- November 14, 2017
- Posted by: CoachShane
- Categories: Advanced Trading Strategies, Trading Article
The inside bar (candlestick) chart pattern shows us consolidation in price which can make it a great trading tool if you trade the inside bar setups correctly.
What happens though is that many traders don’t understand what this chart pattern represents and they end up trading it incorrectly. In doing so, traders get frustrated by their lack of success and end up believing that the inside bar pattern doesn’t work.
The biggest issue is that traders may think that the presence of an inside bar is a pattern that can be traded easily whenever it appears.
That is not the correct approach.
That type of inside bar trading approach will lead to losses. Why?
Golden Rule About Trading With Inside Bars: Do not trade an inside bar in isolation
What that means is if you were to pull up any chart and ensure there is at least 300 bars showing on the chart, you could spend a lot of time circling every inside bar that shows up.
Not all of them are in a location where we expect with some degree of certainty that a move that can be traded will come from that location.
The question becomes if there is any such thing as an inside bar trading strategy. Let’s find out.
What Is An Inside Candlestick?
As the name implies, an inside candlestick forms inside the range of the previous candlestick. Keep in mind that there can be more than one candlestick (bar) that forms and is also fully engulfed by the candlestick to the left. At minimum, it is a two bar pattern.
What does the inside bar indicate? In our graphic, we have a strong bullish candlestick.
Let’s step back for one second and be precise: the candlestick looks strong because it’s one of only two candlesticks shown. We can only say with confidence “strong bullish” if the green candlestick is larger than most of the price action that would have formed to the left of it.
Let’s assume our green “mother bar” is the largest one in recent price action on the chart. The market has moved with momentum and the next candlestick on the chart can’t take out the previous bar high or low. We can say that volatility has dried up at this point or at least is not as strong as the previous move.
This happens as the move is digested. Remember we have traders using all different time frames so we could have traders:
- Taking profits on their buys from a lower time frame
- Momentum traders bailing as there is no follow-thru
- Contrarian traders (who may be trend traders from another time frame) taking short positions
There are more reasons of course but we can’t cover all scenarios..just the higher level ones. Understand that when you see this type of chart pattern, whether Forex trading or trading stocks, you are looking at inside bar trading type of setups that depend on momentum showing up to carry price through the high/low of the previous candlestick.
Does Time Frame Matter With Inside Bars?
On a lower time frame chart, we are going to have many inside bars showing up. If you are trading a 15 minute chart and are trading Forex, in one 24 session you will see 96 bars. Given that there are slower sessions in Forex, you have the potential to see too many inside bars that you may decide to trade.
Trading an inside bar strategy without context or location is a mistake. It is not a trading strategy by itself.
There is nothing inherently important about an inside bar showing up on a chart in most locations. That’s not to say that lower time frame charts are useless for trading. You never know which time frame will start to exert control.
For my money, I believe there is a lot of noise in the markets and I (and many others) prefer looking for any type of candlestick pattern not on day trading time frames but on the higher time frame charts.
Higher time frame charts such as the daily chart remove a lot of the noise of the market. The setups are much cleaner.
There are several inside candlesticks on this chart and the majority of them do not lead to any type of trade that is worthwhile. We are seeing just normal price evolution. The presence of these inside candles could be considered meaningless in the grand scheme of things.
Let’s also consider that there may be places on these lower time frames where an “inside bar trading strategy” will work wonderfully. Look at the top of the chart prior to the move downwards. That is actually a rally on the daily chart that ends with the collapse. (Keep this in mind – it will come in handy later)
Location’s Not Just For Real Estate
If we can agree that there is no edge in simply selling or buying areas where inside bars show up, what type of strategy can we use?
We can use any type of trading strategy – it’s not an inside bar trading strategy though. We are not trading the inside bar, we are trading location, structure, market mechanics and using the inside bar as a trade entry strategy.
That is a vital distinction.
Look for inside bars to show up in areas where we can expect some type of price reaction. This will give us a better chance of success and to highlight that, I’m going to look at the 15 minute chart from above.
Look for inside bars around support/resistance levels, at either side of a trading range, even at the end of pullbacks against the trend.
Remember that inside bars show us a lack of volatility as the move is digested. We are looking for a relieving of that pressure that builds up in consolidations to get us into a trade at a favorable location on the chart.
A. This top was put in after a 1150 pip run to the upside.
B. Price pushes above the A resistance but we do not see follow-through which is something we’d expect to see at least a few candlesticks later. Our green inside candlestick forms above and below the tested resistance line. Given the context – an extended market, a breakout with no follow-through – a short makes sense.
C. Price has broken (with momentum) the support level that formed around B and price has pulled back towards what may be potential resistance. Price forms a trading range, we get a poke above the range, price recovers back inside and we get an inside candlestick. No reason not to short.
While many will argue you should always trade with the trend, in the right context, reversal trades do set up when markets are “over stretched” in one direction.
How Do We Enter Trades With Inside Bars?
Remember we are NOT really trading an inside bar strategy but in this case we are trading two strategies and using inside bars for our entry:
- Our first trade is actually a resistance holding trade. We are using the inside bar – the sign of lower volatility – to position short in this context
- This is a trade that sets up via mean reversion – a pullback trade. We are using the previous support now going to act as potential resistance.
- You can short the break of the low of the mother bar and place your stop using an ATR stop or some distance away from where price pivots
Keep in mind that the first trade is actually going against the trend that was occurring. Price action lead us to consider a short trade and we would know we were wrong if price reverses and keeps moving upwards. You may want to use a slightly tighter stop in that situation.
The general way to enter a trade using an inside bar is a breakout of the highs/lows of the mother bar.
Profit targets would be the same regardless of your entry strategy.
Our first trade could be the start of a new trend so we would want to see how price reacts at the pivot before the final run up in price.
The second trade target could be a measured move from the first leg down projected from the top of the pullback at C.
You may also want to consider taking partial profits are 1R to ensure some type of discipline and consistency in your trading.
Do You Need A Perfect Inside Bar?
Rarely in trading is anything perfectly clean especially if you take into consideration the mechanics of the market. Anybody that tries to tell you that price needs to react perfectly is confused and most times close is close enough.
There are too many variables at play to expect or demand perfection in price.
Take a look at this chart for example:
The white trend line connects highs to the left of this portion of the chart indicating a down trend is the bigger picture price has rallied into the zone.
- This candlestick exceeds the high by 5 pips which does not make it a perfect inside candlestick. Price rarely reacts cleanly at these areas and price probing the highs is normal evolution of price. It is to be expected and one way larger traders will short at locations like this would be to run price to the upside, trigger stops/trades, and then reverse. The 2 bars after the green pivot are actually contained inside the green candle or “mother bar”. To ignore this setup is a mistake even though it’s not a perfectly clean inside bar.
- Bear flag as price pushes down and you can see the green candlestick contained inside the red. Price is drifting weakly and this is what we want on a pullback if we want to short.
Even though we see price near the end of the bear flag exceed the high of the mother bar, do you disregard what this pattern is telling us?
Do we disregard what an inside bar indicates, lower volatility, even if price is still drifting? No. We WANT to see that with a pullback.
Is The Inside Bar A Real Trading Strategy?
I think you can see that the inside bar is not a trading strategy by itself. It makes up part of a trading strategy and that must take into account location and the context of the market.
It doesn’t matter which trading article you read that implies that an inside bar is a strategy by itself – the fact is that it is not.
You may be better off thinking that an inside bar strategy is actually an inside bar ENTRY strategy. Use this price pattern to give you an entry trigger into a trading setup that takes place at areas where there is a high probability of “something” happening.
Inside Bar Pullback Trading Strategy
That title is a little “tongue in cheek” but we can even use an inside bar pattern to help us get on board the trend after price has a pullback.
This chart is the four hour chart of the daily chart that is shown in the inset.
The daily chart pulls back to a location that was once resistance and has the potential to act as support. Once price hits the area, you can drill down into a lower time frame to find an inside candlestick to get you into the trade.
You can see with the blue lines the high and low of the mother bar defined which can also be considered a trading range. There are multiple candles inside of the mother bar but we do get a poke below the low of the mother bar.
Is that a concern? No. It is a natural evolution of price and does not discount the impact a break of the mother bar can have. In fact, that type of price action adds to the probability of an upside break and a probability of a break that will last.
We have the consolidation, the price compression, and from that, we know that momentum of some sort will arrive. Better yet, we have this all happening at a significant level from a higher time frame chart.
We are using the lower time frame pattern – the inside bar – to get us in a trade from a higher time frame pattern, the pullback.
Price holding above on the break above the mother bar high is still a sign of the bulls in power, especially after seeing the sharp push in and close back outside the breakout level.
Inside Bars Happen In All Markets In Any Time Frame
From the Forex market to stocks, inside bars can show up on any chart and time frame. Most of them are meaningless and simply show a pause in the price advancement.
For my money, I much prefer seeing this and all chart patterns on the daily chart and above. I find when the inside bar pattern breaks while in the context of a pattern such as a pullback, the daily chart and higher give more bang for the buck.
In the context of some type of trading structure or pattern such as a pullback, the break of mother bar high signifies an increase in momentum from a period of lower momentum shown by the inside bar pattern.
It is vital that you have a trading plan when you are choosing to use this chart pattern as part of an overall trading strategy. The inside bar strategy does not truly exist on it’s own but can be a useful objective trade trigger when appearing in price patterns that are centered around the tendencies of the markets.