Hello friends, and welcome to this podcast by Angel One!
Today, we are discussing a candlestick pattern that can help you predict a trend reversal. What’s really cool about this indicator is that you don’t need to wait for a confirmation to plan your trading strategy if you are using this indicator’s signal.
Before we discuss that, let’s check out this argument between Ramesh and his professor Catherine, who taught him finance during his MBA at one of the top B--schools in the US. Ramesh had basically started trading in the stock market recently and wanted advice from his professor about whether he should purchase a short position of a stock, whose prices were going to fall according to him. However, he was confused about the string uptrend that lasted until two days back. During his call with the professor, Catherine told him that the bearish reversal has already been confirmed, and he should execute the trade without waiting any further. This sounded risky to Ramesh. To calm him down, Catherine gave him some material to read, about the three outside down candlestick pattern.
After going through it, Ramesh was convinced and he could purchase a short position with confidence, and it worked out for him!
It might work out for you too! So let’s understand what this pattern means, how to identify it, and how to make trades by using it’s signal.
The first thing to know about the three outside down candlestick pattern is that it appears along a bullish trend, or an uptrend. And second thing to know is that this pattern predicts or signals a bearish trend reversal. Remember how Ramesh was confused about purchasing a short position despite a recent strong uptrend? This pattern always follows after an uptrend. Now, this pattern consists of three candlesticks.
The first candlestick of this pattern is usually a small bullish candle. The second candle, however, is a tall bearish candle. This candle opens above the previous day’s close and closes below the previous days open. If you are confused, try to visualize a tall candle on the right side of a short candle - the first one is white, and the second one is black. The tall candle completely engulf the range covered by the first white candle, and opens and closes beyond the first candle’s extremities.
That’s it, the confusing part about this pattern is over, and it’s actually quite simple when you look at it in practice.
Now the third candle is, again, a bearish candle, that begins somewhere between the second candle’s open and close, but closes fairly below the second candle’s close.
Okay! Let’s look at what’s happening in the market as this pattern forms.
Since this pattern appears along an uptrend, it starts when the bulls are in control of the market. However, the small first candle indicates that the buying sentiment is losing momentum.
The second candle is where the more interesting action begins. Actually, the trend reversal has already happened when the second candle has formed. This is indicated by the fact that the markets open above the previous day’s close after a positive session, but the prices plummet to levels below the previous day’s open. This signals that the bears are beginning to take control of the market.
The second candle is where we will focus when we discuss how to trade based on this pattern.
Now, following the second candle, the third candle simply acts as a kind of confirmation of the trend reversal, since the prices have already fallen beyond the previous day’s close.
By this point, the bears have completely taken control of the market and the pattern has completed with a trend reversal. Now, let’s consider how you can trade based on this signal.
The three outside down candlestick pattern predicts a bearish reversal, and therefore it can help you create solid short positions. But before you execute a trade, note this down: the greater the length of the second candle, the stronger the probability of reversal. While you can create a short position at this point, it is advisable to wait for the pattern to form till completion. The third candle is, more or less, a confirmation of the trend reversal.
Now, it is also important to remember that while this pattern can help you predict trend reversals with a considerable accuracy, it is always to make use of other technical indicators in conjunction with the three outside down candlestick patterns, you are missing any other market dynamics from the equation.
And lastly, if you are curious: there is a counterpart of this pattern which is called the three outside up candlestick pattern, which signals a bullish reversal of an existing downtrend. Check out our podcast on the three outside up pattern to learn more about it.
Making use of these patterns can help you spot some great opportunities for placing and timing your trade. , to become a pro, you shouldn’t discount the importance of staying abreast with the market happenings.
Visit www.angelone.in to learn more about markets and cool trading strategies.
Until the next podcast, goodbye from Angel One, and happy investing!