What Is Outside Day?
An outside day is a two-day candlestick pattern in technical analysis where the entire price range of the second day (its high and low) completely encompasses the price range of the preceding day. This means the second day's high price is higher than the first day's high, and its low price is lower than the first day's low. The appearance of an outside day on a price chart suggests a notable increase in volatility and can signal either a potential trend reversal or a trend continuation, depending on other market factors and the subsequent price action.
History and Origin
The concept of charting price movements, from which the outside day pattern derives, has deep historical roots. Candlestick charts themselves are believed to have originated in 18th-century Japan, developed by Munehisa Homma, a renowned rice trader. Homma observed that market prices were influenced not only by the fundamental principles of supply and demand but also by the emotions and psychology of traders. While Homma is credited with developing techniques to track rice prices and anticipate movements, the specific "candlestick" graphical representation and patterns, including variations like the outside day, were likely refined and formally introduced to Western financial markets much later in the late 20th century by Steve Nison. Today, modern financial data providers, such as Thomson Reuters, offer extensive historical data that allows for the identification and analysis of such patterns.6
Key Takeaways
- An outside day is a two-bar candlestick pattern where the current day's trading range entirely engulfs the previous day's range.
- It signifies increased volatility and heightened participation in the market.
- An outside day can act as either a trend reversal or a trend continuation pattern, requiring confirmation from subsequent price action.
- The closing price relative to the previous day's close and the overall trend context are crucial for interpreting the pattern.
Interpreting the Outside Day
Interpreting an outside day requires considering the context in which it appears. An outside day suggests that there has been a significant battle between buyers and sellers, leading to an expansion of the trading range. If the outside day occurs during an established uptrend and closes lower than the previous day's close, it might indicate a potential bearish trend reversal. Conversely, if it occurs in a downtrend and closes higher, it could signal a bullish reversal.
However, an outside day can also act as a trend continuation pattern. For example, in a strong uptrend, an outside day that closes significantly higher than the previous day's close might indicate renewed buying pressure and a continuation of the upward movement. The key to effective interpretation lies in observing the closing price of the outside day candle and its relationship to the prior day's close, as well as the broader market sentiment and surrounding candlestick patterns. Analyzing support and resistance levels can further aid in determining the pattern's implications.
Hypothetical Example
Consider a stock, "Company XYZ," trading at $50. On Day 1, the stock opens at $49, reaches a high of $51, a low of $48, and closes at $50. The range for Day 1 is $3 ($51 - $48).
On Day 2, Company XYZ opens at $48.50, drops to a low of $47.50, then rallies to a high of $52.50, and finally closes at $51.50.
In this scenario, Day 2 is an outside day because its high ($52.50) is greater than Day 1's high ($51), and its low ($47.50) is lower than Day 1's low ($48). The entire range of Day 1 ($48 to $51) is contained within Day 2's range ($47.50 to $52.50). This expanded range and higher close on Day 2, following a rally from the low, might suggest strong buying interest and potential for further upward price action, indicating a bullish continuation or reversal depending on the prevailing trend before Day 1. Traders might look for a breakout above Day 2's high for confirmation.
Practical Applications
The outside day is a pattern observed in various financial markets, including equities, commodities, and foreign exchange, as part of a trading strategy. Traders often use it to gauge potential shifts in market dynamics. For instance, in commodity trading, an outside day with high volatility can indicate a significant reaction to economic news or supply data.
In practical applications, an outside day that closes near its high suggests strong buying pressure, potentially leading to further upward movement, while one closing near its low indicates strong selling pressure. Traders might incorporate this pattern into their decision-making process for setting stop loss orders or identifying potential entry and exit points. Historical market data, often provided by financial services like Thomson Reuters, is crucial for backtesting and validating strategies that utilize outside days.5
Limitations and Criticisms
While the outside day pattern can offer insights into market activity, it is subject to the general limitations and criticisms of technical analysis. One significant criticism is that technical patterns, including the outside day, do not inherently predict future prices. Critics argue that past price movements do not guarantee future performance, and patterns can be subjective to interpret4. Some academic studies suggest there is no significant support for the notion that technical analysis is an effective tool to consistently improve trading results when realistic trading costs are considered3.
Furthermore, an outside day can generate false signals, especially in choppy or sideways markets where definitive trends are absent. The pattern's predictive power is often debated, with some attributing observed successes to a self-fulfilling prophecy, where enough traders act on the same signal to cause the predicted movement2. It is generally advised to use the outside day in conjunction with other forms of analysis, such as fundamental analysis or additional technical indicators, rather than relying on it in isolation1.
Outside Day vs. Inside Day
The outside day and inside day are contrasting candlestick patterns that indicate different market conditions. An outside day signifies an expansion of the trading range, where the current day's high is higher and its low is lower than the previous day's corresponding prices. This indicates increased volatility and strong directional movement, often after a period of indecision or consolidation. Conversely, an inside day occurs when the entire price range of the current day is completely contained within the previous day's range (i.e., the current day's high is lower than the previous day's high, and its low is higher than the previous day's low). An inside day typically suggests decreased volatility, consolidation, or indecision in the market, often preceding a potential breakout in either direction. Traders often look for opposite implications when interpreting these two patterns, with the outside day suggesting potential strong moves and the inside day signaling a pause before a move.
FAQs
What does an outside day tell a trader?
An outside day tells a trader that there was a significant expansion of the trading range for the period, indicating increased volatility and a strong struggle between buyers and sellers. It suggests that a major move may be underway or impending, possibly leading to a trend reversal or a reinforced trend continuation.
Is an outside day always a reversal signal?
No, an outside day is not always a trend reversal signal. While it can often precede a reversal, especially if it closes in the opposite direction of the preceding trend, it can also act as a trend continuation pattern. Its interpretation depends heavily on the context of the overall market trend and the closing price of the candle.
How is volume related to an outside day?
High trading volume accompanying an outside day often reinforces the significance of the pattern. Increased volume during an outside day suggests strong participation from market participants, lending more weight to the potential implications of the price action, whether it signals a reversal or continuation.
Can outside days be used for all types of trading?
Outside days are primarily used in short to medium-term trading strategy contexts, such as day trading and swing trading, where visual candlestick patterns are closely monitored. They are less relevant for long-term investment strategies that focus more on fundamental analysis. They can be observed across various asset classes, including stocks, futures contracts, and currencies.