The outside bar trading pattern, also called an outside reversal, is a one bar bullish or bearish pattern that shows strong volatility in the instrument you are trading.
Unlike the inside bar that is completely inside the previous bar, the outside bar takes out both the high and the low of the previous bar.
While traders may also call this an engulfing candle, the important thing to know is what this pattern means.
Understanding Outside Bars
This is a reversal pattern and what makes it powerful is not only did sellers sell lower in the case of a bullish outside bar, but buyers were able to completely overtake the sellers and potentially trigger stops just above the high of the first candle.
This is a daily stock chart of BK. Price wasn’t doing too much for several days and the upper shadows show the buyers would push price up and sellers would slam it back down.
After several days, price opens lower (the large green candlestick) with some more downside (lower shadow) which originally would have had the candlestick red. That helps bring in sellers and gives confidence to those short.
In one day, buyers step in and not only puts shorts underwater during the session, they end the day by taking the stops of those short when potential resistance levels failed to show up. As stops fire during the day, price drives higher and brings in more buyers.
It’s the same dynamic with bearish outside bars
This is NEOUSD and the play is similar.
People are long and the big green candle brings in more buyers. The next day price pokes upside and then rips to break the other side showing sellers are in control. One day later, 12 days of gains are taken back and those with stops in the textbook places, below the lows in an uptrend, are taken out.
Can these change the trends?
They can but they can also:
- set up strong corrections
- simple price exploration looking for sellers/buyers at different levels
What happens after the outside bar shows up is what matters although knowing these bars exist, can help your trading and we’ll discuss that later.
Lower Time Frame Megaphone (Broadening Formation)
On the time frame you spot an outside bar, what is forming on a lower time frame?
A broadening formation or megaphone pattern.
This is a weekly and daily chart of the stock Marvell Tech. Let’s break this chart down:
- This is our outside bar that took out the highs of the previous candle and reversed to take out the lows.
- This is the beginning of the next week where the previous week at the outside bar
- Price makes a lower low filling in the gap and begins to bounce off the support zone drawn off the outside candle lows
- Price stalls and ranges at the resistance line drawn from the highs of the outside candle
The overall trend direction is up and the daily chart, using the weekly context of outside candle, gives you places to buy and either sell out or tighten stops.
This should give you a better understanding of how price plays out with outside bars and how to draw the support and resistance lines.
Outside Bar Trading Strategies
There are two ways to trade an outside bar: as reversals and as continuation patterns.
For a reversal pattern for a buy trade, we want to see an outside bar closing to the downside. There are two main ways we can trade this reversal.
For the first reversal pattern, we see the OB take out the high of the previous candle, and then rip right through to take out the lows. The higher time frame chart is an uptrend and this chart has put in a higher low after a lower high. That points to the potential of the uptrend resuming.
The next candle we get an inside bar (candle IB). This is a compression of volatility and as mentioned in this article: 4 High Probability Setups, an inside bar is actually a triangle on the lower time frame. We would place a buy stop order just above the high (red circle) or if watching real time, hit the buy button once price breaks the high.
- Stop loss – This will vary according to the trader. You could use the low of the inside candle pattern, put the stop in the middle of the inside bar, use ATR…..
- Profit targets – We want to target the previous high in this case the top of the outside bar. You can trail the stop or pick other profit targets
I don’t wait to find the outside setups at specific price points. Since my initial target is close and the break of the the inside bar shows upside momentum, the odds favor some gain.
Secondary OB Reversal
We won’t always get inside bars to help us enter a trade so we need another method and that is simply a break of the highs
This outside bar opened down, buyers stepped in, stops were hit and then selling took over taking out the other side of the past several days. The key is that the outside bar closed red which sets up a potential reversal.
The next day price fails to break down and rips through the outside bar taking out highs. This lead to over 7% gain before pausing.
Let’s look at a continuation trade.
Truth be told, I trade reversals 99% of the time but a continuation can be a viable approach. The main difference is the outside bar being green for an uptrend/red for a downtrend.
This is a 15 min chart of the stock MCK and we are looking at a bigger picture uptrend. The outside bar takes out the low of the red candle and then immediately reverses to the upside. The general play is to take the trade once the high of the OB is broken.
Astute day traders may, once the OB has yet to form, broke lows and then reversed to green, took the entry projecting we are about to see an outside bar.
The risk when taking an aggressive entry is price may go green and then stall and reverse. If that is the case, you’d take an exit on the trade.
Price action traders will love the simplicity of this approach and it does take into account how traders behave.
- Price breaks down, sellers step in and place stop above the high
- Price reverses, takes their stops which can power the trade further in your direction
- Many traders like to catch the turn (trend change) and this will capitalize on the trend being your friend
Profit taking will be unique to each trader. Some will go for exits at highs while others will set targets or trail.
We need stops and while they can be mental stops, you have to know where you will exit. A simple approach is either the low of the previous candle or at the midpoint of that candle.
Like always, ensure you map out a trading plan, risk protocols, and follow it on every single trade.