Engulfing Pattern Strategy
Japanese candlestick charts are a core tool for most traders, and every trading platform offers them. Candlestick patterns are a key part of price-action analysis, and they can give traders possible signals about where price might move next. Because of that, forex traders should be familiar with the different candle types that show up in the market. This article covers one of the more useful candlestick patterns: the engulfing candle, both bullish and bearish. It can be used as an entry method for trades and as a way to read price action. See also our guide to Heikin Ashi Trading Strategy.
What is the engulfing pattern?
The engulfing pattern is made up of two candles, which is why it falls into the double-candle category.
The engulfing candle must fully contain the candle before it. That is how the pattern appears on the chart. Notice that the bearish candle is completely covered by the body of the next bullishcandle, as in a bullish engulfing. In the opposite scenario, the covered candle is bullishand the engulfing candle is bearish, as in a bearish engulfing.
The engulfing candle points to a possible reversal. If price is in an uptrend and an engulfing pattern shows up, it can signal that a top may be forming.
If price is falling and an engulfing pattern appears on the chart, it suggests that price action may be forming a bottom.
Types of engulfing candle
The engulfing pattern has two types: the bullish engulfing and the bearish engulfing. Let’s look at each of these two types.
1- Bullish Engulfing
The bullish engulfing pattern shows up during downtrends. It starts with a bearish candle on the chart, and that candle is then covered by the full body of the next candle. This pattern creates a bullish possibility on the chart and can reverse the current downtrend.
2- Bearish Engulfing
The bearish engulfing pattern works the opposite way to the bullish one. It shows up during uptrends. The pattern starts with a bullish candle, which is then fully contained by the body of the next candle, a bearish one. This pattern creates a strong possibility of a price reversal on the chart, and the current uptrend may turn into a new downward move.
Engulfing candle trading strategy
We have gone over the structure and shape of the engulfing candle in detail. Now let’s look at a trading strategy tied to this pattern.
Trade Entry
Confirmation of the engulfing candle comes from the third candle, the one that follows the engulfing candle. It should break the body of the engulfing candle in the expected direction of the move. When a candle closes beyond that level, you get the pattern confirmation and can open a trade.
If the engulfing scenario is bearish, the breakout should come through the lower level of the engulfing candle’s body, and that is when you prepare to open a trade. If the engulfing scenario is bullish, the breakout should come from the upper level of the candle’s body, which means you should act on an upward move.
Stop Loss
You should always manage the risk you are exposed to. Your engulfing-pattern trades should always be protected with a stop-loss order.
The best place for a stop-loss order is just below the bullish engulfing candle. If the engulfing is bearish, the stop-loss order should be placed above the engulfing candle.
The chart shows where to place the stop loss in bullish and bearish engulfing patterns, along with the third candle and entering the trade after the body of the engulfing candle is broken. If the pattern fails to move in the intended direction and the stop loss is hit, the assumption was wrong, and the stop protects your balance.
Take Profit
The basic rule for taking profit on the engulfing candle is to hold for a target equal to the size of the pattern. That means the minimum target you should follow from the engulfing pattern equals the distance between the upper and lower tips of the engulfing candle.
When price action covers that distance, you can either close the whole trade or part of it. If you decide to keep part of the trade open, watch price action for a possible exit, including the next support or resistance level.
This is the hourly chart for GBP/USD showing a bearish engulfing pattern and some rules for trading it.
The chart starts with a price increase, which we have marked with the green arrow on the image. You will notice that price action consists only of bullish candles, and then suddenly there is a relatively large bearish candle that fully covers the previous one. This confirms a bearish engulfing pattern on the chart.
Even so, a confirmation candle should appear before we can consider taking a position. In this case, the next (third) candle on the chart is bearish again and closes below the body of the engulfing candle. That is the confirmation needed to take a trade based on the bearish engulfing pattern. The stop-loss order for this trade should be placed just above the upper edge of the engulfing candle, as shown in the image.
The yellow arrows on the chart show the size of the pattern and how it is applied as a minimum target on the chart. This target is met by the next candle, which appears after the engulfing confirmation.
So the bullish engulfing trade setup is a green candle that closes above the previous candle’s open after opening below the previous candle’s close. It can be identified and confirmed when it is followed through the pattern rules: a small bearish move appears, then a large green candle follows, showing an upward move whose body fully overlaps or engulfs the body of the previous candle.
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