The three inside down pattern

The three inside down pattern is a handy reversal pattern that shows up fairly regularly. The indecision implied by the pattern's second day (an inside day) provides great insight into the action, telling you that the bears are starting to push against the trend.

Figuring out how to spot the three inside down pattern

The three inside down always occurs in an established uptrend:

1. The first day of the pattern is an up day.

The bulls are in control on the first day of the three inside down.

2. The second day is bearish, and it's also an inside day relative to the

(The open is lower than the previous day's close, and the close is higher than the previous day's close.) The high and low of the second day also fall within the high/low range established on the first day of the pattern. The bears take over on the second and third days (see next bullet

3. The pattern is completed on the third day with another down day that actually violates the low of the first day.

As you may guess, this formation is usually a great sign that an uptrend is set to fizzle out. For an example, see Figure 10-1.

first day.

point).

Figure 10-1:

The three inside down pattern.

Trading on the three inside down pattern

The preceding section shows how to identify the three inside down pattern, so now set your sights on Figure 10-2 for a real-world trading scenario where the pattern can potentially help you turn a profit. The chart in this figure is of Tribune Corporation (TRB), the owner of the Chicago Tribune newspaper, as well as the owner (as of this writing) of the Chicago Cubs. (The Cubs have been in what you could call a downtrend for the last 100 years, but that's a different story altogether.)

The three inside down pattern is the opposite of its bullish counterpart discussed in Chapter 9. It starts out with a bullish first day, but things start to turn bearish after that. Here's how the pattern unfolds:

1. The first day is a long white candle that occurs in the midst of a pretty strong uptrend.

2. The following day, in textbook fashion, a down, inside day appears.

The open of the second day is lower than the close of the first, and the close of the second day is higher than the first. Both the wick and the body are "inside" the first day's price action.

3. The third day reveals a takeover by the bears, and they begin to push prices down.

The stock opens lower and continues to trade down below the low of both the first and second days. The ensuing downtrend is strong, and it lasts for a few weeks.

If you watch this pattern develop and look to make a trade, you need to either be prepared to short near the close of the first day or pick an entry level to try to sell short on the second day.

Figure 10-2:

The three inside down pattern precedes a trend reversal on a chart of TRB.

Figure 10-2:

The three inside down pattern precedes a trend reversal on a chart of TRB.

Failing to give a good bearish signal

If you've read through any of the preceding chapters, you already know that I never provide a winning pattern example without following it up with a similar pattern that fails. For my failure example of the three inside down pattern, I offer up the chart in Figure 10-3. This chart is for BEA Systems (BEAS), a provider of business-oriented software. As far as stock trading goes, software stocks offer as much volatility as any industry, and BEAS has been a great one to trade for years.

Figure 10-3 shows that the inside down day on BEAS occurs at the very beginning of an uptrend. It appears after some relatively strong days, so by trading it, you're either fighting a strong trend or catching the stock when it's due for a turnaround.

The first day in the three inside down pattern in Figure 10-3 is an up day, but it's nothing spectacular because of the recent bullishness. The second day is an inside day, and the third day reveals a rally by the bulls that falls short when the day closes down. The price action that plays out shortly after the pattern is pretty encouraging for the bears, but after a couple of weeks, the trend turns back up and the pattern clearly fails. The most liberal stop level for the three inside down is the pattern's high, but you can always go with a more conservative stop, such as the high of the last day.

Figure 10-3:

The three inside down pattern fails on a chart of BEAS.

Figure 10-3:

The three inside down pattern fails on a chart of BEAS.

The three outside down pattern

Like the closely related three inside down pattern from the preceding section, the three outside down pattern should show up pretty frequently on your charts. The pattern is a solid three-stick bearish trend reversal, and if you know how to correctly identify it, you can rely on it for some lucrative trades.

Spotting the three outside down pattern

This pattern shows up during an uptrend and commences with another up day in the bullish run. On the second day, the bulls get started again with a gap opening, but they don't control the price action for long. The bears find a selling point above the previous day's close and go to work driving down the price. This means that the second day has a close lower than the first day and a low that's lower that the first day. The second day is, therefore, an outside day relative to the first day.

On the third day of the three outside down pattern, the bears call the shots from open to close. The day produces a black candle with the open, high, low, and close all lower than the previous day's levels. The bears are now firmly in control. For an illustration, check out Figure 10-4.

Figure 10-4:

The three outside down pattern.

Making trades with the three outside down pattern

The three outside down pattern does an outstanding job of picking up a change in trend and offering a useful sell or short opportunity, and you can see it really sing in Figure 10-5. The chart in this figure is for Applebee's International (APPB). Applebee's operates in the restaurant industry, and stocks in that industry experience a lot of unpredictability. Restaurant stocks fluctuate with the economy, people's tastes, and even the weather. (Bad weather every weekend during a month can mean a bad month for a restaurant.)

Figure 10-5:

The three outside down pattern offers a sound signal on a chart of APPB.

Figure 10-5:

The three outside down pattern offers a sound signal on a chart of APPB.

The first day of the pattern featured in Figure 10-5 is an up day, and although it's nothing to write home about, it's still an up day occurring in a prevailing uptrend. It's followed by an outside and down day. Both the body and wick of the second day are outside relative to the first day. Finally, on the third day of the pattern, the bears seize control and begin pushing prices down at the start of what becomes a sustained downtrend. In fact, it takes a couple of weeks before the bulls even attempt some sort of rally. The three outside down pattern predicted a trend reversal, and that's exactly what played out.

Offering a failing signal

But what happens when the three outside down pattern doesn't deliver on its suggestion that a downtrend is on the way? For an answer, take a look at Figure 10-6. The chart in Figure 10-6 displays price action for the stock of the biotech company Millennium Pharmaceuticals (MLNM). Biotech stocks can be wildly volatile and fun to trade. This chart is interesting because there's more there than just a failure of the three outside down pattern, and I explain the extra features in a moment.

The outside down pattern on this chart is a classic example of how the pattern appears as it gives a sell signal. The first day is bullish in a bullish trend, followed by a second day where the bulls push higher on the opening, but then the bears push back, creating a down day that's outside compared to the first day. Finally, the bears are in control on the final day as they push prices even lower.

After the pattern, a couple more bearish days exist, and then the trend takes a turn to the upside. As I said, biotech stocks can be highly unpredictable! The pattern fails and then something funny happens. Take a look. You may think I highlighted another instance of the bearish outside day pattern, but that's not the case.

Figure 10-6:

The three outside down pattern offers a failing signal on a chart of MLNM.

Figure 10-6:

The three outside down pattern offers a failing signal on a chart of MLNM.

It's a little difficult to tell, but the highs of the first and second days marked with ??? are equal. This disqualifies the pattern as an outside down pattern. So does a penny of price action on the second day really mean that there was a huge difference in the trading behind these three days? Apparently not. A new downtrend that lasts several weeks pops up right after the appearance of what you may call the "almost bearish outside pattern."

Splitting hairs on candlestick pattern formation can cost you a profitable trade. Just because there's a very small price difference that seems to disqualify a pattern, don't be too quick to disregard the formation altogether. The psychology behind the pattern that almost panned out is the same as what drives a by-the-book pattern, and you may be able to make a successful trade, if you aren't harshly strict with your pattern evaluations.

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