Pattern trading is one of the most popular trading techniques. Trading based only on the design may not guarantee consistent results. However, the combination of price action with the pattern can deliver exceptional results.
In this article, we shall be discussing the Engulfing candlestick pattern. The Engulfing pattern is Price Action traders’ one of the most anticipated candlestick pattern as it gives clear and genuine signals to traders.
What is the Engulfing Candlestick pattern?
The definition of this candlestick pattern goes by the name of the pattern. When a candle engulfs another candle, gobbling it up, it can be considered as an engulfing candlestick pattern. In this pattern, the candle that engulfs the other candle must be of the opposite colour. In other words, if one candle is bullish, the other candle must be bearish and vice-versa.
Types of Engulfing Pattern
There are two types of engulfing patterns – Bullish and Bearish.
Bullish Engulfing candlestick pattern
Below is the figure that represents a bullish engulfing pattern. Here the green candle completely engulfs and overshadows the red candle.
Bearish Engulfing candlestick pattern
This pattern is the exact opposite of a bullish engulfing pattern, as here, a red candle entirely engulfs a green candle. A representation of a bearish engulfing pattern is given below.
Interpretation of engulfing candlestick pattern
Let’s interpret what the candle is trying to tell us by considering a bearish engulfing pattern. Below is the figure of a bearish engulfing pattern with its corresponding line chart representation. In the line chart (right side), the market opened at the point marked ‘O’, dropped a little, shot up hard, and then closed at ‘C’. This clearly indicates that we are in a buyer’s market.
Now, the second candle opens with a gap up, in fact, higher than the previous candle’s high, and even tries to make a higher high. But, it fails to so and drops drastically, to the extent that it even goes below the previous day’s open, and closes below it as well. Therefore, this implies that the sellers have taken over the market.
Acceptable engulfing patterns
Well, to trade this pattern, it is not necessary that the pattern should look the same as the above figure. There can be variations to it as well. Let us discuss some of the acceptable forms of the engulfing pattern.
The most common question that arises in many traders is if they should consider the wick of the candle that is being engulfed. The answer to that differs from trader to trader. However, most of the price action traders do not find it mandatory to consider the wick of the candle, as the wick signifies that the market was unsuccessful in holding at that price. Therefore, that price has less value. Hence, if the engulfing candle engulfs the body of the previous candle, it can be considered as an engulfing candle. An example of the same is given below.
Additionally, if the engulfing candle engulfs the entire candle, including the wick, it is much safer and better for our business.
Many traders show interest in this pattern, only when the engulfing candle opens with a gap up or gap down. However, it is not necessary to consider only such designs. If the engulfing candle (second candle) opens at the close of the first candle, it can be considered as an engulfing pattern without any hesitation because the story behind both the patterns remains almost the same. For example, the below pattern is an acceptable engulfing candlestick pattern.
Therefore, until the logic and story behind the pattern remain the same, one can consider any design as an engulfing pattern.
Analyzing the Engulfing Candlestick Pattern using Price Action Concepts
Typically, a price action trader does not trade solely on the pattern, but usually considers many other factors before taking a trade. The example below will give you an idea of how a price action trader trades a pattern.
Below is the chart of USD/CHF on the 60mins timeframe. We can see that the market is under the control of the buyers after the price broke the orange S&R line. Since it is illogical to buy when the market is high up; we wait for a pullback to kick in, before we go long. The pullback begins with a large red candle. Then, the market goes up a little and again drops down, and starts to hold at the S&R level. Here, the market slows down for a while and suddenly pops up with a green candle. This becomes our bullish engulfing candlestick pattern, as represented within the square. Therefore, this is an indication that the sellers have quit and the big buyers are back in the business.
As far as the entry, stop loss and target are concerned; an entry after the close of the engulfing candle, a stop loss just below the engulfing candle and the target at the recent highs can fetch good profit from the trade.
Note: A price action trader usually considers those engulfing patterns where the engulfing candle engulfs at least two or more candles.
When Not to Trade the Engulfing Pattern
The above explains when and how to trade the engulfing pattern. Now let’s understand when not to trade this pattern. To extract consistent profits from the trades it is necessary to understand when the pattern will not work in your favour. So, let’s discuss it with an example.
Considering the same example as above, if you observe carefully, during the pullback, a bearish engulfing candlestick pattern appeared. And according to textbooks, the market should have gone down from there. However, it did not. Reason being, the pattern appeared at the buyer’s S&R area. This is the area the big buyers are interested in buying. Therefore, any sells around this region is not likely to perform. Taking it a little deeper, the reason for the sell not working is that, the sell orders around that region is eaten up by the buyers to raise the market higher.
From the above two examples, it would’ve been clear that trading a pattern without logic and story could lead to significant losses. Specifically, for a price action trader, understanding the story is more important than identifying a pattern. For them, a pattern is just an additional confirmation that the trade is going to perform in their direction.
Therefore, as a rule of thumb, use a pattern only as a confirmatory tool, and not as an analysis tool. In other words, use a pattern like a cherry on the cake, rather than as an ingredient of the cake. Found this article useful? Let us know your thoughts in the comments below.