While some might argue that candlesticks are just a snapshot of market activity without any true meaning and with even less forecasting value, the trader who can interpret the subtle clues provided by candlesticks and price formations can increase their odds.
In this article, we want to explore two of the most commonly used three-bar price patterns – the inside bar and the engulfing pattern. In contrast to other candlestick patterns, the three-bar formations put more emphasis on market context and thus, allow traders to understand what is going on inside price.
The Inside bar
The inside bar shows a market contraction and a consolidation period often just before a reversal. The inside bar pattern consists of three candlesticks where the second forms completely inside the previous bar, hence the name. The small candle inside the larger previous one shows the contraction and a period of market indecision.
The trigger of the inside bar pattern exists once the third candle breaks either the low or the high of the small candle. A later and more accurate signal is given when the third bar breaks the range of the larger first one.
The inside bar is either a reversal pattern when it occurs at market swing points or a continuation pattern in between trend waves. Context is key for the inside bar; inside patterns occur frequently and it’s important to wait for a signal at a reasonable price level and not trade them by themselves.
Advanced inside bar – The Fakey
The inside bar is a well-known pattern and is often classified an “amateur pattern” which makes it is easy for other market participants to hunt orders around those patterns. The “Fakey” pattern accounts for this problem. After an inside bar, the “Fakey” trader waits for a breakout and an immediate reversal into the opposite direction. Basically, the “Fakey” describes a false breakout pattern and it can improve the accuracy of the trading method.
The engulfing bar is another 3 candle pattern which is best used for reversal trading. The second candle in the engulfing pattern completely engulfs the previous one – it is the opposite to the inside bar and, therefore, sometimes referred to as outside bar. While the inside bar shows a market contraction, the engulfing bar shows an immediate and sudden change in market sentiment.
A bullish engulfing bar that forms at a support level after a bearish trend shows that participants reversed their sentiment within only one candle. Similarly to the Fakey pattern, an engulfing pattern that leaves a candle shadow offers a higher probability trade signal. The shadow often looks like a breakout during the time it forms and would lead amateurs to opening positions into the wrong direction, selling to the professionals that then drive price higher.
Caution: False patterns
To avoid taking false signals, it is important to analyze inside and engulfing candles in the right context. Volatility and other factors impact candle size and shape significantly. For example, before an important news release, you can typically see volatility dry up and candles becoming smaller naturally. Inside bars can form easily under such market conditions although market and investor sentiment is not undergoing any changes.
The same holds true for engulfing patterns. After a period of lower volatility and smaller candles, before news events or during EOD trading, engulfing patterns can form easily once volatility goes back to normal. An engulfing pattern that is being created under such circumstances is usually not a good signal.
Especially in futures and forex trading, this effect can trick traders into making false assumptions. During overnight trading, candles become smaller and then increase size again when equity markets open up. Inside and engulfing bars that form during such times should be avoided if it does not fit into the market context.