Inside Bars – The Hidden Price Action Driver

As odd as it is many aspects of trading analysis aren’t necessarily based on what’s happening as much as what isn’t happening.

If you’ve heard of traders shorting VIX, that’s somewhat related. Traders will wait for a spike in volatility and, once at a certain level, usually around 30 or 35 on VIX, they’ll investigate bearish strategies under the presumption that volatility will eventually settle.

And when volatility does settle – option premiums become cheaper due to the lower value of VIX, which feeds into the Black-Scholes option pricing model. That’s when traders can use the lower volatility levels to begin to look for breakouts, or straddle plays as they look for volatility to then expand. So, volatility in this case is treated as a cyclical tool that waxes and wanes, and traders will often look to position on the other side of that with the goal of maximum benefit.

In price action terms the inside bar is closely related, and many traders ignore these formations – or ‘lack of formation’ – and instead wait around for a more actionable signal of some sort. But, the reality is these can be powerful indicators when they show up and we’ll look at that more deeply in this installment.

What is the Inside Bar

The inside bar is the exact opposite of the engulfing candlestick. The inside bar prints entirely within the prior bar. This illustrates a form of equilibrium in the market – and this is something the trader can use. Unlike the engulf, however, there’s only one type of inside bar – and it needs to print entirely inside of the prior formation. There can’t be any wick penetration of the prior bar or we don’t have that equilibrium that traders are looking for with such formations.

GBP/JPY Daily Price Chart

Chart prepared by James Stanley; GBP/JPY daily chart, Feb – May 2022

On the above chart, you’ll notice that I’ve pointed out five different inside bar formations on the GBP/JPY daily. Each of those daily bars remained entirely inside of the range from the prior day – making it an inside bar representing an ‘inside day.’

But – the more interesting part is what happened after each of those…

How to Work with Inside Bars

A bit of subjectivity is needed here. There could be some sub-optimal situations where inside bars print consecutively or, even worse, in a non-consecutive manner amidst chop and range. Such situations can be indicative of a really big Central Bank meeting or Earnings report or rate announcement. But, the takeaway from that scenario is that the market is somewhat compelled by fear so both buyers and sellers fear going too far offsides.

But, in a less threatening manner this is what makes the inside bar print, right? It’s a form of indecision in and of itself, with a bit of digestion thrown in.

But it’s what happens after the inside bar prints that’s interesting – and that’s the potential for a breakout. On the above chart, that’s the takeaway, that each inside bar that printed was then followed by a breakout that continued for at least one bar after. That is with the exception of the final bar, of course, which showed a reversal. The inside bar printed and the low was immediately broken as a bearish trend started to develop.

Inside Bar Breakouts

On its face, looking to follow breakouts from every inside bar can be an imposing task. So, traders are likely going to want to concentrate their search for inside bars to longer time frames to ensure that they’re not getting snared in a volatility lull.

To work with an inside bar, traders can mark the high and low from that bar, and then look for a breach in one direction. Using the above example, we’ll take a look at the final inside bar that reversed into a bearish trend, but I’m going to use a shorter-term chart below, the four-hour, to show how that pattern had played out. The low of that bar on April 21, 2022 was at 166.99 while the high was at 167.91.

Sellers forced a break later that night, at around 1 AM on the day following that bar closing. And the trend then went on an aggressive downside run that I’ve highlighted with a red box.

But, there were other inside bars, as well, and not all worked as favorably as that final one. On the left side of the chart, we can see four additional inside bars and the market movements that followed. It’s important to note that not all moved into an aggressively strong trend. There’s still the potential for chop. But, the four inside bars on the left side of the chart were all trend-side; in essence, as a mechanism for joining the bullish trend.

GBP/JPY Two-Hour Price Chart (Late March 2022 – May 2022)

Chart prepared by James Stanley; GBP/JPY daily chart, March – May 2022

— Written by James Stanley, Senior Strategist for DailyFX.com

Contact and follow James on Twitter: @JStanleyFX

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