Three Outside Up and Down — Engulfing with confirmation

An Engulfing pattern on its own can halt a trend in a single session, but it can just as easily turn out to be a one-off burst. Three Outside Up and Three Outside Down add a third candle that has to confirm the market truly changed direction rather than simply pausing for breath. That confirming candle separates both patterns from a plain Engulfing, and it is the reason many traders wait for it before they risk an entry.

What are the Three Outside Up and Three Outside Down patterns?

These are three-candle Japanese reversal patterns from the candlestick tradition that Steve Nison brought to Western traders, and each is simply an Engulfing completed by a confirming candle. Three Outside Up is a bullish reversal signal: candles 1 and 2 form a bullish Engulfing, and candle 3 closes even higher than candle 2. Three Outside Down is the mirror image — a bearish reversal signal: candles 1 and 2 form a bearish Engulfing, and candle 3 closes lower than candle 2.

The logic is straightforward. The first candle is a quiet continuation of the trend. The second arrives with force and its body completely swallows the first, signalling that the losing side has taken control. The third candle settles whether that turn held: if it closes still further toward the reversal, you have confirmation; if it turns back, the pattern gives no signal. For background, it helps to recall how the bare bullish and bearish Engulfing pattern works, because it forms the core of both setups.

How does Three Outside relate to Engulfing and to Three Inside?

The simplest way to remember it: Three Outside is an Engulfing with confirmation, while Three Inside is a Harami with confirmation. Both share the same idea — a two-candle reversal signal to which we add a third candle as a filter — and differ only in the core. In Three Outside, candle 2 is larger than candle 1 and swallows it from the outside, hence "outside"; in the Three Inside Up and Down setup, candle 2 is smaller and hides inside candle 1, hence "inside".

That difference matters in practice. The Engulfing is a stronger, more aggressive signal than the Harami pattern, because it shows a full takeover rather than just a loss of momentum. That is why Three Outside is usually seen as slightly more decisive than Three Inside: its first two candles already carry the stronger message.

"The more confirming signals a candle provides, the more reliable the reversal it foretells." — Steve Nison, Japanese Candlestick Charting Techniques, New York Institute of Finance, 2001

How do you spot the setup on a chart?

Look for Three Outside Up after a clear downtrend, and Three Outside Down after an uptrend — without an existing trend there is nothing to reverse. Candle 1 carries a small body in the direction of the trend, candle 2 is a large opposite body that fully covers it (the classic Engulfing, where control changes hands), and candle 3 then closes still further toward the reversal than candle 2.

The most common mistake is confusing the Engulfing with merely touching a level. What counts are the bodies of the candles, the range between open and close, not the wicks; if candle 2 reaches past candle 1 only with its shadow, you do not have a true Engulfing. The second mistake is accepting a candle 3 that closes weaker than candle 2, because then there is no confirmation at all.

What does it look like in an example?

Here is a hypothetical Three Outside Up on EUR/USD, after the market has been falling for several sessions; the numbers are illustrative and only show the mechanics.

Where do you place the entry, stop-loss and target?

You open the entry only after candle 3 closes, or on a break above its high (in the Up version) or below its low (in the Down version). This is the key rule: while candle 3 is still forming, you cannot know whether it will close in the right place. The stop-loss goes on the opposite side — below the low of the engulfing candle for Three Outside Up, and above its high for Three Outside Down — because if price returns there, the whole premise of the pattern no longer holds.

Set the target using prior market structure — the nearest support or resistance, or a Fibonacci retracement of the earlier move. A sensible ratio of potential reward to risk starts at roughly two to one; if the nearest barrier sits right next to your stop, skip the setup. Many traders also add an indicator filter, such as an oversold or overbought RSI reading, as an additional rather than the sole criterion.

Does third-candle confirmation actually help?

Yes, but at a price. By waiting for candle 3 to close, you filter out some false signals where an Engulfing looked promising but the market simply resumed its trend. In return you give up some opportunities: by the time candle 3 closes, price has already moved toward the reversal, so you enter later and at a worse price than someone who took the bare Engulfing — a few missed entries traded for fewer hits into traps.

It is the classic compromise between precision and the number of signals: Three Outside gives stronger, better-confirmed entries, but fewer of them. A similar logic of a confirmed bottom drives the morning star pattern, though its middle candle is one of indecision rather than an Engulfing. The choice depends on whether you value the quality of a single signal or its frequency.

What to do tomorrow

1. Open a daily or four-hour chart and find at least three historical occurrences of Three Outside Up or Down, checking each time that candle 2 truly covered the whole body of candle 1 and did not merely reach past it with a shadow.
2. Before you open any position, verify two conditions: a complete bullish or bearish Engulfing on candles 1–2, and candle 3 closing further toward the reversal than candle 2; entering before candle 3 has actually closed is the single most common mistake here.
3. Set the stop-loss on the opposite side of the engulfing candle before you enter, then measure the distance to the nearest support or resistance to confirm the ratio of potential reward to risk is at least two to one.
4. Compare Three Outside with Three Inside on your own charts and record in your journal whether the stronger engulfing core gives you calmer, more reliable entries than the gentler Harami on the pairs you actually trade.
5. Review the broader logic of candlestick reversals in this technical analysis guide to see where Three Outside fits among other reversal formations, and then practise spotting it on historical data before you trade it live.