These can be useful buy signals. But in order to trade them we have to be able to recognize the reliable patterns from the many false ones.
Definition of a Bullish Engulfing Candle
A bullish engulfing pattern appears when a long white candle follows a shorter black candle. The white should completely engulf the bearish (black) candlestick from top to bottom. This means the top of the white candle should be above the top of the black one and the bottom of the white candle should be at or below the bottom of the black candle.
The bottoms of the candles might be the same if there was no gap between close and open. But if the bottom of the white candle is below the black this means there was a price gap between the close of the black and the opening of the white candle.
That could happen if the market was moving very fast. This could suggest a capitulation as buyers are panicking to close their position.
A gap can also happen, and is likely, if the market closes between the open and the close of the two candles. This would happen over a weekend.
What Does a Bullish Engulfing Mean?
The engulfing pattern means that bulls used the market low as a buying opportunity. A large white candle suggests this was a sudden and decisive shift to bullish sentiment.
It is one sign that market sentiment may have turned bullish. Or at least has during the interval of the candle.
We have to keep in mind though that one candle is just a brief snapshot of the market. Like the other candle patterns, we need to use discretion when using it as a signal to trade on.
When is the Bullish Engulfing Pattern a Reliable Buy Signal?
It’s not enough to trade on a single candlestick just because it happens to be an engulfing pattern. Back testing on various markets shows this simple kind of strategy doesn’t work.
To create a reliable trading rule we need to look for other indications that sentiment is turning bullish. An engulfing pattern is just one part of the analysis.
Before accepting the engulfing candle as a potential buy signal a trader will look at the following:
- Position of candle within the trend: Where is the pattern within the down trend? Does the candle form a deep low? A bullish reversal is more likely if the bearish trend is already oversold. Bullish engulfs are also common once an uptrend gets underway.
- Size of the engulfing candle: Is the engulfing candle much longer than the average length of the trailing candles? If it is it suggests that sentiment turned bullish quickly and decisively.
- Support lines: Did the engulfing candlestick rebound from a key support such as a long term trend line or horizontal low? If the lower shadow pierced the support line but rebounded there could be further strong upward momentum because it suggests there was a capitulation.
As an example, take a look at the chart above. It shows the EUR/USD daily chart (D1). The red box outlines a strong bullish engulfing candle.
- It’s a strong engulfing candlestick in terms of its size. There’s was a quick flip from bearish to bullish sentiment.
- The engulfing candle marks a deep low within the trend.
- It pierces a long term trend support line, yet the market rebounds strongly.
In the example, the market is oversold. When sentiment turns bullish, those who are short the market will need to buy back their positions at the earliest. So this suggest some further upwards momentum could be in store.
Waiting for Further Confirmation
With bullish engulfing candles it’s normal to see some pullback right after the pattern forms. If you look at the chart above, the next two candles are bearish. And the market gives back some of the gains.
If you wait for two or three bars to complete, this will help you to assess which side the strength is on. A short pullback can create a better buy opportunity. If the next couple of candles give up more than half of engulfing candle then it’s probably wise to wait.
In the EUR/USD example above the price has to overcome a strong resistance line. A day trader would probably use that as a profit target. A trader with a longer term outlook would probably wait for that resistance line to break through as it does in the next upswing.
See next the bearish engulfing pattern.
This ebook is a must read for anyone using a grid trading strategy or who's planning to do so. Grid trading is a powerful trading methodology but it's full of traps for the unwary. This new edition includes brand new exclusive material and case studies with real examples.