If you are going to focus your attention on one candlestick pattern then the outside bar would be a great choice. It’s certainly one of the confluence factors we look for in our own trading but what is the outside bar and how best can it be traded?
The outside bar, or sometimes referred to as an engulfing candle, is significant because of the amount of volume required to create it. There are a few different definitions as to what constitutes and outside bar but out definition is as follows:
The current bar, including the open, close, high and low has to completely engulf the candle prior to it including the open, close, high and low.
Let’s look at how these bars form on a price chart.
The first thing you will note from looking at this chart is the resulting moves that occurred after the formation of the outside bar. There are a number of ways these bars can be traded but like most situations in trading context is everything.
Trading these bars in isolation with no other forms of confluence will at best leave you breakeven over the long term, we know because we’ve tested it! Like in most trading situations, context is everything and you need to be mindful of where these candles are forming.
You can breakdown the set-up in to two broad categories, continuation and reversal. Continuation candles occur during a price run and are in line with that run. We can see in the chart example below that the bearish outside bar occurred during a downward run. Price didn’t continue any further in that direction.
Outside bars in the opposite direction to the current run are far more significant as it takes a lot of volume to stop price in its current trending run. If we can another look at the example above we can see such an example.
These are isolated examples but if you back test these two types you will find that the performance of reversal out side bars far out-weighs the continuation patterns.
As well as taking reversal candles there is another layer of confluence that you can add to these trades to increase your chances of success. Trading at key locations is an important element as long as you are patient enough to wait for them to occur. Prior swing points or support and resistance are prime locations for outside bars to form and as we can see from this example the resulting move can be significant.
Entry, Stop and Target
Typically the daily time frame is where you would look for these trades so our routine is to look through the charts after the New York close at 22:00 GMT. Depending on how the candle closes one particular strategy is to place a pending order to trigger in the direction of the candle, with the stop loss on the other side.
The target is far more subjective, we certainly don’t recommend a fixed target approach. Learning to understand market structure and picking your targets accordingly is the key to long term success.
In this particular trade we had an ultimate target with an intermediate point where we were prepared to react should price not make it through.
Prior swing points and S/R are more logical in determining your targets but wherever you target is make sure there is an appropriate gain in terms of R compared to your strike rate.
There are more advanced methods for trading outside bars so check out our trading course for more of a detailed insight.