The Coil Effect

Lessons from the Pros

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Markets are continually in a state of moving from range contraction to range expansion. The purpose of any exchange traded market is to facilitate trade. To do this, the market must search for orders. Unfortunately, for some of us, this search for orders can be when the market makes a new high or low and hits our protective stops we have in the market.

During this pursuit of orders, the markets can sometimes become lethargic. While looking for these orders, the market may have a hard time finding orders to move the market much. Remember, it takes buy and sell orders to move a market. Once supply/demand becomes out-of-balance, a move will originate.

An indicator that can measure when the market's range is expanding or contracting is the Bollinger Band. This is a volatility indicator with overbought/oversold bands, usually 2 standard deviations from a 20 period mean (moving average). Traders are well aware that the best trades come from markets that are moving from low volatility to high volatility; this is usually the origin of a trend. In using the Bollinger Band indicator, we can see when the market is contracting by observing the difference between the upper and lower bands.
Figure 1 shows us that when the bands are getting closer (yellow boxes), the market is usually consolidating (supply/demand is in balance). Then when the supply/demand becomes out-of-balance, the market moves from low volatility to high volatility (blues boxes).

Now that you have a conceptual idea of how markets can go from low volatility to high or vice versa, let's look at a chart pattern that can tell us the same thing. This pattern has been around for many years. It is called an Inside Bar (IB) or Inside Candle, depending on your chart preference. We will use an inside bar (IB) for the purpose of this article.

To identify an IB, we look for a candle that has a high that is equal to or less than the previous candle high, and a low that is equal to or greater than the previous candle low. Below are two examples in Figure 2:

Figure 2 shows us that if candle B high is less than candle A high and greater than candle A low, then B is an inside bar. Also, it shows us that if candle B high equals candle A high and candle B low is equal to candle A low, then B is also an inside bar. There can be combinations of these patterns too and still be an inside bar. The key is that candle B high or low does not exceed candle A high or low. When measuring the high or low of a candle, we will always use the entire candle length, not just the body.

When we see an inside bar setup, we can visualize the same concept as the Bollinger Bands getting closer together. The inside candle is telling us that we are entering into a state of low volatility, which is usually followed by a state of high volatility very soon.

Figure 3 shows us some inside bar patterns. These are just to show you what it looks like, not necessarily to provide trade setups.

Notice that when there is an inside bar pattern, that very soon there is a higher volatility move away from that area once supply/demand becomes out-of-balance. Another observation you have probably already made is that this pattern appears very frequently and not all of them are going to yield high probability trades. What we need to do is to identify this pattern near some form of support/resistance, indicator overbought/oversold reading or indicator divergence signal, just to name a few points on a chart to use the inside bar pattern.

The inside bar pattern serves two purposes:

Figure 4 demonstrates an inside bar at a supply and a demand level.

After you have identified your supply and demand levels, you can look for an inside bar pattern to confirm your entry. These will be very helpful on those 2nd and 3rd visits back to the zone when you need a little more confirmation.

To set up some rules to use the inside bar, we will identify where your entry price might be and where you might place your protective stop. Figure 5 & 6 illustrate these areas for you. They both show the buy and sell setups.

This pattern will serve you well when you need confirmation at a turning point. Normally, the first time back to a supply or demand level, we don't need this confirmation. But the next few times price returns to these same levels we might want some confirmation before we place our capital at risk. You can use this on any time frame or market. The inside pattern has been around for a very long time, but few people know how to interpret the pattern. You can count yourself as one who does know how to after reading this article.

"One who fears failure limits his activities. Failure is only the opportunity to more intelligently begin again." Henry Ford

Every trade is real, even demo; make them count.

Source: http://www.fxstreet.com/education/related-markets/lessons-from-the-pros-futures/2011-08-02.html

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