What is an Engulfing Pattern?
Engulfing pattern, or engulfing candlestick pattern is a technical chart pattern that signals a potential reversal in the current market trend. These patterns are extremely important in price-action analysis, as engulfing patterns enable traders to enter the market, while anticipating the direction in which the market is likely to move. An engulfing candle pattern involves two candles, and the movement in the price of assets is shown graphically using a candlestick chart.
An engulfing pattern is formed by using two candles, with the first candle “engulfed” by the second candle on the chart. Furthermore, in order to obtain a valid engulfing pattern, it is imperative that the first candle completely fits within the body of the next candle. If the engulfing candlestick pattern appears on the chart while the price is increasing, it suggests that a top might be forming, while the appearance of the engulfing pattern when the price is in downtrend suggests that a bottom might be forming.
What are the Types of Engulfing Patterns?
Based on where the engulfing candle forms in relation to the current market trend, there are two types of engulfing patterns: Bullish engulfing pattern and Bearish engulfing pattern.
Bullish Engulfing Pattern
A bullish engulfing pattern is a reversal pattern consisting of two candles, with the latter completely engulfing the first candle, regardless of the length of tail shadows. Furthermore, a bullish engulfing candle also gives the clearest signal when appearing in a downtrend, which suggests an uptick in buying pressure. A bullish engulfing pattern indicates the entry of more buyers into the market, thus driving up the price. It often triggers a reversal of the existing market trend.
Traders generally enter long positions when the price opens lower than the previous low, and moves higher than the high of the second engulfing candle, which confirms the downtrend reversal.
Bearish Engulfing Pattern
A bearish engulfing pattern is the opposite of the bullish pattern, and provides the clearest signal when it appears during an uptrend. The pattern suggests an abatement of buying pressure, and an uptick in selling pressure. The pattern involves two candles, with an up candlestick engulfed by a large down candlestick. A bearish engulfing pattern indicates the entry of more sellers into the market, thus driving down the prices. Therefore, it often triggers a reversal of the existing market trend.
In the image shown above, the candle being ‘engulfed’ is bullish, while the engulfing candle is bearish. The bearish engulfing pattern indicates that the selling pressure will overcome the buying pressure, with the market closing below the open of the day prior, predicting a reversal in the market trend.
Key Differences Between Bullish Engulfing Patterns and Bearish Engulfing Patterns
Bullish engulfing pattern is the opposite to a bearish engulfing pattern. In a bullish engulfing pattern, the first candle in the two-candle pattern is a down candle, with the second candle being a larger up candle, with its real body engulfing the first. In a bearish engulfing pattern, the first candle in the two-candle pattern is an up candle, with the second candle being a larger down candle, with its real body engulfing the former, suggesting a reversal in the market trend.
Importance of Engulfing Patterns
Engulfing patterns enable traders to predict trend reversals, provide them with an indication about the trend continuing or give them an exit strategy.
Trend Reversal: Predicting trend reversal enables traders to enter the market at the best possible time while anticipating a potential reversal in the market trend and see the trend through to the end.
Market Trend Continuation: Traders can also use the engulfing candle pattern to predict the continuation of the current trend. For instance, traders can use the engulfing candlestick pattern to spot a bullish or bearish pattern during an uptrend or downtrend and predict the continuation of the existing trend.
Exit Plan: If a trader holds a position during the existing trend, the engulfing pattern can be utilized as a signal to exit the trade if the engulfing pattern indicates that the trend is coming to an end.
Limitations of Engulfing Patterns
While engulfing candlestick patterns are powerful tools which can indicate a trend reversal, they needn’t always be accurate. Furthermore, engulfing patterns as analytical tools are extremely useful following either a clean upward or downward price movement, with the pattern showing a clear shift in momentum. However, if the price action is choppy, even if the price is either increasing or decreasing, the importance of engulfing patterns is reduced, as the price movement is looked at as a fairly common signal.
Engulfing candlestick patterns also do not provide price targets, and traders must rely on other indicators which help them in determining when to exit a profitable trade.