Downside Gap Three Methods

The downside gap three methods is a three-bar bearish continuation Japanese candlestick pattern that is best traded using a bullish mean reversion strategy according to backtests spanning multiple decades.

If you’re a candlestick technical analyst, you might be surprised that history doesn’t support the bearish lean. The data shows you should capitalize on incoming volatility instead of a trend continuation.

Keep reading if using data to learn the best downside gap three methods trading strategy get you going.

What Is a Downside Gap Three Methods Candlestick Pattern?

Downside Gap Three Methods Candlestick Pattern Illustration © Analyzing Alpha
Downside Gap Three Methods Candlestick Pattern Illustration

The downside gap three methods is a three-bar candle pattern that supposedly signals a bearish continuation.

The name comes from how it looks on a candlestick chart: Three candlesticks with an initial downward gap.

But before we discuss how best to trade this gapping pattern, let’s learn how to identify it on our candlestick charts.

How to Identify the Downside Gap Three Methods Candlestick Pattern

Downside Gap Three Methods Candlestick Pattern on the Apple (AAPL) December 18th, 2018 daily chart
Downside Gap Three Methods Candlestick Pattern on the Apple (AAPL) December 18th, 2018 daily chart

The following are the requirements for a valid downside gap three methods candlestick pattern:

  • The first candle must be bearish.
  • The second candle must be bearish and gap down.
  • The third candle must be bullish, open within the last candle’s real body, and close within the first candle’s real body.
  • The downside gap three methods must occur during a downtrend.

We see the downside gap three methods candlestick pattern on the Apple (AAPL) December 18th, 2018 daily chart.

Price is in a bearish trend as it’s below the fifty-day moving average. The first candlestick is bearish. The second candlestick has a bearish downside gap and closes bearishly. The third candle opens within the second candle’s real body and closes within the first day’s real body, fulfilling our three methods pattern requirements. 

Now that we know how to identify the downside gap three methods on our candlestick charts, how do we profit from these three-bar patterns?

How to Trade the Downside Gap Three Methods Pattern

The downside gap three methods should be traded using a bullish mean reversion trade strategy in the stock markets and a bearish mean reversion in the forex market, according to our 21-year backtest.

Crypto traders that want statistical significance in their trading should avoid this pattern on the daily timeframe.

But before we learn how to trade the downside gap three methods optimally, let’s know how conventional wisdom has led most traders astray.

Downside Gap Three Methods Bearish Continuation Trade Setup

Downside Gap Three Methods Bearish Continuation Trade Setup on the Netflix (NFLX) December 18th, 2018 daily chart
Downside Gap Three Methods Bearish Continuation Trade Setup on the Netflix (NFLX) December 18th, 2018 daily chart

Let’s practice identifying the downside gap three methods one more time. 

We see the price below the fifty-day moving average, giving us a downtrend. We have a red candle followed by another bearish candle that gaped lower (barely), followed by a green candle that opened within the last candle’s real body and closed within the first candle’s real body. 

With the signal set, traditional traders short at a break of the third candle’s low and set a stop loss above the first candle’s high.

These traditional traders should expect to lose money on every trade if history repeats itself. Instead, let’s go in the other direction.

Downside Gap Three Methods Bullish Mean Reversion Trade Setup

Downside Gap Three Methods Bullish Mean Reversion Trade Setup on the AbCellera (ABCL) January 6th, 2021 daily chart
Downside Gap Three Methods Bullish Mean Reversion Trade Setup on the AbCellera (ABCL) January 6th, 2021 daily chart

The recently IPOed AbCellera (ABCL) has a downtrend followed by the requisite candle order. We see a bearish candle, followed by a gap down into another bearish candle, into a third candle that opens within the last candle’s real body and closes the gap.

With the pattern identified, data-driven traders wait for the price to cross below the pattern’s low and enter long when the price moves back above that low, setting a stop loss of one ATR.

Let’s authorize this chart for public use to clear things up.

The pattern low occurs on the third candle at $36.82. The price crosses below $36.82 on the 11th, signaling for the mean reversion trade to get ready to enter. The price opens the very next day at $37.00, causing an immediate entry at the open. This data-driven trader captured significant profits using this as a bullish reversal pattern.

Downside Gap Three Methods Bearish Mean Reversion Trade Setup

Savvy forex traders do it in the other direction expecting a shorter move.

The pattern high occurs on the first candle at $0.8879. The price moved above this high on November 21st, 2014, alerting traders to a future potential short entry. The price crosses below this high the next day, and eventually, the bears win, leading to a significant profit.

Speaking of significant profits, what types of profits were garnered through these best downside gap three methods trading strategies?

Does the Downside Gap Three Methods Pattern Work? (Backtest Results)

Using the following rules, I backtested the downside gap three methods pattern on the daily timeframe in the crypto, forex, and stock markets.

  • A close above the 50-day SMA constitutes an uptrend.
  • I tested risk-reward ranges from 1 to 5. 
  • The optimal risk-reward ratio is selected using profit per bar.
  • Entry and exits are discussed in the how-to trade section above.
  • Confirmation must occur within three days of the pattern signal.

Similar Candlestick Patterns

Multiple candlestick patterns are often confused with the downside gap three methods pattern. It’s essential to understand the differences when using candlestick pattern technical analysis.

Upside Gap Three Methods vs. Downside Gap Three Methods

Upside Gap Three Methods Candlestick Pattern Illustration © Analyzing Alpha
Upside Gap Three Methods Candlestick Pattern Illustration

The upside gap three methods is the bullish version of its bearish brethren–they’re mirror opposites. The upside gap occurs in an uptrend, and the candle colors are reversed. The first candle is bullish, the second candle gaps up and is bullish, and the third candle opens within the second candle’s real body and closes within the first candle’s real body.

Down Gap Side-by-Side White Lines vs. Downside Gap Three Methods

Down Gap Side-by-Side White Lines Candlestick Pattern © Analyzing Alpha
Down Gap Side-by-Side White Lines Candlestick Pattern

The down gap side-by-side white lines is a three-bar bearish continuation pattern, just like the downside gap three methods. The difference between the down gap side-by-side white lines and the downside gap three methods is the second candle is white, and the third candle is roughly the same size as the previous, and it does close the gap, whereas the second candle is black, and the third candle does not close the window in the white lines.

Downside Tasuki Gap vs. Downside Gap Three Methods

Downside Tasuki Gap Candlestick Pattern Illustration © Analyzing Alpha
Downside Tasuki Gap Candlestick Pattern Illustration

The downside tasuki gap is a three-bar bearish continuation pattern. The difference between the downside tasuki gap and the downside gap three methods is that the third candle closes within the window in the tasuki gap pattern, whereas the downside gap three methods close the window.

The Bottom Line

The downside gap three methods is a three-bar bearish continuation pattern that’s best traded using a mean reversion strategy according to a 21-year backtest. Traditional traders believe this pattern continues the bearish trend. Still, data-driven traders know that history shows us that this is a volatility pattern that tends to resolve in the opposite direction. This is common for many popular candlestick patterns.

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