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Bullish and Bearish Engulfing Pattern

Engulfing pattern are potent change in trend indicators, especially when occurring during an exhausting trend. A bullish engulfing pattern consists of a wide-spread, green candle body that encapsulates the red candle body preceding it. This pattern is a strong potential change in trend indicator when forming during an exhausting downtrend, but can also form during an uptrend as a continuation signal. For a bullish engulfing pattern to be constituted as valid, two objectives must be fulfilled. The opening of the engulfing green candle must extend under the close of the preceding red candle, and the closing price of the engulfing green candle must close above the open price of the red candle. This pattern is more potent when the engulfed candle is of a narrow-spread, and the engulfing candle has a wide-spread. Two small candle bodies can technically form an engulfing pattern, although we want to see a considerable shift in buying/selling. An engulfing pattern consisting of two narrow-spread candlesticks is not indicative of strong sentiment countering the predominant trend. A wide-spread candle can engulf another wide-spread candle and still be a potent signal.

The appearance of a wide-spread, green candle and a narrow-spread, red candle does not necessarily mean that a change in trend is forthcoming. We must understand the significance of the pattern. For the bullish engulfing pattern, prices closed lower on the first session, and then gapped down the next session to open at a lower price; supply exceeded demand at open. However, at this lower gapped-down price, demand (buying) increased substantially. Buyers controlled the market at this price and ultimately closed prices above the opening price of the initial red candlestick. This pattern indicates that demand is high at this lower price area. Unless the bears step up, prices are unlikely to move lower than this price area.

The bearish engulfing pattern has similar criteria, although a wide-spread, red candle body should engulf the preceding green candle body. For this pattern, the opening of the red engulfing candle must open above the close of the preceding green candle and then close below the open of that green candle. This formation is a strong change in trend indicator during an exhausting uptrend, but can also form during a downtrend and serve as a potential continuation indicator. To the competent trader, this pattern signifies that buying exceeded selling at the beginning of the period; however, sellers entered the market aggressively near the intrasession low to close prices higher. An engulfing pattern that is shaven (no wicks) contains even stronger reversal energy than one with wicks. This is because a candlestick with no wicks indicates strong pressure since prices opened on their high and closed on their low or opened on their low and closed on their high. For this to happen, buying or selling intensity must dominate the entire session.

Engulfing patterns generate more reliable signals when the initial candle body, the one that is engulfed, is of a narrow-spread, or even a doji. Remember, a doji or spinning top that forms during a trend reflects weakness. Now, if a bearish engulfing candle forms the subsequent session, we know sellers are entering the market aggressively at the price area.

A high volume bearish engulfing pattern is more likely to precede a complete reversal. However, we can’t confirm a reversal at its starting point; a high volume bearish engulfing pattern shouldn’t be considered a trend reversal. This pattern on high volume is telling us that a considerable amount of traders are going short at this price area. If doji or spinning top form during a downtrend and a bullish engulfing pattern forms subsequently, we can rationalize the downtrend is losing momentum and the bulls have entered the market more aggressively. Demand is increasing.

Figure 1.1 Bullish Engulfing Pattern

A picture containing chart

Description automatically generated Figure 1.1 illustrates a bullish engulfing pattern. An ideal bullish engulfing pattern should incorporate a wide-spread, green candlestick. Remember, the pattern is considered a bullish reversal signal; however, we should approach it as a change in trend signal. If the downtrend is going to change, we need proof buying intensity is strong enough to do so.

Figure 1.2 Bearish Engulfing Pattern

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Description automatically generated Figure 1.2 illustrates a bearish engulfing pattern. An ideal bearish engulfing pattern should incorporate a wide-spread red candlestick. The pattern is considered a bearish reversal signal; however, we should approach it as a change in trend signal. If the uptrend is going to change, we need proof selling intensity is strong enough to do so.

Figure 1.3: Valid Bearish Engulfing Pattern

Chart, bar chart

Description automatically generated (NYSE: K)

In Figure 1.3, the price movement of $K is uptrending. Price movement continues to rise until a doji and spinning top form, signaling weakness at the higher price area. A valid bearish engulfing pattern forms shortly after. It is now apparent that there is increased selling intensity at this price level, and a change in trend may serve as a consequence. Soon after that, prices gap down considerably and continue the bearish reversal.

We can see that a doji formed at the $71 price area and a spinning top formed the next session. Buying intensity is exhausted. A bearish engulfing pattern forms. Sellers are now entering the market aggressively at this higher price.

Figure 1.4 Example of a Bullish Engulfing Pattern

Chart

Description automatically generated (NASDAQ: ROKU)

In Figure 1.4, the price movement of $ROKU is downtrending vigorously until a low point is reached and prices begin to increase. In real-time, we would consider the price bounce to be a bullish retracement of the downtrend. Significant indecision can be observed after the low is reached as indicated by a long-legged doji. A bullish engulfing pattern then emerges a few sessions later and an uptrend sets in motion. The nearly shaven top indicates prices closed near the high of the session; buyers were aggressive throughout the session. In addition, the engulfed candle is of a narrow spread. The price movement subsequently gaps up and goes into a phase of congestion until another bullish engulfing pattern forms, and prices continue to ascend. Buyers are trading the market more aggressively than sellers at this lower price area. We can see that prices increased after both bullish engulfing patterns. The increased demand/buying intensity signaled that bears (sellers) are no longer in control at these particular price levels, and prices are unlikely to continue the downtrend.

Figure 1.5 Bullish Engulfing Pattern Precedes Bullish Retracement

Engulfing Pattern Bullish (NYSE: OC)

Figure 1.5 shows a bullish engulfing pattern that precedes a bullish retracement of the intermediate-term downtrend. Prices vigorously downtrend, achieving a new low until an average-spread green candlestick engulfs a preceding narrow-spread, red candlestick. Prices increase expeditiously; however, a dark cloud cover (bearish) forms at the top of increasing prices. A dark cloud cover is a bearish reversal candlestick pattern. Prices continue downtrending afterward to achieve a new low. Demand exceeds supply at this low and continues to do so, instituting a bullish reversal.

To be fair, the final price low, before the complete bullish reversal, incorporated a hammer candlestick (unmarked).

Figure 1.14 Example of a Bearish Engulfing Pattern

Chart

Description automatically generated (NASDAQ: EYE)

In Figure 1.14, the bearish engulfing patterns form at the top of transient price increases, preceding rapid declines. In real-time, the first two bearish engulfing patterns preceded a bearish retracement of the uptrend. In hindsight, we can see the patterns preceded an intermediate-term sideways market. Some analysts are skeptical of engulfing patterns that form during sideways markets. This skepticism is justifiable, but if an engulfing pattern forms near the highs (resistance) or lows (support) of a range it can be considered a reliable signal. Engulfing patterns forming in the middle of a sideways, range-bound market are generally unreliable.

Objectifying the Bullish and Bearish Engulfing Patterns

I highly advocate objectifying candlestick patterns, and testing them, before trading them.

Here’s an example of objectifying the bullish and bearish engulfing pattern.

Bullish Engulfing Criteria

  1. Previous session’s close <= Previous session’s open

(The engulfed candle’s close is less than or equal to the engulfed candle’s open)

2. Current session’s close > Previous session’s open

(The engulfing candle’s close is greater than the engulfed candle’s open)

3. Current session’s open < Previous session’s close

(The engulfing candle’s open is less than the engulfed candle’s close)

4. (Current session’s close – Current Session’s open) >= ((Previous session’s open – Previous session’s close)*2)

The difference between the engulfing candle’s open and close is double or greater the difference between the open and close of the engulfed candle)

5. (Current session’s close – Current session’s open) >= Average True Range

(The difference between the engulfing candle’s open and close is greater than or equal to the Average True Range)

  • The true range of a session is the greatest of the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close.
  • The Average True Range is a moving average of the true ranges. The moving average covers 14 sessions by default.

Bearish Engulfing Criteria

  1. Previous session’s close >= Previous session’s open

(The engulfed candle’s close is greater than or equal to the engulfed candle’s open)

2. Current session’s close < Previous session’s open

(The engulfing candle’s close is less than the engulfed candle’s open)

3. Current session’s open > Previous session’s close

(The engulfing candle’s open is greater than the engulfed candle’s close)

4. (Current session’s open – Current Session’s close) >= ((Previous session’s close – Previous session’s open)*2)

The difference between the engulfing candle’s open and close is double or greater the difference between the open and close of the engulfed candle)

5. (Current session’s open – Current session’s close) >= Average True Range

(The difference between the engulfing candle’s open and close is greater than or equal to the Average True Range)

Engulfing Pattern Coded

Figure 1.15

Engulfing Pattern Conditions

Figure 1.15 shows our criteria satisfied for the bullish engulfing pattern and bearish engulfing pattern. The ATR measurement displayed in the figure accounts for the bullish engulfing candle session. The open, high, low, and close price of the bullish engulfing candle are displayed in the top-left corner of the figure. Subtract the open price from the close price and compare the result to the ATR measurement.

The difference between the close and open was 0.56, while the ATR measurement was 0.51; Our ATR condition was satisfied. In addition, the engulfing candle body was 2x greater than the engulfed candle body. Condition #4 was satisfied as a result.

All criteria for the objectified bearish engulfing pattern were fulfilled in November; therefore, a short position was entered.

It’s important to objectify the patterns if we’re going to trade them. If we subjectively interpret each pattern we come across, we can’t test the reliability of the pattern. It’s better to know something doesn’t work than trading it unsubstantiated.

Backtesting our Objectified Engulfing Patterns

The backtest conditions incorporate an indicator discussed in our RSI article. For now, just know the indicator computes the average gain and the average loss over 14 sessions (default parameters). A measurement of 0 indicates there were no gains over the lookback period; prices moved lower each session. A measurement of 100 indicates there were no losses over the lookback period; prices moved higher each session.

RSI measures the magnitude of gains vs. losses over the lookback period. An RSI measurement greater than 50 indicates the average gain exceeds the average loss over the look back period. An RSI measurement less than 50 indicates the average loss exceeds the average gain over the lookback period. Simply put, RSI continuously closing above 50 means prices are increasing, while continuous closes below 50 reflect descending prices.

It’s theorized that RSI closing at, or above, 70 indicates “overbought” conditions; measurements at, or below, 30 indicate “oversold” conditions. Without getting too into detail, we can think of RSI closing below 30 or above 70 as an increased chance of a mean reversion, not necessarily a reversal. Therefore, our engulfing candle backtest requires RSI to close below 70 for long positions (bullish engulfing) and above 30 for short positions (bearish engulfing).

Requiring these conditions increases the chance we don’t enter at the close of a pattern that has a higher chance of subsequently reverting to the mean.

Let’s backtest our objectified engulfing patterns.

Entry Criteria (Long)

  1. RSI < 70 (RSI closes below 70)

RSI is less than 70. We’re requiring this condition be met to decrease the chance of entry immediately prior to a mean reversion.

  1. Bullish Engulfing Pattern forms

Exit Criteria (From Long Position)

  1. A 10% profit is achieved

Or

  1. A trailing stop of 5% is achieved

Or

  1. RSI > 70 (RSI closes above 70)

If RSI closes above 70, we’ll exit the position. For this backtest, we’re using RSI as a tool to avoid mean reversions. The indicator isn’t infallible, and there’s several methods to project a potential mean reversion. Therefore, we’re exiting when RSI closes above 70 to take-profit in anticipation of a mean reversion.

Entry Criteria (Short)

  1. RSI > 30 (RSI closes above 30)

RSI is greater than 30. We’re requiring this condition be met to decrease the chance of entry immediately prior to a mean reversion.

  1. Bearish Engulfing Pattern forms

Exit Criteria (From Short Position)

  1. A 10% profit is achieved

Or

  1. A trailing stop of 5% is achieved

Or

  1. RSI < 30 (RSI closes below 30)

If RSI closes below 30, we’ll exit the position. We’re exiting when RSI closes below 30 to take-profit in anticipation of a mean reversion.

Figure 1.16

Engulfing Pattern Criteria

Figure 1.16 shows our precisely defined entry/exit conditions being satisfied.

Figure 1.17 Sample Results

Engulfing Pattern Backtest

Figure 1.17 shows backtest results for our engulfing pattern strategy.

The Truth About Engulfing Patterns

Engulfing patterns are reliable/potent signals only when objectified with strict criteria. You’re going to see engulfing patterns form all over a chart without strict criteria and most will be inconsequential. I don’t advise subjectively interpreting each pattern. Doing so consumes time and it’s virtually impossible to know if you’re interpretation has a positive expected outcome without objectifying your interpretation and testing it.

Engulfing patterns are great exit signals for swing-traders and day-traders. If you’re long and a bearish engulfing pattern forms, you might exit your position. If you’re short and a bullish engulfing pattern forms, you might exit your position.

It’s imprudent to contrive a trading strategy predicated on candlestick patterns alone. In addition, candlestick patterns function better as exit signals rather than entry-points.

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Legal Disclaimer: The information contained in the article is not intended as, and shall not be understood or construed as, financial advice. The author is  not an attorney, accountant, or financial advisor, nor are they holding themselves out to be, and the information contained in this article is not a substitute for a professional who is aware of the circumstances and facts of your personal financial situation. 

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