My younger sister doesn't like instant noodles. She says they're too gooey and that they end up either too soupy or rather flavourless. However I noticed that I could reverse her aversion to instant noodles with a very precise three-step process. First bring the noodles and water to a boil, then drain all the water out of the noodles and last, toss in the taste-maker and a dash of butter. She gets perfectly smooth, deeply-flavoured noodles and reverses her dislike for instant noodles. However the steps need to be done in precisely that order.
The three inside down candlestick pattern reminds me of making noodles for my younger sister. Just like the precise three-step process that makes her reverse her dislike for noodles, in the same way the appearance of three candle-sticks in a precise order indicates a stock price reversal.
So what are these precise requirements for a candlestick pattern to qualify as a three down candlestick pattern?
First of all, as the name suggests, there need to be three candles and all of them must line up exactly as follows.
The first candle will be a green or white candle depending on the colour scheme chosen. It will have a really large real body, that is the rectangular or cylindrical part of the candlestick will be fairly long.
The second candlestick body will be red or black depending on the colour scheme chosen and will be smaller. Its entire height must be less than the height of the first candlestick's body and it should appear in such a way that it is within the real body of the first candle.
The third candle will also be red or black. The base of the real body of this candlestick (representing the closing price) will be lower than that of the second candlestick.
The market also needs to be in an uptrend, or in other words for the three-candle alignment described above to qualify as a three inside down candlestick pattern, it must appear during an upswing.
Since the three down candlestick pattern appears during an upswing and is a reversal pattern, it heralds a bearish trend. The general expectation is that stock prices will drop in the short term.
Traders will usually wait for the next candlestick to confirm their prediction of an oncoming downtrend, before making any moves hinged on the prediction.
The general understanding of the three inside down candlestick is that prices continued to rise during the first candlestick, but then on the second day or period, represented by the new candle, the price closed below the previous days close and open. At this point, it is usually witnessed that buyers might start to panic, selling stock and thus driving the price down further. The third candle displays an even lower closing price and a general bearish attitude.
The three inside down candlestick patterns appear fairly frequently on stock graphs. As a result many traders choose to treat it as a signal but will not trade on it.
Even when traders do choose to trade the three inside down candlestick patterns, it is done so keeping in mind that the reversal might be short term, if it occurs at all. And - as mentioned before - they will wait for a price confirmation before going ahead with the trade.
Experienced traders who choose to trade on the three inside down candlestick patterns, often enter short. This means they will look to borrow shares from.a broker, sell the shares at the present price and buy them back at a still lower price, in order to earn. The stop loss in such a move, is placed above the high of any of the three candles in the pattern, depending on the level of the trader's risk appetite. A profit target or target price is usually not drawn by using the same pattern. The trader might opt for a target price using a risk-reward ratio calculation or might use another technical indicator or candlestick pattern to arrive at the profit target.
Some traders advocate the philosophy that the three inside down candlestick pattern is best seen as a reversal pattern that marks the end of a blip in the overall, long term trend. This approach dictates that when a three inside down candlestick pattern appears during a temporary uptrend amidst a long-term downtrend, it signals that the downtrend is going to resume. A temporary trend in the opposite direction of the long term trend is referred to as a pullback. So if you hear someone say "three inside down candlesticks are best used to identify the oncoming end of a pullback" they are talking about this approach.
It is important to note that the three inside down candlestick pattern has a twin, called the three inside up candlestick pattern. It appears as a reverse of the three inside down candlestick patterns that we have been looking at as part of today's discussion. In contrast, this twin pattern appears during a downtrend and is seen to signal an oncoming bullish trend.
Whatever candlestick pattern you are using as a signal or as a basis for your predictions, be sure to back your prediction up with data from other technical indicators. And never forget that despite what the data might say, the stock market is risky and makes no guarantees. Trade in small amounts and consider your risk appetite.
Visit www.angelone.in today to learn more about these patterns. And for more knowledge on markets and trading strategies, don’t forget to check out our other podcasts. Until then, goodbye from Angel One and happy investing!