Engulfing Patterns: Visual Signals to Buy Low, Sell High

[RichardCox 10]

Engulfing Patterns: Visual Signals to Buy Low, Sell High

 

Any trader that is interested in “buying low, and selling high” will need strategies to help identify when major price moves (either bullish or bearish) are establishing themselves in the early stages. Of course, all traders should be looking for areas to buy low, sell high -- and one of the easiest ways of successfully entering into trending positions is through the use of “engulfing patterns.” These candlestick patterns can be seen as major trends have reached an exhaustion point, as prices enter into oversold/overbought territory in preparation of a major trending turnaround. These turning points mark the “high” and “low” points in the all-important trading maxim, and for these reasons, engulfing patterns should be utilized as part of regular trading routines.

 

Defining the Engulfing Pattern

 

Specific definitions for engulfing patterns can, to some extent, vary from trader to trader. But the essence of these patterns requires a significant difference in the size and direction of consecutive candlestick periods. In a bullish engulfing pattern, a small negative candlestick will be followed by a much larger positive candlestick, which can be said to eclipse (or “engulf”) the previously bearish price activity. In the first charted example, the prior (negative) candle is shown in in black, next to a much larger positive white candle. In an ideal case, the shadows (or “candle wicks”) will be relatively small as this indicates a stronger close and better bullish momentum. In either case, the candle body of the large candle must completely cover (and extend past) what is seen in the previous bear candle.

 

In a bearish engulfing pattern, a small positive candlestick will be followed by a much larger negative candlestick, and will engulf the previously bullish price activity. In the second charted example, the prior (positive) candle is shown in in white, next to a much larger negative black candle. Stronger momentum is seen when the candle wick in the later candles are short, as this implies a weaker close and less evidence the market is ready to push prices higher. As with the bullish pattern, the candle body of the larger candle must completely cover (and extend past) what is seen in the previous bull candle.

 

Pattern Variations

 

The above definitions of the pattern outline the basics of the engulfing structure. Where traders start to differ will be in the length of the candles themselves. For example, one trader might require the reversal candle to be twice the size (or even larger) when compared to the trend-ending candle that preceeds it. Other traders might look for the reversal candle to be simply larger than the trend-ending candle. The method you choose when spotting these reversals will have some key differences for the trades you eventually place.

 

For example, it is much more rare to see extreme reversals, signified by engulfing candles that are 3 or 4 times the size (or larger) when compared to the trend-ending candle. Because of this, you will receive fewer trading signals. It will also be more difficult to get in near the lows (for long positions) or near the highs (for short positions), and this does take away some of your ability to “buy low, and sell high.” At the same time, however, the signals that you do receive will indicate much stronger momentum is in place, and these are the situations that will create the best follow-through for your positions. This essentially means you will have a better win-to-loss ratio, as well.

 

Alternatively, traders can opt for smaller-sized engulfing patterns as the basis for long and short decisions. This type of approach is better for more active, higher frequency traders that are able to monitor their stations with better regularity -- as this approach will result in a larger number of total signals sent. The main advantage of this approach is that you will be able to buy-in closer to the lows, and sell closer to the highs. But at the same time, you will need to keep your stops tighter, as the quality of these signals will be lower (along with your win-to-loss ratio). In both of these approaches, there are advantages and disadvantages, so the path you choose will depend on your normal trading behaviors, and your overall risk tolerance.

 

Continuations

 

Once an engulfing pattern is recognized, the central expectation is that prices will continue in the direction of the engulfing candle. Because of this, it becomes clear very quickly if the pattern is failing, or was never really valid in the first place. With this in mind, we must start with a definition of a proper continuation, as this will allow us to see whether or not we should stick with the trade that was generated by the original pattern. For long positions, the bullish engulfing pattern should be followed by three bull candles, all with higher lows and higher closes. For short positions, the bearish engulfing pattern should be followed by three bear candles, all with lower highs and lower closes.

 

Of course, this definition can be tweaked as more conservative traders might want to see a larger succession of candles that post in agreement with the direction indicated by the original engulfing pattern. But in the third charted example we will use this “rule of three” to show examples of failed engulfing patterns. In the third charted example, we can see an example of a bullish engulfing candle that fails to result in a reversal uptrend. The initial bull candle is not followed by three positive candles, but instead shows an immediate bear candle. This should be viewed as an immediate signal that the original pattern will fail, and this in fact does happen as a downtrend later emerges.

 

To avoid losses, traders could have closed the position as soon as the next candle closing did not agree with the original signal. In the fourth charted example, we see a similar situation for bearish engulfing patterns. Here, we see only one following candle in agreement with the original signal, and this is then followed by a series of higher lows that invalidates the original signal. This should have been a clear sign for those in bear positions to close those trades.

 

Conclusion: For Reversal Traders, Engulfing Patterns Can Send the Earliest Signals

 

Bullish and Bearish engulfing patterns should be viewed as an easy tool to use when looking to buy low, and sell high in reversal trades. These patterns are easy to visualize and can be tailored to meet your individual trading style in active positions. Depending on your tolerance for risk, and your overall balance as a conservative or aggressive trader, there are strategies that can be implemented in order to meet those needs.

 

Stop losses can either be manual (as positions are closed after patterns fail) or above/below the high/low of the candle that immediately precedes the engulfing pattern. The logic here would be seen in the fact that any moves above or below these prior areas would signal momentum is not reversing and invalidate the idea behind the original trade. Engulfing patterns are relative easy to not only grasp but to actively manage once positions are opened, and these signals are often one of the first signs that one trend has completed and another is beginning.

[handle 10]

On your second chart, it does not appear that the candle the green arrow is pointing to is an engulfing candle. It has a lower low but now a higher high. Is that correct?

 

Thank you.

[Rashedbgd 10]

Very nice logic. I will try to implement this logic....!!!

[RichardCox 10]

On your second chart, it does not appear that the candle the green arrow is pointing to is an engulfing candle. It has a lower low but now a higher high. Is that correct?

 

Thank you.

 

 

Handle, very good eye. Technically you are correct, but it is very close and I was using that graphic more as an example of what a failure looks like rather than a textbook engulfing pattern. I

[mslezak 10]

So programming this in to find the engulfing pattern at a high or low.... What's an easy indicator to use? Low = min[30 bars] High = max[30 bars]? Easy to see on a chart but more difficult to program.

 

Besides that, how about a volume or volatility indicator to confirm the reversal? AvgTrueRange for volatility and StandardDeviation(volume[30 bars]) > 2 or something.

 

Thoughts?

[RichardCox 10]

So programming this in to find the engulfing pattern at a high or low.... What's an easy indicator to use? Low = min[30 bars] High = max[30 bars]? Easy to see on a chart but more difficult to program.

 

Besides that, how about a volume or volatility indicator to confirm the reversal? AvgTrueRange for volatility and StandardDeviation(volume[30 bars]) > 2 or something.

 

Thoughts?

 

Higher trading volumes always suggest more valid technical patterns because a larger section of the market is present when the patterns occur.