One of the most common questions I receive via email is, “what makes an inside bar worth trading?”. So rather than continuing to answer these questions one at a time, I figured why not address the topic in a lesson?
Truth is, a favorable inside bar setup doesn’t come around often. Of the price action strategies we use here at Daily Price Action, the inside bar is the least common.
Why is that, you ask? It’s mostly due to the fact that this particular strategy requires a strong trend in a market that has room to run. In other words, a trend that is strong but not exhausted.
As you may well know, markets spend most of their time consolidating or ranging, so finding a favorable inside bar setup within a trending market can be a challenge. However, when you know what to look for, these setups can be quite profitable.
In this lesson, we’re going to discuss the five characteristics of a profitable inside bar setup. But before we do that, let’s first take a look at how an inside bar forms and what the pattern represents.
What is an Inside Bar?
As the name implies, an inside bar forms inside of a large candle called a mother bar. It’s a pattern that forms after a large move in the market and represents a period of consolidation. This is why trading this pattern can be so profitable – you are essentially buying or selling a breakout, or continuation of the preceding trend.
The illustration below shows the characteristics of an inside bar.
Notice how the second candle in the image above is completely engulfed, or contained, by the previous candle. In this case, the bearish candle (mother bar) represents a broader downtrend, while the bullish candle (inside bar) represents consolidation after the large decline.
The Five Characteristics of a Valid Inside Bar Setup
There are five things you want to look for when evaluating any inside bar pattern. Think of this as a checklist for trading inside bars.
1) Time Frame
First and foremost, the time frame you use to trade inside bars is extremely important. As a general rule, any time frame less than the daily should be avoided with this strategy. This is because the lower time frames are influenced by “noise” and therefore produce false signals.
An inside bar that forms on the higher time frame has more “weight” simply because the pattern took more time to form. This means more traders were actively involved in its formation, which as a result equals higher capital flows.
As you know, I’m a huge advocate of trading from the higher time frames as they tend to cancel out most of the noise from scheduled and unscheduled news events.
2) The Trend is Your (Best) Friend When Trading Inside Patterns
Ah, the age-old saying – the trend is your friend. If you have been trading for any length of time I’m sure you have heard this one many times. As common as this saying may be, it has never lost its significance in the financial markets, especially when it comes to trading inside bars.
In fact, trading with the trend is the only way to trade an inside bar setup.
Below are two examples of inside bar patterns that formed in different market conditions. The first example is what you want to look for while the second is what you should avoid.
Inside bar setup with the trend (what to look for)
The bullish inside bar setups above formed on the USDJPY daily time frame. Note that this pair was in a strong uptrend leading up to both setups. This is the kind of momentum you want to look for when trading this strategy.
Inside bars in a choppy market (what to avoid)
The inside bars in the chart above formed on the GBPJPY daily chart in a choppy market. This sideways price action represents consolidation, which is what you want to avoid when evaluating an inside bar setup.
3) It’s All About the Breakout
The best inside bar setups form just after a break of consolidation where the preceding trend is set to resume. The reason for this is quite simple…
A period of consolidation within a broader trend is the market’s way of regrouping. In an uptrend, the consolidation is triggered when longs decide to begin taking profits (selling). This causes the market to pullback, where new buyers step in and buy, which keeps prices elevated. This pattern continues for days, weeks or even months until new buyers are able to once again outweigh the sellers and drive the market higher.
Below is a great example of a bullish inside bar that formed on the USDCAD daily time frame. This is actually a trade setup that was called here at Daily Price Action and has worked out beautifully thus far.
Notice how the bullish inside bar above formed after USDCAD broke out from multi-week consolidation. This period of consolidation allowed the market to “reset”, or shake out profit takers and attract new buyers for the next leg up.
This is the ideal scenario for trading a bullish inside bar setup as the market has gained a fresh set of buyers who are ready to push prices higher. Of course the opposite holds true for trading a bearish inside bar after a break of consolidation.
4) What’s the Risk to Reward Ratio?
A favorable risk to reward ratio is needed for any setup taken here at Daily Price Action. This is true whether we’re trading an inside bar, pin bar or wedge breakout. Each and every strategy needs to be accompanied by a favorable risk to reward ratio.
What is a favorable ratio, you ask?
It means always keeping your risk to no more than half the potential reward. So if your take profit is 200 pips, your stop loss can be no more than 100 pips away from your entry price.
If using the more aggressive stop loss strategy, this means selecting inside bars that form near the upper or lower range of the mother bar. This allows you to achieve a much more favorable risk to reward ratio.
The two illustrations below explain this point further.
Bullish inside bar at the top of the range:
Notice how the bullish inside bar in the above illustration formed at the top of the mother bar’s range. This is what you want to see in a favorable setup, especially if you are using the more aggressive stop loss placement, which means placing your stop loss below the inside bar rather than the mother bar.
Bearish inside bar at the bottom of the range:
The same holds true for the bearish inside bar pictured above – the formation at the lower range of the mother bar is more favorable as it provides you with a better risk to reward ratio. Again, this assumes that you are placing your stop loss above the high of the inside bar rather than the high of the mother bar.
5) The Size of the Candles Matter
Last but not least, the size of the inside bar relative to the mother bar is extremely important. This idea piggybacks off of number four above, where the inside bar forms in the upper or lower range of the mother bar.
In my experience, the smaller the inside bar is relative to the mother bar, the greater your chances are of experiencing a profitable trade setup. Ideally, we want to see the inside bar form within the upper or lower half of the mother bar.
Why is this?
Remember that an inside bar represents consolidation after a large move. This is what makes these patterns so lucrative – the fact that we are trading a breakout after a period of consolidation. Therefore the tighter this consolidation is, the more volatile the ensuing breakout will be. Of course, this isn’t always the case, but in my experience, it holds true more often than not.
What Doesn’t Matter When Trading Inside Candles
What doesn’t matter when trading this particular pattern is whether the inside bar itself is bullish or bearish. In other words, if a market is in an uptrend and an inside bar forms inside of a large bullish candle, it doesn’t matter if that inside bar is bullish or bearish. The same holds true when trading a bearish pattern.
The only thing that matters is whether the mother bar is bullish or bearish. The formation of the mother bar, in combination with the trend, is what tells you which way to trade an inside bar setup.
There’s no doubt that inside bars can be a profitable way to trade the Forex market. After all, it’s a setup that I teach as part of my price action course and one that has served me extremely well since 2009.
However, it isn’t a setup that occurs often, at least not in a favorable context. This is why I don’t advocate using the inside bar as your only setup to trade the market. By doing so, you limit your trade potential to the point that you are likely to begin taking subpar setups. It is, therefore, important to treat inside bars as another tool inside your trading toolbox rather than the toolbox itself.
The inside bar setup is capable of producing consistent profits, but only to the traders who mind the five characteristics discussed above.
Do you currently trade inside bars? Do you see yourself taking a different approach to trading them having read this lesson?
Leave your question or comment below. I look forward to hearing from you.