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4 Steps to Using the Inside Bar for Trading

   

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When analyzing chart patterns to identify potential volatility with an asset’s price, an inside bar indicator is one of the stronger signals traders can spot. Inside bars on a candlestick chart represent the consolidation of price action where the bulls and bears are both struggling to move the price higher or lower from its current position.

When looking at a candlestick chart, you can spot an inside bar indicator when a given bar’s high and low are fully contained by the bar directly preceding it. This signals a narrowing of price action that can be used to predict upcoming movements outside of this range.

One way to think of an inside bar is to compare it to a volcano, where pressure is building underneath before an eruption. For traders, an inside bar can signal a price breakout coming in the near future, which creates a profit opportunity, whether you’re buying or shorting the asset.

Here are four steps to using the inside bar for trading:

1. Identify Breakout Potential as It Develops

When an inside bar develops, it signals consolidation that could preview a breakout coming in the near future. But to capitalize on this breakout potential, you need to identify whether the breakout is likely to result in price appreciation or depreciation.

One way to do this is to look at the price’s trend up to that point. One of the most useful characteristics of a profitable inside bar setup is a price movement that continues the trend prior to the inside bar development. If the price of a pair is already trending up before the period of consolidation marked by an inside bar, the breakout is likely to continue that trend.

Based on the trending price movement of the pair, you should also consider the risk/reward potential of any given trade. In general, your risk should be less than half of your potential reward, which means that an inside bar setup is only favorable when its trend, its relationship to existing lines of resistance, and other chart indicators point to strong breakout potential. 

To evaluate this risk/reward ratio, you may want to consider other technical indicators and chart patterns you regularly use in your trade analysis. Although some traders are strong advocates of inside bars as a reliable indicator, most traders likely want to use other chart patterns and technical indicators to evaluate potential price movements. Using these other indicators can lend more credibility to the indications coming from the inside bar.

Keep in mind that, while inside bars can represent the calm before the storm, you’ll be able to turn a profit only if you can reliably evaluate these trades to determine what kind of position you should open.

2. Tread Lightly When Trading Inside Bars Under the Daily Chart

Inside bars are most valuable when you’re looking at daily charts because they offer a larger sample size of price action on a given asset. On charts with a smaller time frame, such as one-hour or four-hour charts, inside bars are fairly common and not always a reflection of consolidation taking place.

If you can back up short-term inside bars with strong chart patterns or other technical indicators suggesting near-term movement, it might be worth opening a position. But be aware that, when you’re evaluating data from narrower time frames, the validity of your inside bar evidence isn’t as strong as what you could expect from a daily chart.

3. Track Consolidation from One Day to the Next

The best use of inside bars as a technical indicator is on daily charts. An inside bar illustrates that consolidation has taken place over the course of an entire trading day, which signals that the shrinking range is due to expand and become more volatile.

To help identify the direction in which the price might break out, always consult the day bar trend as well as Fibonacci retracement and other applicable chart patterns and technical indicators.

Traders should open a position when the price is still within the range established by the inside bar or when the price breaks just above the upper level of the inside bar. By the time you wait for the price action to move swiftly in one direction, you’ve already sacrificed a huge chunk of your would-be profits.

In the AUD/JPY daily chart below, an inside bar develops on November 6. This consolidation is quickly marked by a breakout up and out of that range on November 9, creating a brief window to turn a profit:

In this case, the right inside bar trading move would be to open a position on November 9, while the price is still within the range set by the inside bar.

Remember that on daily charts, it can still take several days for consolidation to yield a breakout. An inside bar might forecast price volatility, but it doesn’t promise to deliver that movement on a fixed schedule.

Finally, pay attention to the size of the inside bar relative to the mother bar. In general, a smaller inside bar relative to the preceding bar is a stronger indicator of consolidation ahead of a breakout. When the size difference is slight, the strength of that indicator is reduced. Use the proportions of this inside bar setup as you evaluate trade potential moving from one day to the next.

4. Always Place a Stop-Loss Order

Inside bars are a valuable indicator of a breakout, but traders can never guarantee that the price will break the way they’ve predicted. A stop-loss order should always be placed on any trade that relies on an inside bar to identify price consolidation.

When buying, place the stop-loss order just below the lower limit of the inside bar. Because an inside bar essentially represents a tug-of-war between the bears and bulls, traders need to expect that bears will win a few of those battles. Setting stop-loss orders will help you minimize those losses, preserving your profit from the instances when your prediction comes true.

Advantages and Disadvantages of Inside Bar Trading

Traders who frequently turn to inside bar trading are typically traders who build their strategies around price-action trading. By opening positions based on breakout and momentum indicators, even amateur traders can use inside bar trading, among other price-action indicators, to identify trade opportunities that lead to quick profits.

Inside bar trading is also relatively easy to use when analyzing trade opportunities. Because this approach is best utilized on daily charts, you only need to check charts once a day to look for inside bar opportunities. For some traders, this can amount to a few minutes a day to look for trade potential and set pending orders.

As with any chart pattern, though, inside bar trading isn’t perfect. It isn’t reliable when applied to shorter time frames, which can make it less effective for day trading and intraday trading. Inside bars are more common on these shorter time frames, so traders looking for inside bars are likely to get a lot of “false positives” when looking for breakout potential. 

And even when inside bars do point to a breakout, there’s no guarantee that this price action will come to fruition. In the EUR/JPY chart below, for example, an inside bar development on September 14 points to a period of consolidation for the currency pair. But instead of breaking out toward a quick price gain, the pairing takes a seven-day tumble:

This price reversal occurs even though the pair was trending up in value, exhibiting multiple signs of a profitable setup. The risk of a price reversal has to be accounted for whenever you’re trading on inside bars. This is why a stop-loss is so important to building a sustainable trading strategy.

The Inside Bar Is a Great Tool

Inside bars are a great tool for identifying potential price breakouts on forex and other assets. Some online trading platforms even offer indicator tools to help identify inside bars on a chart, making it easy to discover and take advantage of strong trade opportunities.

Because an inside bar is an easy indicator to identify, it’s a strong data point for both amateurs and seasoned traders to consider. Just make sure to use the inside bar as a starting point for further evaluation of potential trading positions.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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