Among the complex patterns you see in candlesticks -- involving three sessions -- two of the more subtle are the inside and outside formations. These consist of two parts: inside patterns begin with a two-session harami and a third decisive day; outside patterns start with a two-session engulfing formation and then a third, decisive day.
The inside up pattern starts with a bull harami (black session followed by a smaller white session in a narrower trading range), and a third upward-moving session.
The inside down starts with a bear harami (white first day and then a black second day in a narrower range); and then a third, downward-moving day.
The outside up begins with a two-session bull engulfing pattern (a black session followed by a white day with a higher high and a higher low), and then a third, upward-moving session.
The outside down starts with a bear engulfing pattern (a white day and then a black day with higher high and higher low), and a third day moving lower.
These four patterns all indicate that a trend reversal is in the making. You expect to see the direction of price movement turn. With this in mind, the most meaningful place to spot the bullish varieties (inside up or outside up) will be at the bottom of a downtrend; and the most meaningful place to spot the bearish varieties (inside down or outside down) is at the top of an uptrend.
The harami and engulfing patterns are in a sense opposites. Harami formation consists of the second day smaller in range than the first; and the engulfing is made up of a second day larger on both sides than the first day. Thus the term “inside” (harami) and “outside” (engulfing).
As with all indicators, these candlestick formations may be weak or strong depending on where they are spotted and of course, on what follows. Nothing is 100% certain, so the best way to use inside and outside formations is as the spark to look for confirming signals. These may be found in additional candlestick formations, volume spikes, or Western patterns (tests of resistance or support, gapping price action, or double tops and bottoms). The key to smart candlestick analysis is in spotting patterns and knowing what they mean, and then confirming them independently.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com.