The three outside up pattern

The three outside up pattern is another relatively simple three-stick reversal pattern that you can pick up on with a little patience and a basic understanding of the necessary components. This section gives you the full scoop.

Spotting the three outside up pattern

Like all bullish reversal patterns, the three outside up should occur in the midst of a downtrend. Here is how the days play out:

1. Day one: The pattern's first day is actually a down day, but just a slight down day.

2. Day two: The second day opens with a gap down from the first day, but prices don't stay down for long.

This day creates an "outside day" relative to the first day with the high being higher, the low being lower than the first day. Also, the open of the day is lower than the previous close, and the close of this second day is higher than the open of the first day.

The bulls take over at some point during the second day and push prices higher until the close is near the day's high. The second day is a long white bar, and it's an outside day relative to the first day. Outside means that the price action for the second day traded outside of the high and low of the first day.

3. Day three: The third day completes the pattern with another up day.

On the third day it's clear that the bulls aren't done, and the day closes higher than the high of the second day. The trend has definitely turned, and it's headed up, up and away.

For a straightforward example of the three outside up pattern, see Figure 9-4.

Figure 9-4:

The three outside up pattern.

Trading on the three outside up pattern

For a real-world example of the three outside up pattern, I use a chart of the stock for a company that helps its customers escape the real world. The chart is in Figure 9-5, and the company is Electronic Arts (ERTS), which produces some of the world's top video games. Its Madden Football games comprise its flagship series, and the company's stock is great on both the short and long side because it has many volatile moves based on the popularity of individual games and the platforms on which the games are played.

On the chart in Figure 9-5, ERTS stock appears to have found a bottom, and it looks like an uptrend is on the horizon. When you're working with three-day reversal patterns, try to buy at the beginning of a trend when prices are relatively low compared to recent history. The pattern plays out fairly well: The trend is down, and a down day — albeit not a very convincing one — occurs on the first day. It's followed by an outside up day, and then the third day is an up day that outpaces the bullishness of the second day.

The three outside up pattern comes before more bearishness instead of bullishness

The three outside up pattern is a thing of beauty, but Figure 9-6 shows you the pattern's potential for ugliness when it goes bad. The chart is for Hewlett Packard (HPQ). The pattern shows up in a downtrend, and the first day is indeed a down day. The second day is an up day, and it's an outside day relative to the first day. Very promising! Then, to top it all off, the pattern is completed with an up day on the third day that exhibits some bullish behavior.

Figure 9-5:

The three outside up pattern makes for a winning trading scenario on a chart of ERTS.

Figure 9-5:

The three outside up pattern makes for a winning trading scenario on a chart of ERTS.

Figure 9-6:

The three outside up pattern fails on a chart of HPQ.

Figure 9-6:

The three outside up pattern fails on a chart of HPQ.

But the bullishness isn't meant to last. On the very next trading day after the pattern appears, the stock never even gets over the previous day's closing price. The gap is quickly filled, and then in a few days anything that may be considered a support level is compromised. Easy come, easy go.

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