Engulfing Candles - Part 2/2

SUBJECT SUMMARY

Candlestick Charting

The open and close set the top and bottom of the body of the candle. The high and low are drawn as a single line above and below the body. Up days are clear and down days are filled in on most computer candlestick charts. These charts are excellent for showing relationships between clusters of down and up days. This in turn helps to understand how the forces of supply and demand are balanced. There are many candlestick chart patterns, most with exotic names like Three Crows, or Dark Cloud Cover. These names are aides to recognising the pattern relationships.

When we move beyond simple pattern recognition, the full power of candlestick charting is revealed. These charts can be used to provide important details about the emotional state of the crowd and the psychology of the market.

Many traders find the “leading indicator” quality of candles and candle patterns, and the exquisite sensitivity of candle trend detection and analysis methods, to be superior in many ways to most Western methods of technical analysis. Steve Nison has stressed the importance of combining the Far Eastern candle methods with the Western methods of technical analysis.

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Candlestick charts offer a distinct advantage over the conventional line charts, or even the standard bar charts, since the structure of the Candlesticks form certain patterns, which give vital clues of the price movement. It is well worth studying the numerous Candlestick patterns, as it can give an extra edge to the trader. Last week we examined the “Engulfing” pattern, which is one of the most reliable patterns of the Candlesticks.

The “Engulfing” pattern is a reversal pattern, which usually occurs at the end of a trend. This pattern generally indicates a trend reversal and subsequently the beginning of the opposite trend.

In the previous article we looked at identifying and pinpointing high probability ‘Bullish and Bearish Engulfing’ patterns.

Now, once we have a confirmation of the Bullish engulfing pattern, what should be the ideal entry point for the trade? For that, we look at another Candlestick pattern called the “Three Outside” pattern, which is a more reliable addition to the standard Engulfing pattern.

A “Bullish Three Outside Up” pattern is identified as follows - (simply reverse the rules for a “Bearish Three Outside Down” pattern)

• A bullish Engulfing pattern occurs in the first two days

• The third day is an up closing day with a higher close than the second day

• The third day then becomes the confirmation of the bullish trend reversal.

This effectively means that the Bullish engulfing pattern is a very strong indication of a change to the uptrend, and the next higher close day is the confirmation. Hence the Bullish engulfing bar by itself would be a very effective point for an entry and stop. Thus we can place our entry order above the high of the bullish engulfing bar, and place the stop beneath the low of the same bar.

The drawback is that since the bullish engulfing bar is a wide range bar, the stop would be very far from the entry, thus exposing a larger than required capital in the trade. Following the price movement with trailing stops would be one way of controlling the overall risk.

But we could follow another method to reduce our risk, while keeping the rewards unchanged. Basically this method looks to get a head-start into the pattern. This would take some effort, but the rewards can be great. Now there is no way to know what day will turn into an engulfment day, but by monitoring the price action on the open we can prepare ourselves.

For a Bullish Engulfing trade -

1) If the previous bar has closed down relative to the open.

2) If the open of the current bar is lower than the previous bar's close, then place a buy stop order above the previous bar's open.

3) If filled, place the protective sell stop order below the current bars low.

4) If price does not close above the purchase price, exit the position on the close and repeat for the next bar.

The advantage is that we are filled in the trade at a better level, thereby reducing our risk vis-à-vis the entry and stop. And if at all, the engulfing bar does not form and price continues with the downtrend, then our order does not get filled. The exit of the trades cannot be clearly defined, and it depends on ones personal choice of conditions for the same. But we can be assured of a sizeable movement in price from this pattern. So taking profits at mid levels, and following the price with a trailing stop would be the best option.

Bullish and Bearish Engulfing Setups (with the early 'Head Start' entries)

This daily chart of the AUD has both the situations of the bearish and bullish engulfing bars.

(Hence the chart is looking a little crowded - we have a long trade and a short trade, with all the conditions marked on it.)

The bullish engulfing bar had a larger range as compared to the previous 5 days, and we had price forming lower highs prior to the engulfing bar. As observed earlier, this price action is like a coil which springs out as soon as the previous bar high is taken out. The regular entry to the trade is marked, as well as the early “Head-Start” entry - which we could have anticipated - which shows the sizeable difference between the two entry levels.

The exact same conditions appear on the short trade, thereby demonstrating the effectiveness of this pattern.

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Article as published in the Guppytraders.com weekly newsletter, November 4th, 2006 edition.