Engulfing Candle: How to Trade with Bullish and Bearish Candlestick Patterns

2023.09.29 2023.09.29
Engulfing Candlestick Patterns: Full Guide & Tips

Alan Tsagaraevhttps://www.litefinance.org/blog/authors/alan-tsagaraev/

The engulfing pattern is of Japanese origin, where candlestick technical analysis appeared in the 18th century on the rice exchange. The pattern consists of two outside bars on a candlestick chart, in which the second candle engulfs the first.

Despite its age, the pattern is still relevant in the 21st century. First of all, it reflects the psychological state of market participants, as well as the balance of power between sellers and buyers in the market. In addition, engulfing is one of the key reversal patterns that warn of an imminent trend reversal.

Read this article to find out what an engulfing candlestick can predict and how to trade using this pattern.

Key facts

• The engulfing candlestick pattern is a chart pattern consisting of green and red candles. In a bearish pattern, a red candle forms after the green one appears and absorbs it. In a bullish pattern, on the contrary, the green candle absorbs the red one.

• The engulfing pattern most likely signals a trend reversal. However, as with other candlestick patterns, the engulfing requires additional confirmation on the price chart.

• There are a number of key strategies for engulfing trading, thanks to which traders can minimize risks and earn high profits.

• The engulfing pattern has certain advantages and disadvantages.

What is the Engulfing Candlestick Pattern?

The engulfing candlestick pattern is a Japanese candlestick pattern that consists of two candlesticks, a bullish and a bearish one. The figure warns market participants about an upcoming price reversal, depending on the nature of the pattern.

The engulfing pattern is often used in Forex, as well as the stock, cryptocurrency and commodity markets.

The larger the timeframe on which the pattern appears, the stronger the reversal signal it gives. In addition, the possibility of a price reversal increases if other candlestick patterns or technical indicators confirm the engulfing pattern.

Types of Engulf Candlestick Patterns

In this section, you will learn about the types of patterns found in the market. There are two types of this pattern: bullish and bearish engulfing.

It is important not to confuse this pattern with the harami pattern.

In a harami, the first candle engulfs the second, but this pattern is not a reversal. This is rather a warning about a short lull in the market. In addition, the harami pattern is a single-candle pattern that can be either bullish or bearish.

Bullish engulfing pattern

A bullish engulfing pattern is a pattern in which the second ascending candle engulfs the first bearish candle. That is, the bulls show their strength and open large purchases of the asset.

A bullish engulfing pattern occurs after a downtrend in the area of low prices. The pattern at the bottom warns that the price is about to reverse. On higher timeframes from H4, the pattern gives a stronger signal for trend reversal.

On timeframes up to H1, the pattern is formed mainly during price corrections. Often, on smaller timeframes, this pattern can be found in the middle of a downtrend or at a local top. This is due to the high level of market noise. False patterns are formed on the chart, which can mislead traders.

Engulfing can be used for intraday trading. However, it is important to further confirm the pattern using other candlestick patterns or technical indicators.

What do Bullish engulfing patterns show traders?

The formation of a bullish engulfing pattern in the chart signals that the price has reached the bottom and is preparing to reverse the trend to bullish.

A bullish engulfing candle must meet the following criteria to confirm an impending price reversal:

• a bullish engulfing pattern must be preceded by a distinctive downtrend;

• first, a bearish candle must form, which can be full-bodied or with small wicks up and down;

• the opening price of the second candle must be lower than the closing price of the first candle. That is, a downward price gap should form;

• by the end of the second candle, the closing price should be higher than the opening price of the first candle. In this case, shadows of the absorbing candle are allowed.

It should be emphasized that a bullish engulfing signal can be enhanced if:

• A large downward gap has been formed. The second candle closed much higher.

• A long bullish engulfing candle has formed. Thus, the probability of a trend reversal increases.

• An engulfing candle overlapped several previous candles.

• There are no shadows of the engulfing candle.

• The engulfing candle covers not only the body of the first candle but also its shadows.

• When a bullish engulfing candle is built, trading volumes increase.

Bullish Engulfing Pattern Examples

Let’s take a closer look at the bullish engulfing pattern on the Nvidia daily timeframe.

The chart shows a series of reversal bullish engulfing candlestick patterns after a long downtrend. These patterns served as a signal for a global price reversal and the beginning of a long-term bullish trend.

Another example of a bullish engulfing candle can be seen below in the XAUUSD daily chart. After the formation of the gold pattern, quotes reversed upward and grew by more than 43% in 5 months.

Bearish engulfing pattern

A bearish engulfing pattern consists of two candles, the first of which should be bullish, and the second should be bearish. The second candle is an engulfing candle and warns of an imminent price reversal downwards after an uptrend. The smaller the body of the first candle and the longer the body of the engulfing candle, the higher the possibility of a bearish reversal. Also, engulfing the shadows of the first candle in addition to its body enhances the effect and increases the possibility of a reversal.

What Can a Bearish Engulfing Pattern Tell You

A bearish engulfing pattern occurs at the top in the high-price area. This pattern signals an imminent price reversal downwards. The appearance of a bearish engulfing candle is preceded by a long upward trend. At the moment of formation of the first bullish candle, trading volumes decrease. In this case, the size of the candle body does not matter.

When the second candle opens, an upward price gap is formed, which serves as a signal of an uptrend continuation. However, by the end of the selected time period, quotes fall below the opening price of the first candle. That is, the body of the second candle engulfs the body of the first candle while trading volumes begin to grow.

At this time, the bulls begin to close their positions with a profit. Bears, on the contrary, look for profitable entry points into the market and open short trades.

The trend reversal signal is strengthened if the following conditions are met:

• the longer the body of the engulfing bearish candle and the shorter the body of the bullish one, the stronger the signal for a downward reversal;

• short wicks or their absence in a bearish candle indicates strong pressure from sellers and the rapid development of a downtrend;

• a larger gap between candles also strengthens the reversal signal;

• if a bearish candle engulfs not only the body of the bullish candle, but also its shadows.

Bearish Engulfing Pattern Examples

The Adidas AG stock chart below shows bearish engulfing. After an upward trend, the asset price reversed down in the key resistance zone.

Buyers tried to restore the price from the support level, but a series of bearish engulfing candlestick patterns formed in this zone. The signal for a trend reversal was strengthened by the absence of upper wicks in both the first and second figures. A decrease in volumes during the formation of the first candle and their increase during the formation of an engulfing candle serve as additional confirmation.

The last confirmation signal for opening short trades was the breakout of the first support level, after which the price began to decline actively.

Let’s consider the bearish engulfing pattern in the EURUSD hourly chart.

When trading Forex, you can see an engulfing pattern without a price gap. This is due to the fact that currency pairs are traded without interruption, except on weekends. In this case, a price gap may arise due to certain fundamental factors.

After the appearance of bearish engulfing candlesticks patterns, the price reversed down and began to actively decline. The bearish trend was stopped by two reversal patterns, the hammer and the inverted hammer.

Bullish and Bearish Engulfing Patterns: What’s the Difference?

Bullish and bearish engulfing patterns are opposite to each other.

However, they both warn of a trend reversal and provide strong signals to market participants.

More detailed information about the differences between these patterns is presented below.

How to Use Engulf Candle in Trading Strategies

As with any other technical analysis patterns, the engulfing pattern provides unique warning signals. Below is an analysis of engulfing trading strategies.

Engulfing Candle Reversal Strategy

This strategy involves opening positions on a trend reversal after the pattern formation. Opening/closing a trade is carried out according to the rules of risk and money management.

For a bullish candle

The formation of a bullish engulfing candlestick pattern at the bottom after a prolonged downtrend suggests a subsequent reversal as the asset has reached a low price zone.

Let’s consider bullish engulfing trading using the example of the GBPUSD currency pair. The H4 chart below shows several reversal patterns of bullish engulfing and hammer near support 1.2331. Then, the price reversed up and reached resistance at 1.2493. After this, the quotes experienced a correction.

However, it became clear that the price had reached its bottom. Thus, after the first engulfing pattern appeared at the level of 1.2385, it was possible to open a long trade. Stop loss is set below the support level around 1.2304.

Then, another series of bullish engulfing and hammer patterns formed in the chart. Price lows and highs are also rising, which is another sign of a bullish reversal.

The second opportunity to open a long trade was around 1.2439. The stop loss had to be set lower, around 1.2358. The breakout of the key resistance at 1.2493 allowed us to reach the first target at the level of 1.2574. In this case, it was possible to take 50% of the profit and leave part of the trade for the second and third targets at the levels of 1.2682 and 1.2763, respectively.

For a bearish candle

A bearish engulfing pattern forms at the top in the high price zone after a long uptrend. Let’s consider bearish engulfing trading using the example of the Tesla Inc shares. The screenshot below shows that the asset has reached 310.00 and cannot break out the resistance level.

The price was in the side channel 268.00 – 310.00 for a long time, forming reversal patterns. The first signal for a reversal was the formation of the evening star pattern, which signals the bulls to close long trades. Two more reversal candlestick patterns, a hanging man and a dark cloud cover, formed one after the other.

Before the final reversal and breakout of the key support at 268.00, a series of bearish engulfing patterns formed in the chart. The formed pattern after retesting the level of 310.00 became a signal to open short trades with targets at 268.00, 226.00, 194.50, 163.00, 142.00. The stop loss had to be set higher, around 320.50.

Engulfing Candle When Trend Trading

Engulfing patterns cannot always be considered reversal patterns. In a strong trend, these patterns can become a signal of trend continuation. Let’s study this case in more detail using the example of Apple Inc shares.

In the chart below, the price of the asset reached the bottom at the key support zone of 22.40, where a double bottom price pattern was formed. This was confirmed by the bullish engulfing reversal pattern, after which it was possible to open a long trade around 24.00 with a profit target of 27.20. The stop loss is set below the low of the engulfing candle at 23.20.

Then, the price successfully tested the first resistance level 24.80, having previously formed another bullish engulfing candlestick pattern. It should be noted that these patterns are formed at almost every new level that the bulls have overcome within the trend. At the same time, a bearish engulfing pattern has formed at the level of 27.20, which indicates the critical importance of this level for traders. However, the sellers’ attempt to change the situation was unsuccessful, as indicated by bullish hammer patterns.

The strategy for trading the engulfing pattern according to the trend is based on a consistent increase or decrease in price to new target levels at which this pattern is formed. The formation of such patterns indicates the continuation of stable price movement.

This strategy provides traders with the opportunity to see an objective picture of the market and open trades with visible targets. It should be emphasized that this strategy should be used during a strong trend and from the point of price reversal.

Engulfing Potential Trade Entry & Sell Signals

The engulfing pattern is a strong reversal pattern. The appearance of a pattern in the chart signals an imminent trend reversal. However, engulfing requires additional confirmation from other technical indicators or candlestick patterns.

It should be emphasized that engulfing gives more accurate signals on higher timeframes from H4 and higher. On lower timeframes, the pattern can give false signals, leading traders into a trap. This happens due to strong market noise.

Engulfing must meet the following criteria:

• The pattern is formed in the zone of high or low prices after a long upward or downward trend, respectively. In cases of a strong trend, engulfing can confirm the continuation of the trend.

• The two candles that make up the pattern must have different directions. An engulfing candle must overlap the previous candle.

The factors below can enhance an engulfing candle:

• A decrease in trading volumes when the first candle is formed and an increase in volumes when the second candle is formed.

• The larger the engulfing candle and the smaller the first candle of the pattern, the stronger the signal for a price reversal.

• An engulfing candle overlaps several previous candles.

How to Trade on Engulfing Candlestick Patterns

To successfully trade Forex using engulfing, you can use candlestick analysis with various technical indicators.

Below is a step-by-step guide using the GBPUSD currency pair as an example:

1. First of all, having chosen an instrument for trading, determine the nearest support and resistance levels.

2. Add the following technical indicators to the chart: volume, RSI and MACD.

3. If a bullish engulfing pattern is detected, wait for confirmation of this pattern using technical indicators and other candlestick patterns.

   After the formation of a bullish engulfing pattern, another engulfing pattern and a hammer reversal pattern formed in the chart. In the hammer zone, the MACD indicator crossed the zero border from bottom to top and began to grow in the positive zone. In addition, the RSI crossed level 50, which means a bullish reversal.

4. Only after such confirmation can we say that growth begins. After the price consolidates above the first resistance level, you need to open a long trade. In our case, profit targets were at local levels of the second and third resistance.

5. The stop loss must be set below the first resistance. In our case, according to risk management, the stop order had to be placed in the maximum zone of the engulfing candles. If you set it even lower, then if the forecast is incorrect, traders may lose a significant part of the deposit.

Engulfing Pattern Trading Tips

Below are a number of tips for using the engulfing candlestick pattern in trading:

• Try to use engulfing on higher time frames, at which stronger signals appear indicating a trend reversal or its continuation. For intraday trading, it is better to use timeframes from H1.

• To check the pattern, use the volume indicator to avoid market traps.

• Be sure to wait for engulfing confirmation using other candlestick patterns and technical indicators before opening a position.

• Use support and resistance levels to set profit targets.

• Since the market is unpredictable, set stop losses to minimize the risk of losing your deposit.

Advantages of Trading the Engulfing Pattern

Bullish and bearish engulfing are very popular among both beginners and experienced traders. So why is this pattern attractive for trading?

Below are the benefits of the engulfing candlestick pattern:

1. The pattern is easy to spot on the price chart. It consists of two candles that have different directions. The second of these candles is clearly visible in the chart.

2. The engulfing pattern can be found in any time frame in any financial market.

3. Attractive risk-reward ratio. An engulfing stop loss is set slightly below or above the low or high of the engulfing candle, depending on the trend.

Limitations of Engulfing Patterns

1. Traders often confuse the engulfing pattern with a price rollback. It appears in the zone of key resistance and support levels. Also, pay attention to volumes when building the second candle. If the volume of the second candle is lower than that of the first, then the price is more likely to roll back. Also, the engulfing pattern can easily be confused with the Marubozu pattern, which indicates a continuation of a trend and has a long body.

2. The engulfing pattern needs to be confirmed using additional candlestick patterns and technical indicators. Therefore, before trading, it is necessary to study other reversal patterns in candlestick analysis.

Conclusion

The engulfing pattern has a special role in trading. The formation of this pattern in the chart precedes a trend reversal in the market. The pattern is common in financial markets and is easy to identify. The appearance of a pattern on higher timeframes signals a more global trend reversal.

From a psychological point of view, at the moment the pattern is formed, the previous trend weakens due to the massive closure of positions. At the same time, the alternative trend strengthens, as a result, trades are opened in the opposite direction.

You can try trading using the engulfing pattern in the convenient and multifunctional LiteFinance web terminal with a wide range of trading instruments.