Outside Reversal

What is an Outside Reversal (Outside Bar / Engulfing)?

An outside reversal is a two‑bar price pattern that suggests the prior short‑term trend may be reversing. On a bar or candlestick chart it occurs when the second bar’s high is above the prior bar’s high and its low is below the prior bar’s low — i.e., the second bar “goes outside” the previous bar. On candlestick charts the pattern is often called an engulfing pattern when the second candle’s real body (open-to-close) also engulfs the prior candle’s body. When the outside bar appears after a downtrend it is interpreted as bullish (bullish outside reversal / bullish engulfing); after an uptrend it is interpreted as bearish (bearish outside reversal / bearish engulfing).

Key takeaways

– An outside reversal is a two‑bar pattern where the second bar’s high > prior high and low Bar 1 high AND Bar 2 low < Bar 1 low.
– Engulfing (candles) stricter rule: Bar 2’s real body completely engulfs Bar 1’s real body (open/close), and the pattern occurs after a recognizable trend.
– Consider the body size: a large real body on Bar 2 that engulfs Bar 1 is stronger than one where Bar 2’s range is wide but the body is small (wick-dominated).
– Volume: higher-than-average volume on Bar 2 increases reliability.
– Context: pattern is meaningful only when it appears after a discernible uptrend or downtrend, or at key support/resistance levels.

Bullish outside reversal (how to read it)

– Occurs after a down move or corrective pullback.
– Price opens lower (or near low) and then rallies strongly to close above the prior bar’s close (or open), creating an outside or engulfing bullish candle.
– Interpretation: bears initially push price lower, but bulls overwhelm them, signaling a possible shift to buying pressure.

Bearish outside reversal (how to read it)

– Occurs after an uptrend or rally.
– Price opens higher (or near high) but sellers push price down sharply so the candle closes below the prior bar’s close (or open), making an outside/bearish engulfing candle.
– Interpretation: bulls lose control and sellers take over, suggesting a potential top or corrective decline.

Confirmation and filters (to reduce false signals)

– Volume: confirmation when Bar 2 has above‑average volume (esp. in equities). Higher volume on a bearish outside reversal near resistance or bullish outside reversal near support is stronger.
– Trend confirmation: a reversal against a strong, long-term trend is less reliable. Prefer outside reversals that complete a corrective leg within a larger trend or appear at clear trendlines/support/resistance.
– Support/resistance: pattern at horizontal support/resistance, moving averages, trendlines, Fibonacci levels is more meaningful.
– Momentum indicators: RSI divergence, MACD cross or stochastic overbought/oversold can corroborate a reversal.
– Timeframe agreement: check the pattern on the trading timeframe and one higher timeframe for alignment.

Practical trade setups (step‑by‑step)

Below are standard, rule‑based ways traders use outside reversals. Adjust parameters to your strategy and backtest.

A. Bullish outside reversal — two common entries

1) Aggressive entry: enter long at Bar 2 close (or on a small pullback after the close).
2) Conservative entry: wait for price to break above Bar 2 high (confirm breakout) and enter on that break.

Stop placement

– Tight: below Bar 2 low (or a few ticks/pips below for FX) — invalidates the pattern if price revisits the low.
– Buffer: below Bar 1 low (wider stop) if you expect volatility.
– Volatility based: use 1–1.5 ATR below the entry for a measured stop.

Targets and exits

– Fixed risk‑reward: aim for minimum 1.5–2:1 R:R; trail stops once price moves in your favor.
– Structure based: target nearby resistance, previous swing high, or a measured move (height of the preceding leg).
– Trailing: use moving average or ATR trailing stop to capture extended moves.

B. Bearish outside reversal — entry and stops

– Aggressive: enter short at Bar 2 close.
– Conservative: enter on a break below Bar 2 low.
– Stop: above Bar 2 high (or above Bar 1 high for wider buffer), or ATR-based.
– Target: prior support, recent swing low, or a fixed R:R objective; trail stops to manage winners.

Example trade scenarios (illustrative)

– Bullish outside reversal at daily support and trendline with above-average volume → enter on break above Bar 2 high; stop below Bar 2 low; target recent resistance or 2:1 reward.
– Bearish outside reversal after extended rally near 50‑day moving average and bearish divergence on RSI → wait for close confirmation, enter short on close or break below Bar 2 low; stop above Bar 2 high.

Timeframes and holding periods

– Outside reversals work on all timeframes, from intraday to weekly. Higher timeframe signals (daily/weekly) tend to be more reliable but less frequent. Intraday outside bars can produce quick trades but more noise.
– Holding period depends on timeframe: intraday trades may last minutes–hours; swing trades use daily outside reversals and hold days–weeks.

Risk management and position sizing

– Risk only a small percentage of equity per trade (commonly 0.5–2%).
– Compute position size so that the dollar risk (entry to stop) equals your target risk per trade.
– Use limit orders or guarded market orders for execution slippage control; be aware of overnight gaps.

Limitations and common pitfalls

– False signals: outside reversals sometimes fail, especially in choppy markets. Always use confirmation and manage risk.
– Misreading trend: pattern appearing inside congestion or with no defined prior trend is less useful.
– Overreliance on single pattern: combine with other technicals and context — no pattern is infallible.
– Volume differences across instruments: some markets (e.g., some FX pairs) don’t have centralized volume; use tick volume or other proxies.

Backtesting and validation (practical steps)

1) Define precise rules: what constitutes an outside bar/engulfing, required prior trend length, volume filter, entry rule, stop rule, target rule.
2) Run historical backtest across the chosen instrument(s) and timeframe.
3) Track performance metrics: win rate, average R:R, max drawdown, expectancy.
4) Optimize conservatively and validate with out‑of‑sample/testing period.
5) Paper trade the validated rules before live deployment.

Checklist before taking an outside reversal trade

– Is there a clear prior uptrend (for bearish) or downtrend (for bullish)?
– Does Bar 2’s range and/or body sufficiently “engulf” Bar 1 per your rules?
– Is volume supportive (higher-than-normal on Bar 2)?
– Is the pattern at a logical level (support/resistance, moving average, trendline, Fibonacci)?
– Do momentum indicators support a reversal?
– Is the risk/reward acceptable and position size correct?

Quick summary — a practical trading checklist (one line)

Confirm trend context → validate outside/engulfing definition → check volume/support → decide entry type (aggressive/conservative) → set stop (below/above Bar 2) → set target/trail → size for risk → execute.

Final note

Outside reversals are a simple, visually intuitive pattern that can be incorporated into many trading systems. Their usefulness depends on strict definition, market context, confirmation methods, and sound risk management. Backtest your rules and treat each signal as a hypothesis to be managed, not a certainty.