Three Outside Down Candlestick Pattern

The three outside down is a Japanese candlestick pattern that loses $6.40, $4.30, and $2.00 in the crypto, forex, and stock markets, respectively, on average per $100 risked.

Not so hot, right?

But what if I told you that you could turn this unprofitable pattern into a profitable one by listening to the data?

Would you be interested?

If so, keep reading if you want to learn how to trade three outside down candlestick patterns in a profitable, data-driven way.

What Is a Three Outside Down Candlestick Pattern?

Three Outside Down Candlestick Pattern Illustration

The three outside down pattern is considered a bearish reversal candlestick pattern that lets you know the existing uptrend is starting to fail.

While this is somewhat true, the way traditional traders capitalize on this pattern is less than ideal (to be nice). 

But before we dig into these details, let’s first learn how to identify this pattern on our candlestick charts.

How to Identify the Three Outside Down Candlestick Pattern

The following are the requirements for a valid three outside down pattern:

  • The first candlestick in this pattern must be bullish.
  • The real body of the second bearish candlestick must engulf the first candle’s real body.
  • The third bearish candle must close lower than the second candle.
  • The pattern must occur during an uptrend.

We can see a clear example of the three inside down candlestick pattern on the Amazon (AMZN) daily chart on December 1st, 2021. 

The first candlestick of this pattern is bullish and follows the current bullish trend. The second candle of the pattern turns bearish and engulfs the previous candle.

The third bearish candle closes lower than the previous candle and completes the pattern. 

Now that we know how to identify these three candle reversal patterns, how should we trade them? 

How to Trade the Three Outside Down Candlestick Pattern

You should trade the three outside down patterns using a bearish mean reversion strategy using an optimal risk-reward ratio of 1:1.

But before we dig into the optimal strategy, let’s understand how most traders have been tough to trade this pattern.

Three Outside Down Bearish Reversal Trade Setup

The three outside down pattern occurred on the Apple (AAPL) daily chart on August 26th, 2021. 

We see that price is above the fifty-day moving average, which we consider an uptrend. The first candle of the pattern is bullish. The second is a bearish engulfing candle fully engulfing the first candle’s body, completing a two-day reversal pattern. The third bearish candlestick closes lower than the previous candle and completes the three outside down pattern.

The traditional way to trade this supposed trend reversal pattern is to go short at the third candle’s low break with a stop loss above the second candle’s high.

If you do this, you’ll lose money in every tested market.

You can improve these results by shorting price breaks at the close of the third candlestick, but there’s a much better, more profitable way to trade this pattern.

Three Outside Down Bearish Mean Reversion Trade Setup

Identifying the three outside up patterns should be almost second nature at this point. The candlestick pattern occurred on the Tesla (TSLA) daily chart on August 11th, 2021.

Price is in an uptrend; the first bar is a small bullish candle, the second is bearish and fully engulfing the previous, and the third candle closes lower than the second. With the pattern identified, let’s learn how to trade this pattern profitably.

A bearish mean reversion strategy uses the pattern’s high price as an entry and a stop of one ATR above the high price. A savvy trader waits for the price to cross above the pattern’s high and then goes short when the price crosses back below that same price. 

In our Tesla example, the pattern high occurred on the first bar at $719.03. Price crosses That high on August 12th, 2021, and then triggers a short entry the next day.

We can see that trading the pattern as a bearish mean reversion strategy, in this case, was highly profitable.

Does the Three Outside Down Candlestick Pattern Work? (Backtest Results)

Using the following rules, I backtested three outside down candlestick patterns 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 trading section above.
  • Confirmation must occur within three days of the pattern signal.

Three Outside Down Bearish Reversal Backtest Results

cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbearish reversalbearish reversalbearish reversal
stop_bar_typehighhighhigh
entry_bar_typelowlowlow
risk_reward111
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns8849857107567
trades594711177920
confirm_perc0.670.720.72
wins277339538186
losses317371639734
win_perc0.4660.4770.49
avg_win_bars7.6511.757.59
avg_loss_bars10.7610.668.13
cons_wins71628
cons_losses51212
edge-0.064-0.043-0.02
cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbearish reversalbearish reversalbearish reversal
stop_bar_typehighhighhigh
entry_bar_typeclosecloseclose
risk_reward211
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns8479855108195
trades822964097653
confirm_perc0.970.980.9
wins257499050809
losses565465046844
win_perc0.3130.5180.52
avg_win_bars14.587.525.11
avg_loss_bars13.557.246.18
cons_wins92334
cons_losses121314
edge-0.0640.0380.04

Three Outside Down Bullish Continuation Backtest Results

cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbullish continuationbullish continuationbullish continuation
stop_bar_typelowlowlow
entry_bar_typehighhighhigh
risk_reward555
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns94010080111737
trades500447764740
confirm_perc0.530.440.58
wins402336441
losses460424458299
win_perc0.080.0520.099
avg_win_bars8.6527.449.13
avg_loss_bars1.022.851.32
cons_wins234
cons_losses131841
edge-0.52-0.69-0.405
cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbullish continuationbullish continuationbullish continuation
stop_bar_typelowlowlow
entry_bar_typeclosecloseclose
risk_reward555
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns93710161112904
trades91810069105294
confirm_perc0.980.990.93
wins5252510231
losses866954495063
win_perc0.0570.0520.097
avg_win_bars7.886.41.97
avg_loss_bars0.570.70.27
cons_wins123
cons_losses193655
edge-0.655-0.69-0.415

Three Outside Down Mean Reversion Backtest Results

cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbullish mean reversionbullish mean reversionbullish mean reversion
stop_bar_typeatratratr
entry_bar_typepattern_lowpattern_lowpattern_low
risk_reward111
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns91010132111490
trades507604867001
confirm_perc0.560.60.6
wins298381641627
losses209223225374
win_perc0.5880.6310.621
avg_win_bars3.212.792.34
avg_loss_bars4.03.873.12
cons_wins61315
cons_losses378
edge0.1780.2610.241
cryptoforexstock
pattern_namethree outside downthree outside downthree outside down
pattern_categorybearish reversalbearish reversalbearish reversal
pattern_bars333
required_trenduptrenduptrenduptrend
traded_asbearish mean reversionbearish mean reversionbearish mean reversion
stop_bar_typeatratratr
entry_bar_typepattern_highpattern_highpattern_high
risk_reward111
timeframe2015-20212010-20212000-2021
bar_perioddailydailydaily
total_tickers39513516951
pattern_tickers1426914709
patterns94810220112898
trades173157523054
confirm_perc0.180.150.2
wins105111314827
losses684628227
win_perc0.6070.7070.643
avg_win_bars1.121.181.3
avg_loss_bars1.352.622.13
cons_wins5715
cons_losses256
edge0.2170.4170.283

The data shows that the optimal way to trade these reversal patterns is to expect volatility and extract profit from these opportunities using a mean reversion strategy.

Similar Candlestick Patterns

Three Outside Up Pattern vs. Three Outside Down Candlestick Pattern

Often, it’s easiest to break down these candlestick patterns by understanding their name.

The three outside up candlestick pattern and three outside down are three candle reversal patterns. The three outside up occurs in a downtrend, while the three outside down patterns occur in an uptrend.

In both patterns, the first candle is in the direction of the existing trend. The second candle fully engulfs the prior candles, which is why it’s called an “outside” pattern. The only difference is that the three outside up is a bullish outside day candlestick, and the three outside down is a bearish outside day candlestick. 

The final candle either moves up or down in the direction of the trend reversal.

Three Inside Down vs. Three Outside Down Candlestick Pattern

The three inside down candlestick pattern and three outside down are the same except for the second day. The three inside down’s second candlestick is an inside day fully engulfed by the first candlestick, and the three outside down is an outside day that fully engulfs the first candlestick.

The Bottom Line

While most traders see three outside down patterns as bearish reversal opportunities, the data shows us the likely outcome from this pattern is a range-bound market where we should be utilizing mean reversion strategies.

And this makes sense because if you’ve analyzed every candlestick pattern like me, you’ll notice that trend turning points often contain heightened volatility.

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