Inside Down And Outside Down – Revealing Candlesticks

Aug. 10, 2013 10:07 AM ET
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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for and the Top Advisor Corner 

Some candlestick formations have similar or confusing names, but their distinctions are very specific. An example involves two bearish three-stick indicators: the inside down and outside down.

The inside down indicator starts out with a harami. This is a two-session indicator with opposite-colored real bodies; the second day is smaller than the first day, in both opening and closing prices. The first session is white and the second is black.

The third and last session is black. It can trade in the same range or a lower range, but if there is a downside gap before this final session, the bearish indication is much stronger. In this sense, the third session confirms the bear harami in the first two, so the inside down can be thought of as a three-session bear reversal, or as a bear harami with a confirming downward-moving session immediately after.

The outside down is very similar to the inside down, with a notable exception. Instead of a harami in the first two sessions, you find an engulfing pattern. In this opposite formation from harami, the first session is "engulfed" by the second, which opens and closes on both sides beyond the range of the first session's real body. In the bear version, two important distinctions are found. The bear harami starts with a white session and is then followed by a black. The third session is also black.

To tell inside and outside indicators apart, remember that the harami and engulfing are opposite one another in the sequence of sessions. The harami starts with a smaller second day, and the engulfing pattern has a larger second day. In both cases, the first day is white, the second is black, and the third (confirming) day is also black.

These inside and outside down patterns are very useful because the third day confirms the indication in the first two. Both harami and engulfing patterns are strong reversal signs, but that third session moving downward makes both much stronger.

All candlestick indicators can signal reversal, but this in only the first step in a broader policy of confirmation. Before acting on inside down or outside down, be sure you find confirming signals at the same time. These will appear in momentum oscillators or in price patterns.

The strongest bear reversals are most likely to be found at or near resistance. You need an uptrend to reverse, or the indicator doesn't provide any value. However, when the price movement has been taken right up to the top level, reversal is always a strong possibility. This is true with gapping price movement, or even when price breaks out above resistance only to be followed by the inside down or outside down. When that is found, it is most likely that price is going to retreat and fill, and return to the established trading range.

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