongoing trend.
• Before the second period opened, price continued moving with trend, creating a gapped open.
• During the second period, price moved against trend dramatically, closing beyond the open of the first period.
• During the third period, price moved against trend even further.

This sets the stage for reversal, as it appears countertrend pressure is on the verge of taking full control.

How To Recognize Three Outside Candlestick Patterns

Traders are attracted to patterns partly because they are easy to spot.

However, it’s also easy to see things on the charts that aren’t truly there (or anticipate events that never come to fruition).  That’s one of the reasons why waiting for confirmation is so important.

Technically, a three outside pattern must:

• Begin with a (non-short) candle moving in the direction of trend
• Have a long engulfing candlestick moving against trend as the second candle
• End with a third candle moving in the same direction as the second (and against trend)

In practicality though, many traders will make various exceptions.

• The first candle can be a neutral/short candle (ie. a doji), as long as it is fully contained within the body of the second.
• The first candle can move against trend, as long as it is fully contained within the body of the second.
• The open of the second candle can be even with the close of the first candle, especially in markets where gaps are less common like cryptocurrency.

Depending on who you ask, any of these standards may be more or less important.  Moreover, some of these variations may be more properly classified as other reversal candlestick patterns, such as a bullish engulfing or bearish engulfing.

Remember, identifying the reversal itself is more important than labeling the formation.  That’s not to say these standards are completely unimportant (as we’ll touch on shortly).  It’s just to say that the implications are more important than the criteria.

In other words, you need to put it into context.

Where Three Outsides Fit in the Chart Narrative

The markets are often characterized as a battle between the bulls and the bears.

Three outside patterns show that one side attempted to press their advantage on candle one, then again between candles one and two, were completely upended by the end of candle two, and continued to lose ground on candle three.

On the chart, it looks like a complete turnaround.

It might happen like this on a daily time frame:

After a strongly trending day, traders awoke the next day to a price gap.  Later that morning, news broke that changed the sentiment surrounding the asset completely.  Massive position shifting proceeded throughout the rest of the day, leading to a complete turnaround.  On the third day, more players on the side of the original trend surrendered, resulting in a continuation of the second day’s price action.

In the short-term, it amounts to a devastating counterstrike.

The question traders need to ask themselves is, “Is the trend dead or will this end as a minor setback?”

To answer that question, you’ll need more than just an understanding of Japanese candlesticks and candlestick patterns.  You’ll want to analyze both within the context of greater chart patterns as well as trend and price levels.  You’ll also want to make use of your own chart markup and indicators.

Analyze the history of your preferred asset(s) with respect to three outside patterns and apply it to your own trading style.

Now, you can test (and/or stretch) the criteria we mentioned above to find the most tradeable opportunities.  For example, you may find that three outsides where the second candlestick is at least 25% larger than the first play out more reliably than those in which the first and second candle are closer to the same size.  Or, you may find the opposite.

Here is where the story in the charts begins to come into focus.

This is what we call technical analysis.

How To Trade Three Outside Patterns

Reversal points are great places to enter or exit trades.

Three outside patterns serve as easy-to-spot signs of potential reversals—and may even lead to longer-term tops or bottoms when found on higher time frames.

Generally, you can put more weight into multi-stick patterns than single candles.  They give you more information over a longer amount of time.  Still, it is considered unwise to trade based on candlestick patterns alone.  They rarely have extremely high hit rates by themselves.

You need additional points of confluence to shift the probabilities in your favor.

Some of the more important ones include:

• Volume – Reversals are often accompanied by elevated trading volume.  For three outsides, be on the lookout for it on the second and third candles.
• Price Formations – Reversal patterns like the three outside often form near important price levels or trend lines, leading to a bounce at support or rejection at resistance.
• Oscillator Shift – Oscillating indicators like the RSI or stochastics are commonly used to identify reversals by analyzing slope, percentile, and/or divergence.

The fewer such factors corroborating the reversal, the less confident you can be about it.

It would be difficult to form a comprehensive trading strategy around three outside patterns.  There simply isn’t enough there to develop a strong edge.  Even with a great understanding of trading math, orders, psychology, risk management, options, and automation, you’d still have a hard time.

You’re much better off building your strategy around other tools then using reversal patterns as an additional point of confirmation.

Patterns like the three outside are much better idea givers than trade makers.

Other Candlestick Pattern Types

The three outside is but one of many candlestick patterns.

You’d be wise to get familiar with all of the other ones too.

• Abandoned Baby
• Breakaway
• Counterattack Lines
• Doji Star
• Engulfing
• Harami
• Harami Cross
• In Neck
• Kicking
• Ladder
• Last Engulfing
• Mat Hold
• Matching
• Meeting Lines
• On Neck
• Separating Lines
• Star
• Stomach
• Tasuki Gap
• Three Inside
• Three Methods
• Three-Line Strike
• Tri-Star
• Tweezer
• Window

Sure, there are quite a few of them.  But don’t let that intimidate you.

It’s unnecessary to memorize all the names and criteria for every pattern.  What’s more important is to learn the principles of price action and technical analysis.

In fact, you’re free to forget all of the names and specifications as long as you can look at a group of candlesticks and understand what they are trying to tell you.

Takeaways

To review:

Three outsides are a type of candlestick pattern that signals a potential reversal.  While not a guarantee, their appearance may indicate that market conditions are changing.  Thus, they can help you find winning trades.

Of course, there are other candlestick patterns that you should learn about.  And even so, the ability to recognize patterns is not enough to trade successfully on its own.

Nonetheless, you’ve now added one more tool to your toolkit.

Have questions or more information to add?  Contribute to the conversation in the comments below!  Or, if you know someone who could benefit from this post, share it with them.  You can also check out our Candlestick Patterns Guide to improve your candlestick analysis skills.