What it means
Both patterns start with a candle in the existing trend and then an "engulfing" candle in the opposite direction. An engulfing candle is one whose body completely covers the body of the previous candle, showing that the other side of the market has taken over.
A third candle then confirms the new direction by closing beyond the second one. In Three Outside Up, the first candle is a small down candle in a falling market.
The second is a larger up candle that engulfs the first, and the third is another up candle that closes higher than the second. The result is a pattern that tells a story of sellers losing control and buyers stepping in.
Three Outside Down is the mirror image. A small up candle in a rising market is followed by a larger down candle that engulfs it, and a third down candle closes lower.
Traders read it as a sign that buyers have run out of steam. The third candle matters, because the engulfing pattern by itself is only a warning.
Waiting for confirmation reduces false signals, though it also means the trader enters later at a less favourable price. This trade-off between early action and certainty is common in technical analysis.
As with other patterns, context improves reliability. A signal near a known support or resistance level, with rising volume, deserves more attention than one in a quiet market.
Responsible traders also decide in advance where they will exit if the signal fails. Many charting platforms identify these patterns automatically, which makes them easy to spot but also easy to over-trade.
A scan may flag dozens of examples in a single day, most of which will not be worth acting on. The skill lies in choosing the few that fit the trend, the volume and the wider market picture.
In practice
Real-world examples.
Example
A trader follows a manufacturing share that has dropped for two weeks. A small down day is followed by a large up day that covers it, and the next day closes higher again. He buys a small position and places a stop-loss below the low of the pattern.
Example
A fund analyst sees a Three Outside Down on the chart of a bank share after a long rally. She checks news and finds nothing unusual. She trims the position and waits for more evidence before selling the rest.
Example
An individual investor reads about the pattern and applies it to a currency chart. The signals prove inconsistent because the market trades in a narrow range. She learns that the pattern works best in a clear trend.
Formula
Calculation
Three Outside Up test: Candle 1 is down; Candle 2 is up with open below Candle 1's close and close above Candle 1's open; Candle 3 closes above Candle 2's close.
Suppose a share is falling. Candle 1 opens at $20.00 and closes at $19.40, a down candle. Candle 2 opens at $19.30 and closes at $20.30, so it engulfs candle 1, because 19.30 is below 19.40 and 20.30 is above 20.00. Candle 3 opens at $20.30 and closes at $20.90, above candle 2's close of $20.30. The rise from the pattern's low of $19.30 to $20.90 is 20.90 - 19.30 = $1.60, which is 1.60 / 19.30 = about 8.3%.Case study
Seen in the real world.
Lighthouse Asset Management is an illustrative, fictional firm that trains junior analysts on charts. In a workshop, the trainer showed the group six months of data for a fictional share and asked them to mark any Three Outside Up or Down patterns.
The group found four. Two led to clear moves in the expected direction, one failed within three days and one was too close to a quiet holiday period to mean much. The trainer used the exercise to show that patterns are clues, not promises.
In this illustrative session, the juniors agreed on a rule to require both volume and trend context before acting on a pattern. The firm recorded the exercise as part of its training, and the analysts later applied the same discipline to other signals. The trainer closed the session by asking each junior to write down the reason for every trade before placing it, so that decisions could be reviewed fairly afterwards.
Watch out
Common mistakes.
- Acting on the second candle alone, without waiting for the third to confirm the move.
- Ignoring the prior trend, when the patterns are meaningful only as reversals of an existing direction.
- Believing a pattern predicts the size of the move, when it only hints at the direction.
Questions
People also ask.
What does engulfing mean?
The body of the second candle completely covers the body of the first, showing a decisive shift in control between buyers and sellers. The wicks, or thin lines above and below the body, are usually ignored in this test.
How is it different from a simple engulfing pattern?
The three-candle version adds a confirming third candle, which makes the signal slower but more reliable.
Which markets can use it?
Any market that produces candlestick charts, including shares, currencies, commodities and indices. Liquid markets with plenty of trading tend to give cleaner patterns than thin ones.
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