Price Action Forex Piercing Pattern & Outside Candles
In the current environment with the Euro getting punished across the board against every major currency and likely even the Iraqi Dinar, as traders we want to be taking advantage of these environments by getting short and staying short. However, there are times when the short term moves day traders like to take advantage of in these strong sell-offs communicate something different that we do not want to keep adding on shorts to a current downtrend or move. This is often found two simple price action formations called the ‘Piercing‘ & ‘Outside‘ formations. We will go over both so you can recognize them, learn what they mean from a price action perspective and how to relate or trade them.
The Piercing Candle
This is a simple two candle setup that is probably best applied to nothing less than 1hr time frames and ideally higher. The higher you go, the stronger it will be. Below is a traditional example of a Piercing Candle.
The way the formation works is we have to be in an established trend (either up or down). We will call this two candle formation an AB formation meaning there is an A candle (first) and a B candle (second). In this AB formation, the A candle is in the direction of the trend and is generally strong, one of the stronger or larger candles in the current trend. It could be large for two reasons;
1) Market is heavily participating in the trend
2) The market is giving one last push possibly before short covering (or long covering depending upon the direction of the trend) and taking profits
The institutionals usually like to give a really strong push before giving up a trend. An example of a piercing candle is in the chart below.
As you can see from the chart above, we clearly have a strong downtrend on the EURGBP. This is the 2hr chart and notice how at the end of the move, the A candle is quite large but is countered by a very strong blue candle. This AB formation meets the first two requirements being that;
a) we have to be in a clear trend and
b) the A candle has to be strong or large (ideally one of the larger ones in the move). We will address another reason why it helps for the A candle to be large soon.
Another requirement of the piercing formation is that the B candle ‘pierces’ a minimum of 50% into the previous candle. The more the better but it cannot engulf it which is another pattern. The max. it could pierce into the A candle is 99% for it to remain a piercing pattern.
Why is the 50% the line in the sand?
The reason why is anytime you have a strong downtrend, you have one side of the market clearly in control. For a really strong with-trend candle to be followed up and reversed minimally 50% or more by the next candle suggests it has the strength to counter the already existing momentum. This signifies strength to stop a moving force and reject it by 50% or more. Once it closes 50% or higher, it becomes a piercing pattern.
When we see these, its no longer a good idea to keep selling or trading in the direction of the trend until the coming reversal shows signs of weakening and the trend will likely resume. Below is the follow up candle to the AB piercing pattern.
It is very common to see a strong follow up candle to a piercing pattern and this confirms its validity.
Thus, it is very good to be able to spot these patterns, especially if you are trading a strong downtrend and adding onto the position as it continues to advance. If you feel the trend is going to continue, one technique could be to wait for the pullback to reach a 20ema on the 2hr or 4hr time frame. If price stops here and then forms another reversal candle, then you can start to look for with-trend setups. You can also check out my article on the with-trend failure setups using the 20ema for another technique as well.
One other technique to get back in the trend is wait for a break of the lowest low or highest high from where the piercing formation was. A break of this level means whoever countered the trend has given up all the ground they made and are now losing money and the trend is likely to continue. Either way, being aware of these formations on the 1hr, 4hr, or daily time frames can alert you to take profits on your trend trades and wait for another setup.
This is another price action formation that you need to be aware of if you are trading trends and are wanting to know when to take profits and get out. Remember trends can go much farther than you think so having fixed targets or parameters for getting out of them is not always advised. It is better to wait for price to confirm the trend is ending before you get out and the Outside Reversal formation can often signal such.
Taking a look at the same pair but on the 4hr time frame, we can see from the chart below the downtrend is met by a very large candle which engulfs or the price action is completely outside the previous candle. This formation is also an AB formation whereby the A candle is also like the piercing, a large candle, yet the B candles’ price action is ‘outside‘ meaning the wicks and ideally body of the B candle are both higher and lower then the highs and lows of the A candle. See chart below.
The same mentality applies with this and the piercing pattern, meaning when we see such a strong rejection without any hesitation, stalling, or bottoming formation, we have to pay serious attention to it and make sure to take profits when trading the trend and this formation shows up. Notice how the A candle at the end there is the largest in the last swing down, but is completely taken out by the B candle. To stop the trend momentum so forcefully and take out all the gains means the order flow changed hands real fast and control has been taken by the other side. We have to take profits on this and then wait for another setup to get back in the trend or look to see if its going to start a full on reversal of the trend.
Another example of this formation is in the chart below.
Look at how long this trend has been active with the euro losing 1700 pips to the kiwi. Then out of nowhere the pair reverses course with a huge outside formation and follows it up with another upcandle. All the other blue candles were not game changers for this trend, however this outside formation in two candle climbed 300+pips of the 1700 = 17.5% reversal of all the gains. You can bet any institutional traders short who just watched 17.5% of their gains get wiped out in 8hrs after being short for over 20days will take profits or even exit all together.
Thus it becomes critical to be able to spot these formations when trend trading. This is crucial because environments like these where one currency (the euro) is suffering against everything across the board gives traders really good environments to make a lot of money in a concentrated period of time. These are times where the best traders like Jesse Livermore and Richard Wyckoff would die for and make large amounts of money just trading these environments. In some sense, it totally makes sense because the direction is easy to call and we just have to get in and stay in to make the money on these trends. Learning how to do this can often bring about a month or two worth of gains in a matter of a few trades. However, we have to be aware of the price action formations which undermine these moves and tell us to take profits.
If you would like to learn how to spot these price action formations to where they will just pop out of the charts, then check out our Price Action Course where you will learn high-probability rule-based systems to take advantage of such moves. If you want to learn how to get into trends and take 80% of the move, then check out our ProForex or Advanced Ichimoku Courses.