Last updated on February 14th, 2020
The three-bar reversal is a bullish or bearish candlestick chart pattern that can be used as a day trading setup for all markets and time frames.
The issue for traders, especially day traders, is you will see the three-bar reversal pattern all over your trading chart. It is a common occurrence.
What Does The 3 Bar Reversal Pattern Look Like?
We are looking, in the case of a down-trending market, for 3 candlesticks to form in this sequence:
- A down candlestick (generally red)
- The next candlestick has it’s low below the first candlestick and will be the lowest low of the pattern
- The third candle closes above the middle candlestick
Nothing too fancy but this pattern is pure price action and has the potential to set you up in some decent trades.
Note this is an idealized pattern shown. In reality, you could have several bars heading down (or up) and the pattern is still valid.
Breaking down this day trading chart of Gold futures:
- The pattern does not exist here because the green candle did not close above the high of the middle candlestick
- Idealized pattern forms here and at the reversal, you would look to establish a long position
- The pattern appears in what starts as a downtrend
- You can see the support zone that price breaks before the pattern appears at #3. Using the 3 bar reversal in conjunction with support and resistance as well as other patterns is good practice.
You can have more than 3 candlesticks in the pattern however we must see the middle bar, low or high, the turning point in the pattern.
3-Bar Reversal – Day Trading
As mentioned, you will see this pattern at many points on the chart especially on lower time frames.
One common way that traders may look to cut down on the number of opportunities is to add some type of confirmation.
Generally, that confirmation would be the third candle closing above the high of the first and second candlestick.
Does this confirmation increase the odds of a winning trade? You have to test this out over a large basket of trades but my opinion, maybe.
Requiring the close to take out two candlesticks would show momentum hitting the market which may be enough to take a small profit.
One thing it will do is removing opportunities that could cut back on over-trading throughout the session.
Notice that I did chose an example that had more than three bars. While fewer bars may show more urgency in the move, a larger pullback could entice more traders into a continuation.
The key for me is that, in the example of looking for a short position:
- The first candlestick in the sequence closes green – bullish
- The second candlestick needs the highest high (forms a pivot) – the turning point in the pattern
- The last bar closes under the low of the first bar – enough momentum to wipe out gains from the prior two candles
The 3 bar pattern makes logical sense but must show an edge in backtesting.
Simple Three Bar Trading Strategy
One key element is to look for a market that is trending. You can determine that by simple price action using:
- Higher highs and lows for an uptrend
- Lower highs and lows for a downtrend
- A mix of both would equal a market in a trading range
Looking at a one-hour Forex chart, here is what we have:
The red X shows an incomplete pattern as the third candle failed to close above the high of either of the candlesticks.
The green line shows a completed pattern that you could trade.
- The price pattern completes and a buy stop order is placed over the high of the trigger candlestick (third)
- Your stop loss would go below the low of the pattern in the case of a long
- Your profit target could be a trailing stop under the low of each swing once a high is broken
We could consider making the pattern more reliable if the pivot, the second candlestick, is coming into previous high/low, or confirmed support and resistance levels.
Pitfalls To Know
If you are using a structure such as support and resistance, how do you know your levels are meaningful? The lines you choose may have no meaning to the market so you must define the rules you use to determine reliable support/resistance levels.
Since the trade position is entered at a break of the high/low of the third candlestick, your stop loss could be well away from our entry price. This is especially true as we look for a momentum bar to take out two bars in the confirmation method.
Your position size will have to decrease to compensate for the entry and stop distance which may limit the markets you can trade.
Do you know what a failure looks like with this pattern?
Just as important as a successful pattern, so is know what show the pattern has failed.
If the successful 3 bar pattern is close above both previous candlesticks, I would consider a close below the high of the pivot candlestick a failed pattern. We could be entering a trading range and I would exit the trade.
Please ensure you test this pattern over the instruments you will be trading. Although there is a logical sense in the pattern, all patterns fail.
Risk is vital and ensures you take your stops the moment they are challenged.
You may decide to combine it with trading indicators such as moving averages or a momentum measure such as RSI.
Whatever you do, write down your trading rules and follow them.