Since candlesticks are the basic building block of most technical analysis, the ability to recognize different candlestick patterns is a crucial trading skill.
First though, let’s start with a definition.
What Is a Three Outside Down Pattern?
A three outside down pattern is a 3-candlestick formation that may signal a bearish reversal. It may appear during an uptrend and is made up of a bullish candle followed by a large bearish engulfing candlestick and another bearish candle after that.
It is a subtype of the three outside pattern and the opposite of the three outside up. It is also similar to the three inside down and could even be considered an extension of the bearish engulfing. For all of these patterns, 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 Down Patterns Mean
Unlike the vast majority of candlestick patterns, the name describes it fairly well.
And unlike some, English speakers do not use the Japanese name for it. It is a three candlestick pattern that includes an engulfing (or “outside”) candle. Thus, “three outside.” Because it implies bearish pressure it’s a three outside “down” (instead of “up”).
(It would be great if all candlestick pattern names were this literal.)
In trading terms:
- During the first period, price continued the pre-existing uptrend.
- Before the second period opened, price continued moving higher, creating a gap up open.
- During the second period, price moved dramatically lower, closing below the open of the first period.
- During the third period, price continued the downward movement of the period before.
This sets the stage for bearish reversal, as it appears selling pressure is on the verge of taking full control.
How To Recognize Three Outside Down 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 down pattern must:
- Appear during an uptrend
- Begin with a (non-short) bullish candle
- Gap up to open the second candle
- Have a bearish long candle as the second candle that fully contains the first
- End with another bearish candle
In practicality though, many traders will make various exceptions.
- The first candle can be a short or neutral (ie. a doji), as long as it is fully contained within the body of the second.
- The first candle can be bearish, as long as it is fully contained within the body of the second.
- The second candle doesn’t necessarily have to be a long candle, as long as it fully contains the body and wicks of the first.
- 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 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 Downs Fit in the Chart Narrative
The markets are often characterized as a battle between the bulls and the bears.
Three outside down patterns show that the bulls attempted to press their advantage on candle one, continued to do so between candles one and two, but were completely upended by the end of candle two, and lost even more ground on candle three.
On the chart, it looks like a sudden downturn.
It might happen like this on a daily time frame:
On the first day, bulls pushed price higher (as they had been for the last couple of weeks). Overnight, price drifted upward even more. However, the next morning began with a change in the fundamentals, leading to a massively bearish day that nullified the action of the previous day. After this unexpected reversal of fortunes, many of the buyers exited the market, which allowed sellers to push price even lower on the third day.
From here, the bears begin to see dollar signs as the bulls focus on regrouping.
In the short-term, it amounts to a devastating counterstrike.
The question traders need to ask themselves is, “Will buyers rally or does this spell the end of the bull market?”
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 outside downs with larger third candles play out more reliably than those with shorter ones. Or, you may find something else entirely.
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 Down Patterns
Bearish reversal points are great places to exit longs or enter shorts.
Three outside down patterns serve as easy-to-spot signs of potential bearish reversals—and may even lead to longer-term tops 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 outside downs, be on the lookout for it on the second and (especially) the third candles.
- Price Formations – Three outside downs that form near important resistance levels are usually more likely to lead to sustained reversals. They may also reinforce the strength of such levels.
- 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 (whether bullish or bearish). 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 down is but one of many candlestick patterns.
You’d be wise to get familiar with all of the other ones too.
- Abandoned Baby – Bearish/Bullish
- – Bearish/Bullish
- Doji Star – Evening/Morning
- Engulfing – Bearish/Bullish
- Harami – Bearish/Bullish
- Harami Cross – Bearish/Bullish
- In Neck – Bearish/Bullish
- Mat Hold – Bearish/Bullish
- On Neck – Bearish/Bullish
- Star – Evening/Morning
- Tasuki Gap – Downside/Upside
- Three Inside – Down/Up
- Three Methods – Falling/Rising
- Tweezer< – Top/Bottom
- Window – Falling/Rising
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 outside downs are a type of candlestick pattern that signals a potential bearish 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.