Type: Reversal Pattern
Appearance: The engulfing pattern is a major reversal signal composed of two candles with opposite color bodies. From now on, we are going to consider "white candles" to be up and "black candles" to be down. A Bullish Engulfing Pattern happens in a down-trend and consists of a white candle whose body fully engulfs the body of the previous down-candle. A Bearish Engulfing Pattern is the exact opposite: It happens in an up-trend and consists of a down-candle whose body fully engulfs the body of the previous up-candle.
Typical Duration: 2 candles
Description: The reasoning behind the Engulfing Pattern is fairly easy. The bulls (or bears) are running out of steam throughout the primary candle, and the opposite side of the market makes a powerful move throughout the second candle. There are 3 main criteria that have to be met so as for a pattern to be thought of as an acceptable Engulfing Pattern.
- The market must be in a clearly defined trend before the emergence of the pattern.
- The body of the second candle should fully engulf the body of the primary candle. It doesn't need to engulf the previous candle's shadows.
- The primary candle should be in the direction of the trend, and the second "engulfing" candle must be in the opposite direction. That is, in an up-trend, the first candle must close higher than it opened, and the second candle must close lower than it opened, and vice verse in a down-trend.
- The larger the difference between the body sizes of the two candles, the more likely it is that the pattern is a vital reversal point.
- Seeing the engulfing pattern after a long trend as opposed to a quick burst increases the probabilities that all the forces pushing the trend have indeed been exhausted, and that the trend is prepared to reverse or retrace.
Weaknesses: Having said all that regarding the pattern's strengths though, it usually doesn't lead to an actual reversal of the trend, however will usually lead to a consolidation or a retrace instead. The buying/selling pressure that causes the engulfing candle may come spontaneous events like large non-speculative flows, or profit taking close to a major support or resistance level.
How to Trade It: Simply wait for the engulfing candle to close, make sure that it does actually form an Engulfing Pattern according to our criteria above, and enter the trade accordingly. Stop losses are often placed simply beyond the top of the formation for Bearish Engulfing Patterns, or just below the bottom of the formation for Bullish Engulfing Patterns. Engulfing Patterns in general don't have any inherent take profit level. Take profit orders are supposed to be placed according to results of other analysis.
Posted on Wednesday, 29th of February, 2012.