Like the name if this article suggests, the topic this week will be related to Japanese candlestick techniques, namely how to trade a bullish or a bearish engulfing.
Before even starting, it goes without saying that one should have a candlestick chart plotted on the screen, otherwise there is no point in applying such strategies.
As mentioned on previous articles dedicated to the subject here on ForexGator.com, a candlestick has two parts, the body and the shadow, and it can be either bullish (mostly shown with the color green on charts) or bearish (red). In the case the candle has no body, but a simple line, it is being called the market formed a doji candle. More about this in future articles.
Coming back to the subject of this article, a bullish engulfing pattern is forming at the end of a bearish trend, so it is mandatory to have a steady bearish trend before looking at such a reversal pattern. Like any reversal pattern, it is showing a battle between bulls and bears so it is rare when bears will not try to take the lows of the pattern.
The engulfing pattern is formed out of two candles, one red and one green (bullish engulfing) and one green and one red (bearish engulfing). The whole idea of the pattern comes from the second candle’s body that needs to fully engulf the previous candle’s body (not the shadow!!!).
If you compare the engulfing pattern with the piercing one, you’ll see that actually the difference between the two comes only from the fact that the second candle is not fully engulfing the previous one.
However, when it comes to interpretation, it should be noted that the engulfing pattern is way more powerful than the piercing one.
Because there is a strong battle between bulls and bears, it is advisable to wait for a retracement after the second candle closes before entering the market. Some people wait for the golden ratio (61.8%) retracement to come before entering, others for the 50%….but it should be noted that there is not a strict rule, as sometimes there is simply no retracement at all when the reversal is caused by fundamental news for example.
A very good question is what follows after such a pattern? In terms of Elliott wave theory, usually an impulsive wave ends with an engulfing that either makes a new high or a new low, so look for a healthy correction that in most cases should go minimum 38.2% retracement of the whole previous trend. And that is given only by two candles. That power is the engulfing pattern.
The example below shows a bearish engulfing pattern forming after a bullish trend, and by the time the second candle closes, it is advisable to wait for a pullback, with the entry being given by a Fibonacci retracement level.
The first pullback into the 50% retracement level comes right with the first candle after the engulfing pattern, and even 61.8% comes one candle later, rewarding the more conservative traders as well.
Needless to say the trend that starts is a powerful one to the opposite direction as these engulfing patterns are a sign of countertrend strength.
The stop loss is mandatory to be at the highest value of the engulfing pattern as at certain times bulls are fighting their way back into the trend. However, with the entry being at the 50% or 61.8% retracement, the risk is worth the trouble and it is recommended to stay for at least 1:5 risk reward ratio.
A bullish engulfing is exactly the same, with the remark that the pattern is forming after a bearish trend and in the example below the very first candle after the engulfing takes place giveing us the entry on the 50% retracement level.
However, in this case, there is no 61.8% dip so conservative trades most likely will miss this trade. Same rules apply here as well: stop loss at the lows of the engulfing pattern and a minimum 1:5 risk reward ratio should be considered.
In order to fully appreciate the importance and power of this reversal pattern, one should look on the bigger time frames like daily, weekly and monthly charts, and wait for an engulfing pattern to form, measure the length of the second candle and then place pending orders to entry into a trade.
It is a simple strategy, works without the need to stare at the screens all day and, more importantly, extremely rewarding.
Next article here on ForexGator.com will deal with the same topic, Japanese candlestick techniques, only that we will discuss the multiple types of a doji candle, as well as their interpretation.