The three inside up pattern

The three inside up pattern is a good place to begin my discussion of the bullish three-stick patterns that can let you know when a downtrend is about to be reversed. This pattern is a straightforward pattern that you can recognize with just a little practice.

Identifying the three inside up pattern

The three inside up pattern has a peculiar name, but a quick look at Figure 9-1 should give you a good idea of where the name originated. The three part comes from there being three days involved in creating the pattern. There are three sticks, and the second day is an inside day relative to the first day, which is a long down day. The final day is an up day that closes higher than the open of the first day.

Figure 9-1:

The three inside up pattern.

The trading activity that results in a three inside up pattern involves a gradual shift of power from the bears to the bulls. I like this pattern and the way it develops because it usually gives a trader time to put on a trade before too much of the reversal has occurred. Traders can always buy high with the intention of selling higher, but it's nice when buying high doesn't mean they're buying too high.

Making effective trades using the three inside up pattern

The chart in Figure 9-2 gives you a very good idea of how the three inside up pattern can tip you off as to when to buy in advance of a forthcoming uptrend. It's a chart of the futures contracts that trade based on the ten-year Treasury bonds issued by the U.S. government. It's one of the most actively traded futures contracts, and it's a very economically sensitive security.

This chart shows an extended downtrend in the price of the ten-year futures. There have been a couple of attempts to change the course of the trend, and before the pattern arrives, it appears that the downtrend has been moderating. I include a couple of trendlines on the chart as an illustration.

^ ^ If you're looking for trend reversal patterns, a good sign is when you see that the prevailing trend is starting to moderate. When you spot a moderating trend, be sure to keep your eyes peeled for a candlestick pattern indicating that a trend reversal is on the way.

The first day of the three inside up pattern in Figure 9-2 is a long black candle, which is followed by a slight up day that's an inside day relative to the first day. The third and final day is a strong up day that closes above the open of the first day of the pattern and completes the bullish signal. Then it's off to the races, and the trend starts shooting upward.

Are you wondering where you may place a wise sell stop order when you're working with the three inside up pattern? If so, good question. You have several choices. In most cases, I use the open or low of the second day. If those levels are violated, I regard the pattern as invalid. You can also use the open or low of the third day; both are viable alternatives.

Figure 9-2:

The three inside up pattern offers a useful buy signal on a chart of ten-year U.S. Treasury bond futures.

Figure 9-2:

The three inside up pattern offers a useful buy signal on a chart of ten-year U.S. Treasury bond futures.

DNG/ Avoid using the first day, because if the security breaks through the lows of the first two days, then there's a good chance that the first day levels are going to be tested if not violated. Wouldn't you rather be out of the long trade before this occurs?

The three inside up pattern not Working out too Weff

This section gives you an example of what can happen when a three inside up pattern fails. Take a look at Figure 9-3, where you can see a three inside up pattern that appears in a downtrend but doesn't signal a trend reversal. It's a chart of the futures contracts that trade based on the level of the Australian dollar versus the U.S. dollar. This isn't the most liquid of currency futures pairs, but it's still active enough to make money on both the long and short side.

The first day of the pattern in Figure 9-3 is a down day, and the second day shows a gap up but doesn't have a low that violates the low of the first day. The second day's close is also higher than its open, but the second day's close stays between the open and close of the first day. And if you're thinking that the second day is an inside day, you're absolutely right! Finally, the third day is also an up day — a long white bar — with an open that's higher than the open of the second day. So where does the pattern go wrong?

The day after the pattern is the culprit. On that day, a long black candle violates anything a savvy trader considers a support level, and that's all she wrote. Even though the pattern fails, the failure day can be a blessing for buyers who have solid stops in place, because that little bit of failure (and the subsequent stop-induced end of the trade) would save them from the effects of a downtrend that continues for several days.

Figure 9-3:

The three inside up pattern fails on the Australian dollar future contracts.

Figure 9-3:

The three inside up pattern fails on the Australian dollar future contracts.

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