The bullish engulf is meant to signal a bearish trend that’s about to turn upwards. Whereas the bearish engulf is meant to signal a bullish trend that’s about to fall. Sounds simple enough.
You may have seen some of the countless articles on the web declaring engulfing strategies are a sure bet and offer high probability trade opportunities. But does this approach really work? In this article I will do a thorough analysis of the data to prove if this method really stacks up. The results may surprise you.
What is an Engulfing Candle Pattern?
Let’s first look at what an engulfing pattern looks like. A bearish engulfing pattern as shown in the diagram below is where the current candle completely “engulfs” the candle before it. By engulf that means the top and bottom of the engulfing candle are above and below the top and bottom of the engulfed candle respectively. The engulfed candle must be bullish. That means the close is higher than open. The engulfing candle must be bearish. That means the close level is lower than open.
The bullish engulfing candle is just the opposite of this. That means the engulfing candle is bullish and the engulfed candle is bearish.
An extension of the basic engulfing pattern is where the engulfing bar must engulf multiple trailing candles to be considered valid. The size of the engulfing candle can also be used as a filter as can the “depth”. Smaller engulfing candles are seen as less likely to signal a strong reversal and are therefore filtered out.
Analyzing the Engulfing Pattern
The basic question I am trying to answer here is whether this pattern actually signifies anything at all or if it’s just noise.
To do this I will look at the currency majors to find all engulfing patterns over a ten year period. I will then measure the corresponding market fall or rise if there was one just after the signal appeared.
By doing this we will see objectively if this pattern can be profitably traded – or if trading it is no better than flipping a coin.
Measuring correction size
To start with I’ll define how I will measure the size of a market correction.
To detect an engulfing candle, both the open and close levels must be set. In other words the candle must be complete. This means any engulfing bar detector will lag by one bar at least. Therefore the earliest point at which a trade can be executed is at the open of the next bar.
To measure the correction I use the following values:
- Open: The trade entry price is taken as the open price of the first bar following the engulfing signal
- Period high: This is taken as the highest price reached over a set number of bars
- Period low: This is taken as the lowest price reached over a set number of bars
The correction size is then:
The “correction review period” is the number of bars ahead of the engulfing bar over which the correction is measured.
Data and setup
The data covers a ten-year time period for the following currency pairs: USDJPY, EURUSD, GBPUSD, USDCHF, USDCAD, and AUDUSD.
The results presented here are for the M5 chart (five minute bars). I did some tests on other time frames but the results were broadly similar. So for the purpose of this article all results I refer to are for the five minute chart.
I used a correction review period of 30 bars. I chose a narrow window to measure the correction size to make sure the effect was attributed to the engulfing candle and not some other event.
I used a Metatrader engulfing bar detector to find the signals. You can freely download and use this indicator yourself and confirm the results. I set the minimum threshold engulfing bar length to 40 points and I set the minimum number of “engulfed bars” to 1 bar and depth to zero.
Again I experimented around with these settings but found very similar results. So for the sake of brevity I haven’t included variations with different data or settings.
Going through every point in the market data, I classified each bar as follows:
- Case 1: Bullish engulfing candle – conventional buy entry point
- Case 2: Bearish engulfing candle- conventional sell entry point
- Case 0: Random candle – no trade
I then aggregated all of the results into one data set covering the ten years’ worth of data for each pair. This set includes over five million individual candle measurements.
I include the random case so that the results of the engulfing patterns can be completely isolated from any background trending bias.
Figure 3 below shows the distribution of corrections following a random candle (case 0). As you can see the results are highly symmetrical and very clearly normally distributed. This is as expected. The black bar shows the zero point – correction size 0%.
In actual fact the data does contain a very small downward trending bias (of 0.55%). That is 49.45% of random candles were followed by upward corrections and 50.55% of candles were followed by downward corrections.
This is coincidental. There were more downward corrections than upward just because of the period that was covered and the markets studied. This means just by chance there would be a higher probability of picking a candle that resulted in a downward correction. So this effect has to be taken into account.
The trend bias was normalized out of the analysis by shifting the distributions accordingly. So we are then left with the true signaling strength of the engulfing bars. The normalized data for the whole set is shown in the table below:
The results above show there was a 48% probability of an upward correction following a bullish engulfing pattern. There was a 52% probability of a downward correction following a bullish engulfing candle.
For the bearish pattern, the situation was virtually the reverse. A bearish engulfing candle had a 51% probability of being followed by an upward correction and a 49% probability of being followed by a downward correction.
The histograms for both cases are shown in Figures 4 and 5 below. Again the black bar denotes the center line. The histogram for the bullish pattern is skewed to the left. This means a downward correction is more probable following this candle pattern.
The histogram for the bearish pattern is the mirror image. It’s skewed to the right. This means an upward correction is more probable following the bearish engulfing candle.
Based on this experiment, the bullish engulfing pattern does seem to be a slightly stronger contrarian signal than the bearish.
Individual Currency Pairs
When looking at individual currency pairs the results were even stronger and remarkably consistent. This suggests the effect wasn’t down to a couple of outlier currencies skewing the result. All pairs tested individually show the same contrarian bias as the entire set and some were much stronger than others.
The table below shows the results for the bullish engulf pattern on individual currency pairs.
|Bullish engulfing||p(up| bullish candle)||p(down | bullish candle)|
With USDCAD for example there’s a 5.6% difference between the probability of a downward correction and an upward correction following the bullish candle pattern. The probability of a downward correction following this bullish signal is significantly higher. A result that contradicts the way most people trade these events.
The table below shows the results for the bearish engulfing pattern on the respective currency pairs.
|Bearish engulfing||p(up| bearish candle )||p(down | bearish candle)|
Again notice the consistent “contrarian bias”. In other words doing the opposite of conventional wisdom would be the most profitable strategy.
Figure 6 below shows the two probability distributions for USDCAD overlaid on one another. The red line is for the bearish engulfing pattern and the green for the bullish engulfing pattern. What this diagram shows is that an upward move is more likely following a bearish candle and a downward move is more likely following a bullish candle.
The arrows show the two modal points for the two distributions.
Figure 7 shows the same diagram but for GBPUSD. Again the result is broadly the same as it was for other currency pairs.
All experiments I did favored the contrarian trade. In fact I didn’t find any pairs or setups that proved that the conventional trade worked.
I also found that the stronger the engulfing signal the more contrarian it was. That is, the stronger an engulfing candle was, as measured by size and depth, the more likely it was to signal trend continuation and not reversal. There may be a tipping point about which a bull or bear engulfing candle is strong enough that it does indeed follow the norm but I didn’t discover any evidence of it in these experiments.
There’s also the argument that a human trader would be capable of using other cues and therefore better able to determine which patterns to trade. This might be true but it isn’t something that can be tested or proven easily.
If you’ve been trading engulfing patterns over the past ten years you’d certainly have done better going against the convention. That is, you’d have done better selling on the bullish engulfing candle and buying on the bearish engulfing candle. That’s at least on the pairs I’ve looked at and probably others too.
What this says is that picking trend reversal points is hard. And in fact there’s a slightly higher probability that you’ll be wrong in timing a trend reversal using conventional approaches. This analysis shows there are better odds trading the other way.
The question is whether or not a 2% or 3% advantage can be turned into real profits after spreads and slippage are taken into consideration. Given that over the long run most trading strategies have close to even odds (50:50 win ratio for an equal amount of risk and reward) it would seem that this method could be useful.
It would be interesting to see what happens when engulfing bar analysis is combined with other signals, for example other trending indicators. Possibly we should be viewing engulfing candles not as signals of trend reversal but rather as markers of trend continuation instead.
You can download the engulfing bar detector here.