Inside Bar Breakout Trading Strategy

The inside bar breakout strategy uses a common two bar price action pattern where the first bar completely overlaps the second bar.  The first bar is called the “mother bar” and the second bar is the inside bar.

It’s called an inside bar breakout because we want to see price break out at either the high or low of the previous bar.

When you see an inside bar, you now know that on a lower time frame, you have a consolidation range from where price will eventually break out from.

This is a 65 minute stock chart and is the lower time frame from the daily time frame chart where the inside bar has set up.

The mother bar is marked at #1.  The previous action is all contained within the high/low of that price action.  Number 2 represents the second day where you can see how price was moving inside that mother bar.

Number 3 is still inside the mother bar from day 1 but has broken from the trading range at number 2.

Number 4, price has broken from the range day at number 3 but is still inside the day one mother bar.

Each day, price breaks the previous days support or resistance of that inside candle but the first day is the support and resistance level marks for the entire pattern.  By this example, you can see that trading inside of mother bars can make for some choppy price action.

Characteristics Of An Inside Bar Setup

As mentioned, inside bars appear on every time frame but does not mean that all time frames are worth trading.

Time Frame

Most candlestick formations are often better to trade on the higher time frames such as daily charts.  There is a lot of price movements on lower time frames and you can often get stuck in periods of low volatility and false signals.  That can make for some price action that is tough to sit through.

Using higher time frames, you know that more traders were involved in the formation of the pattern and the price consolidation is being seen by more participants.  Higher time frames are also able to absorb any economic release without having whipsaw price action.

Inside Bar Size

Size does matter when it comes to the inside bar when comparing it to the mother bar.  For this strategy we will be discussing, we would like to see an inside bar noticeable smaller than the mother bar, but is not a strict requirement.

Notice the inside bar on the left is much smaller than the mother bar when we consider the distance between lows and highs.  This shows that the smaller time frame price consolidations are tighter – less price range.

The right side shows and inside bar with highs and lows close to the extremes of the mother bar.  This shows there was more price movement inside the mother bar but not enough to break the upper level or the lower level.

With inside bars, we prefer to take advantage of tighter price compression with the theory that it leads to bigger price moves.  Also consider, with this rule, where price actually closes on the candle.  For example, on the right, price closed near the bottom of the mother bar and the inside bearish candle.  If we are looking for longs, taking into account the obvious bearish traders, this would be a weaker buy setup.

Also, smaller inside bars will have a greater distance to the high or low of the mother bar.  This can allow for better trade management before price reacts at the potential support or resistance if you are playing the break of the inside bar.  Don’t forget about reward risk ratio.  Smaller bars are better for R:R.

Trend Direction

Counter trend trading is a popular form of trading.  However, latching onto a trend generally makes for a less stressful time while in the trade.  Is trend direction a guarantee of success?  No.  In fact you may buy in an uptrend at the exact top of the instrument you are trading.

Using trend direction as a trading plan variable can actually reduce your temptation to take every inside bar setup.  For my money, ride the trend with an explosion from an inside bar breakout is a better risk.

Inside Bar Breakout Strategy

Now that we discussed the characteristics of an inside bar, let’s cover the typical breakout strategy that is used.

The black horizontal lines indicate the high or low of the inside bar that broke first.  You can see that some gave enough price movement to manage your trades and others, were stopped out quickly.  If you narrow that setups down to the trend direction of down, your outcome was pretty good (in this example).

Let’s circle back to what an inside bar represents:  a price consolidation on a lower time frame.  This will lead to an eventual breakout.

False Breaks Of Ranges

There is nothing better than seeing traders stuck in a position and needing to exit.  Requiring a breakout of the inside bar in the opposite direction to the trend, is something to consider.

I used a trend line to show that the uptrend was in danger when price broke to the downside giving us a potential reversal.  We see an inside bar setup – lower time frame range.  The next candle sees a breakout of the high of the inside candle.

What does that mean?  

Buyers entered the market in hopes of catching a new impulse move.

What happened?

Price reversed and trapped the buyers who now need to exit.  One price breaks the low of the false breakout candle and the inside bar candle low, buyers are jumping out of their positions.  If you are short, you are getting a nice push down in price.

Let’s Make Some Trading Rules

First thing we need to do is determine a trend direction.  We can use trend lines, price structure or even a 20 period moving average.  We will then look to trade in the direction of the trend.

If looking for a buy, we want to see price break to the downside of the inside bar.  Shorts?  We want to see the high of the inside candle broken.

The trend is up on this daily stock chart.

We first see an inside bar on the left side of the chart.  At the close of the next day, price had made an outside bar invalidating the setup.

+ Our other labelled inside bar forms

+ Price breaks to the downside of the inside bar getting traders into a short trade

+ We can place a buy order over this candle or over the inside bar high (prefer the candle after the IB)

+ Stop loss goes below the bar that broke the inside candle to the downside

+ Price forces shorts to exit their positions while you take advantage of a strong move in price

Trade setup and trigger example

+ Trend is up and looking for long signals

+ IB sets up and price breaks lower – Buy stop the high of the candle which will be your entry price

+ Another inside bar formation occurs.  Price breaks lower and you buy stop the high.  Buying pressure steps in your trade is in profit

Setting A Stop Loss For Longs

In these long trade examples, if you set a buy stop order, you need to know where you will exit if the trade goes against you.  Without that, it is difficult to set your risk in terms of dollar amount.

You can use the low of the candle that breaks the low of the inside bar or half of the range of the candle.  Once trade is triggered, you can adjust your stop to the low of the trigger candle.

Keep in mind that these charts are chosen to explain the strategy.  They do not all work out.

The long setup was fine.  The inside bar even had a hint of bullish as it closed near the highs.  Trade triggered and the next day gapped down 8.23% from inside bar break.

This is why risk management is vital and this chart brings up an important consideration.

Strong Close

We expect follow through on these trades given the reasons why they set up.  Traders may want to consider seeing a strong close potential near the end of the day.

The day after the breakout, price essentially pushed higher for one hour and then settled back to the high of trigger candle.  That is not signs of bullish intent.

While you may exit only to see price continue in a strong trend, risk should be your number one priority.

So far we have:

+ Trade in the direction of the trend

+ Look for an inside bar

+ Look for a breakout of the inside bar in the opposite direction of the trend

+ Set a buy stop above (or sell stop below) the breakout candlestick OR the inside bar

+ Set a stop loss 50% through the range of the breakout candlestick on trade trigger

There are further things that we should consider to give us trade opportunities.

Further Confirmation

The more rules you add to a trading strategy, the less trades you will get.  It is important for you to consider each addition to the strategy.  The question should always be:  “Does this make a big difference to my results?”

This is a reversal trading setup from a failed breakout of a trading range.  Can we add something that has the potential of having more traders leaning in one direction?

Yes.  The first candle type.

Notice that the preceding bar to the left of the inside candle is red.  This tells us that market participants were biased short on that day.  The color of the inside bar means little and the main focus is that traders are short – we can see it.

The day after the IB, price breaks to the downside.  The next day, price moves up through the trigger.  The key is to have the mother bar candle a color opposite to the overall trend direction.  In this case, price action was to the upside via the moving average.  We look for a red mother bar.

Take Profit Targets

Taking profits and trade management can be based on the structure of price.  Traders can also consider trailing stops to stop them out when adverse price action sets in.

Let’s discuss price structure targets.

In this example, the bar before the inside bar is red in the context of an uptrend.  Price breaks the low of the IB and buy stop the high of that candle.

Once triggered, we now have potential resistance at the high of the inside bar and the high of the preceding candle.

Consider profit targets or trade management at these areas in case momentum does not take the price further into profit.

Aggressive Trader Consideration

Some traders are more aggressive and may want to add an adjustment to the strategy.  I highly suggest that traders only do this once they’ve proven to themselves that they can follow all trading plan rules.  In fact, some traders may want to use this method for intraday trading.  Quick profit targets and quick stop outs are vital to this approach.

Instead of looking for a trending market, we will look to where price is trading in relation to the opening price of the instrument.

In our example, this is a 5 minute day trading chart and the black line is the opening price for the day.  As long as price is trading above it, we will not consider short positions.  Long positions as noted with the arrow on the chart are the only ones allowed..

Here is another example.  The horizontal line is the open price.  The black arrows show the inside bar, we get a break below the inside bar and look for long only trades.

In Conclusion

The key point is we are looking to catch traders on the opposite side of the real move.  That is why we require a break, for longs, through the lows of the inside bar.  We then want to catch the move back through the inside bar.

Inside bars appear due to a period of consolidation and we are, essentially, looking for a breakout play opportunity after other traders take the wrong position.

Ensure you write out your trading plan and follow it consistently.