Trading with inside bars is a very popular trading method because it is believed to a be an excellent way to find high reward, low-risk trade entries. Yet many traders find they fail with this method. Does it really work well, and are there any ways to make it work better?
Traditional Inside Bars Trading Method
The traditional trading method of using inside bars to find trade entries is quite simple. In the first step, you wait for an inside bar (or candlestick if you prefer, they are the same thing) to form). What is an inside bar? An inside bar is a bar with a lower high and a higher low than the immediately preceding bar. It is called an “inside bar” because its range is “inside” the previous bar. An example of an inside bar formation is shown below.
Once the bar has formed, it is time for the second step. A buy stop order (a long trade entry) is placed just a fraction (let’s say one pip) above the high of the inside bar, with the stop loss placed just a fraction (again let’s say one pip) below the low of the inside bar. An opposite order is placed at the same time: a sell stop order (a short trade entry) is placed just a fraction (let’s say one pip) below the low of the inside bar, with the stop loss placed just a fraction (again let’s say one pip) above the high of the inside bar. Then, price movement will eventually trigger one of the entry orders, at which point the opposite reverse trade should be cancelled. For example, if the price goes at least one pip above the high of the inside bar, a long trade is entered, with the stop just below the inside bar, and the short trade entry is cancelled. To be valid, an entry must be triggered on the very next candle. In the diagram above, a short trade entry would have been triggered, as the price broke below the low of the inside bar, and the high of the inside bar was never broken.
A slight variation on this method which is also popular, is to place the stop loss on the other side of the “mother” bar (the bar just before the inside bar). This means that the entry is the same, but the stop loss is always wider. We will look later at whether this is a good idea, but we will stick with the method as originally described for the time being.
Inside Bars Trading Method Back Test
Is this traditional inside bar trading method any good? Is it profitable and worth following? The best way to answer this question is to conduct a back test using historical price data. I took the 3 major currency pairs (EUR/USD, GBP/USD, and USD/JPY) which together account for more than 80% of the traded volume of the global Forex market. I used the daily time frame as a starting point, from the start of 2001 to the end of 2017: a period of 16 years, which should be long enough to give a statistically significant result over many hundreds of trades. As explained in the previous paragraph, there was no directional bias: if the first break of a daily inside candle is bullish, a long trade was taken within the test; if the first break was bearish, a short trade was taken. The results were measured at different reward-to-risk “expectancies”, representing the ratio of the profit target to the size of the stop loss. For example, if a stop loss is 40 pips, an expectancy of 1:1 is a profit of 40 pips, 3:1 is a profit of 120 pips, etc.
The results of the back test were as follows:
No. of Trades
Interestingly, the traditional inside bars trading method seems to produce a small but statistically significant profitable “edge” at all expectancies. I emphasize that the edge is small and would be reduced further by any slippage (no slippage was assumed within the back test) or wider spreads than would usually be expected (total spreads assumed within the back test were 1 pip for EUR/USD, 1.2 pips for USD/JPY, and 1.5 pips for GBP/USD).
Let’s take a closer look at the results. Inside bars forming on Fridays were included in the test, but maybe should be excluded as if the price opens after the weekend with a gap, the inside bar might not be tradable. How do the results look if we exclude inside bars formed on Fridays?
No. of Trades
The results are not significantly different, which is good, yet the positive edge is still very narrow, so we should look to try to refine the method further. It is sometimes argued that in Forex, the edge present in inside bars does not lie in the consolidation coming before a breakout, but in the tightness of the stop loss order. To test this idea, we can impose a filter where we look only at the results of relatively small inside bars – say, every bar under 50 pips in size from high to low. These narrow range bars are only approximately one quarter of all the inside bars from the previous back test. The results using this size filter are shown in the table below:
No. of Trades
It doesn’t really make any significant difference. This suggests that the variation mentioned earlier on the typical entry method, where a stop is placed the other side of the preceding bar and not the inside bar itself, is not going to be very helpful either. Let us try one final filter before coming to some conclusions: trading in the same direction as the long-term trend. A long-term trend filter which I have found to be very effective in Forex is to take trades only in the direction the price has moved over the past three and six-month periods, and if the period price movements do not agree, to stand aside from the market. When we apply this filter to the back test, the results are as follows.
No. of Trades
Towards a Better Inside Bars Trading Method
Sadly, it must be said that although trading the breaks of inside bars is a very popular method, while it does seem to have a small positive edge, it is not really a good or significantly profitable method. It might be argued that the daily time frame is too high, too long-term. Perhaps if we drop down to lower, tighter time frames, we could show a back test over a similar period giving superior results. It is possible to do this, if you restrict the entries to time frames of H4 or lower, and only take the inside bar entries during the most active market hours relevant to that currency pair in the direction of a long-term trend. As examples, here are a back-test results for the three major Forex currency pairs, but with entries taken only at 8am and noon London time for the European pairs, and USD/JPY taken only at noon and 4pm, all only in the direction of the long-term trend:
No. of Trades
It is obvious that these numbers are significantly better, which tells us that if you want to trade Forex frequently and systematically, you really need to trade on shorter intraday time frames to generate a meaningful and worthwhile positive expectancy. Additionally, you should be trading near the effective start of the trading day in active hours for the relevant currency pair, before the day’s average price range has been made. For example, if you are trading an inside bar on the EUR/USD, the odds will be much more in your favor if you enter after London has opened but while the total range made during the immediately preceding Asian session is less than, say, half of a typical daily range. It does not matter greatly if you use H4, H1, or even shorter time frames to select trade entries, if they are taken at the right time of day, when the price has a chance to travel multiples of the risk within a short time. Do not forget that when you trade Forex, you usually pay a small but significant fee to your broker for each night your trade remains open, so trading higher time frames incurs greater costs because you must leave trades to run for longer periods to profit.
Discretionary Inside Bars Trading Methods
It should be noted that inside bars, contrary to a popular Forex myth, are not necessarily the most profitable way to identify good trade entries. Entries based upon breakouts with higher than average volatility taken in the direction of the long-term trend perform better in Forex than any other mechanical system which has been publicly identified. If you are going to trade inside bars, find entries on lower timeframes early in the trading days (European opens for European pairs, U.S. open for USD/JPY). Make sure you use lower time frames, aim for higher reward to risk multiples, and be prepared for losing trades. If you want to be selective about your entries, you should adopt the following guidelines:
An inside bar that is almost as large as the preceding bar is often a lower-quality entry.
An inside bar that is in a crowded price area is often a lower-quality entry.
Smaller inside bars are good, but don’t become obsessed with trading only the smallest ones.
Some of the best inside bar entries are placed just after two or three consecutive rising or falling bars making breakouts to new highs. They act as momentary pauses before another explosive breakout in the same direction. An example of such a run with an inside bar in the middle is shown in the diagram below:
If you are going to trade inside bars, trade in the direction of the long-term trend, and trade at the appropriate time of day for the relevant currency pair. The easiest route to significant profits is to allow winners to run to several multiples of reward to risk such as 3 to 1 or 5 to 1. Be aware that inside bars as a stand-alone entry method is not the best mechanical edge available to retail traders: momentum is.