Observe any world-class sprinter in training. He will speed down a track in obsessive pursuit of a faster time but occasionally will break and rest before resuming his charge. Often, its during these pauses that the athlete recovers his physical stamina for a perfectly timed surge designed to deliver a superior finish.
In trading, price behaves similarly, moving from periods of expansion and trends to periods of contraction and stability. During these pauses, opportunity can be found. It’s here that traders can identify low-risk entries using a particular price pattern that marks both reversal points and continuation moves.
Inside bar patterns refer to times when the high of a price bar is lower than the previous bar’s high and the low of a price bar is higher than the previous bar’s low. Inside bars reflect reduced volatility in the commodity or stock and identify periods of contraction. Such periods are common when a price has experienced a sustained trend, followed by a shorter-term reversal, but they can occur at any time.
Inside bars can be found on any time frame, and often the pattern precedes a significant price move. Inside bars reveal price points where the ascent or descent of price action is in question. Traders participating in the stock’s trend are at an impasse, and that indecision results in a lack of movement until the bulls or bears assert themselves and take control of the trend (see “Inside Apple,” below).
Multiple inside price bars are a phenomenon that occurs when neither side of the market takes control for subsequent trading sessions. Price meanders with no conviction, typically after a strong run up or decline. Similar to a widely accepted tenet of channel trading, the longer the sideways action, the stronger the expected break in price once that break occurs.
Although the application of inside price bars seems simple, there are some key distinctions that traders must keep in mind to use this method effectively.
Picking your shots
Depending on the context of the market, inside bars can be used to confirm price trends or to fade support and resistance.
For example, a common challenge of breakout trading is that the moves are so explosive they can catch traders unaware, and by the time the trend is clear, a reasonable entry point is history. Inside bars, however, can clue you into the potential move at a more opportune moment.
Once price begins to pull back, any inside bar formed during the brief lull will provide a compelling entry point. A buy entry over the high of the inside bar in a bullish market or a sell entry below the low of the inside bar for a bearish market are reliable entries in the presence of strong price trends (see “Buying the dips,” below).
Trading bounces off support and resistance levels is one of the most reliable and well-known technical trading methods. The reason this approach works is that price zones are defined clearly, and they offer high-probability trades. Inside bars are an excellent supplemental indicator, adding evidence to the likelihood that support or resistance will hold, allowing a low-risk entry.
Once an inside bar occurs at a support or resistance level, place an entry order above or below the formation with the expectation that the price level will bounce accordingly. When the pattern forms in either price zone, it is further confirmation that a short-term reversal is imminent. An entry at the upper level of an inside bar off support is one of the most reliable and simple bullish technical trades you can make — and the opposite is true for bearish trades off resistance.
Inside price bars can be used alone as a reliable method of anticipating trends or confirming support and resistance in the market, but they also can be used in combinations to identify key trading opportunities.
One important characteristic of inside bars is that they reflect lower volatility, typically following strong price movement. This could have a number of causes. New information may have been introduced to the market that impacts current prospects or future price expectations. This sentiment could spread, and the former zeal behind the earlier move could wane. However, often that zeal rests just below the surface, and it doesn’t take much to kickstart a new surge in price and volatility.
This can happen all at once or over the course of several days. In either case, inside bar patterns can clue you in to pending opportunity (see “Reversal play,” below). One of these patterns is known as the Sushi Roll. This is a multiple-period formation consisting of 10 bars where the first five are inside bars, falling within a narrow range of highs and lows, and the next five are outside bars that contain the first five. The name of the pattern was coined by Mark Fisher, trader and author of the book “The Logical Trader.”
The major benefit of this pattern is that it signals a potential price reversal much sooner than chart patterns such as a double bottom or head-and-shoulders formation. Plus, it’s applicable to any time frame, so it can be customized depending on your own trading preference.
To that end, it is important to note that the 10-price-bar rule is not set in stone. What is important is the underlying principle that any price range that trades in a small range followed by expanding price action makes a strong case for a price reversal. This knowledge alone can help you avoid unnecessary losses by tightening up your stops, taking profits or exiting the trade altogether.
The strategy can be adopted for larger time frames by conservative traders simply by increasing the number of days to watch for market reversals. Increasing the day range to as many as 20, for example, can help you avoid false moves compared to using the 10-day pattern. While you sacrifice getting into a market reversal earlier and lose some of the early profit potential, the trade-off is that you can catch trends that have the potential of lasting for years.
Just as the pause between musical notes makes structured music possible and pleasing, market forces are a symphony of buying and selling, with pauses and accelerations giving trends their character and providing the potential for profit.
Inside price action offers a skilled trader the opportunity to recognize when the tide is shifting, providing a relatively low-risk entry or exit. Look for patterns of this type of price action during strong trends or periods of contraction for effective trade setups. This method is effective especially when trades follow the tone of the general market — buying when major indexes are rising and selling when major indexes are falling.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.