Engulfing Patterns and How to Trade with Them

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Engulfing patterns serve as a valuable strategy for traders seeking opportune moments to enter the market, offering a clear signal of a potential reversal in the prevailing trend. When used correctly, these formations can provide traders with an advantageous entry point to capitalise on forthcoming market movements. If you're interested in exploring this trading approach, read this FXOpen article.

What Are Engulfing Patterns?

Engulfing patterns emerge when a candle on the price chart wholly "engulfs" its preceding candle. Whether it's bullish or bearish depends on its position relative to the current market trend. The first candle's small body suggests a weakening trend, while the larger second candle indicates a market sentiment shift.

Bullish Engulfing Pattern

This formation is characterised by the presence of two candles: the first bearish candle represents the prevailing downtrend in the market. It symbolises a period of seller dominance. However, the second larger and bullish candle completely engulfs the body of its predecessor, signifying a dramatic change in momentum.

It is imperative that the price action exhibits a clear downtrend when the bullish engulfing pattern materialises. The large bullish engulfing candle that covers the previous one is indicative of aggressive buying activity. This initial surge in buying sets the stage for a potential upward market trajectory.

Bearish Engulfing Pattern

While the bullish engulfing pattern signals potential price increases, the bearish engulfing is a warning sign of a possible downturn. This pattern is most potent when it emerges at the peak of an uptrend, indicating a surge in selling pressure and suggesting a shift in market sentiment.

It involves two candles, and each one has a specific role to play. The first bullish candle represents the ongoing uptrend, where buyers have been in control, and prices have been rising. However, the second bearish candle completely engulfs or "eclipses" the previous one. This dramatic change in candle size symbolises a sudden influx of sellers eager to drive prices down.

How to Spot Engulfing Patterns in the Chart

Spotting engulfing candlestick on a price chart is a valuable skill for traders looking to identify potential trend reversals. Here are steps on how to spot such formations in a price chart:

  • Start by choosing the financial instrument (e.g., a currency pair, stock, or commodity) and the time frame (e.g., daily, hourly) that you want to analyse.
  • Familiarise yourself with the concept. Remember that there are two types: bullish engulfing and bearish engulfing.
  • Before the pattern can be spotted, you need to determine the prevailing trend. For a bullish engulfing, look for a prior downtrend, and for a bearish engulfing, search for a preceding uptrend.
  • Pay close attention to the candlesticks on the chart. The first candlestick should have a small body, indicating a weakening trend. The second candlestick is the key. It should have a larger body that completely engulfs the previous one. This engulfing of the first candlestick's body is the defining characteristic.
  • For pattern validation, scout for corroborative signals such as support and resistance thresholds, breaches in trendlines, or the alignment of technical indicators like RSI and MACD.

How to Trade with Engulfing Patterns

Trading with these patterns can be a straightforward and effective strategy in the financial market. Here is the theory of how to trade engulfing formations:

  • Entry

To trade using engulfing setups, traders first identify them: two candles where the second engulfs the first.

  • For a bearish engulfing, where the second candle overshadows a bullish predecessor, traders consider a short position.
  • If it's a bullish engulfing with the second candle covering a bearish one, traders lean towards a long position.

Traders usually enter on the subsequent candle after the formation. As with any candlestick setup, engulfing formations are confirmed by other technical analysis tools, including trend indicators or breakouts of support and resistance levels.

  • Take Profit

After entering a trade using the pattern, traders set profit targets. As it doesn’t provide specific levels, traders usually look for the closest support and resistance levels or significant price swings.

  • Stop Loss

Upon confirming the setup, traders set a stop-loss order for effective risk management. For bullish engulfing, traders usually place it below the second candle's low; for bearish, above its high. This safeguards against unwanted market reversals, minimising potential losses.

Live Market Example

Using the TickTrader platform, let's delve into a real-time instance to better grasp the topic.

Bullish engulfing: On the GBP/USD chart, a bullish engulfing formation is evident, signalling a prime buying juncture for traders. The petite red candle indicated a market downturn, but it was swiftly overshadowed by the subsequent green candle. This larger green candle fully encapsulated the prior red one, heralding the start of a bullish phase.

Such a change denoted the fading of sellers' hold and the onset of vigorous buying activity. Traders could have set their profit targets at the closest resistance level or the point where the preceding bearish wave had its inception. The stop-loss level could have been placed below the low of the bullish candle.

Bearish engulfing: The chart depicts an uptrend capped off with a diminutive green candle, soon overshadowed by a subsequent larger red candle, marking the onset of the bearish engulfing pattern. This prominent red candle signalled a cessation of the prevailing uptrend and ushered in a downturn.

This change can be attributed to an influx of sellers exerting downward pressure on prices. In reaction to this, traders, anticipating further decline, drove down prices.

For optimising potential gains, traders might set their profit targets at the closest support or at the juncture where the earlier upward-facing trend was ignited. A stop-loss level could be placed above the high of the bearish candle.

Conclusion

Engulfing patterns are indispensable tools in a trader's arsenal, shedding light on imminent trend shifts in the market. Grasping the nuances of both bullish and bearish formations equips traders to make judicious choices regarding trade entries and exits. For those poised to embark on this trading journey, consider opening an FXOpen account. With FXOpen, you're not just gaining access to a trading platform but also a wealth of resources and expertise to refine your trading acumen and effectively navigate the intricate world of finance.