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.
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. In these notes we examine 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.
We will look at the ‘Bullish and Bearish Engulfing’ pattern to get a better idea of this pattern.
A “Bullish Engulfing” pattern occurs when, during a downtrend, the price bar engulfs the previous price bar. Which means that the current bar’s open is lower than the previous bar’s close (the bar opens down), and its close is higher than the previous bar’s open (the bar closed up significantly).
We can put it briefly as –
1) Today's close is higher than yesterday's open.
2) Today’s open is lower than yesterday’s close.
3) Yesterday's close is lower than yesterday's open.
This signifies that the downtrend has lost momentum and the bulls may be gaining strength, which generally indicates a trend reversal up and the beginning of an uptrend. This bullish engulfment day will usually be a large range day compared with the previous few days.
The example shows the Bullish Engulfing bar, which gives a very good indication of a change in trend.
A “Bearish Engulfing” pattern occurs when, during an uptrend, a price bar engulfs the previous bar. Which means that the current bar’s open is higher than the previous bar’s close (the bar opens up), and its close is lower than the previous bar’s open (the bar closed down significantly).
We can put it briefly as –
1) Today's close is lower than yesterday's open.
2) Today’s open is higher than yesterday’s close.
3) Yesterday's close is higher than yesterday's open.
This signifies that the uptrend has lost momentum and the bears may be gaining strength, which generally indicates a trend reversal and the beginning of a downtrend. This bearish engulfment day will usually be a large range day compared with the previous few days.
This is a similar example showing the Bearish Engulfing Bar.
Now that we know what an Engulfing bar looks like, let us go a little deeper into the pattern to identify some crucial points for identifying this pattern.
Ideally if the following points are observed along with the Engulfing Bar, it increases the probability of the price following the rules of the pattern. These following points are just conditions, and should not be taken as written in stone. Since we can rarely expect perfect conditions in any financial market, the following should be taken as confirming factors after we identify an engulfing bar.
The Bullish/ Bearish engulfing Bar should be have a larger range when compared to the last 5 bars- at least. This generally holds true in case of the engulfing bars forming on the Daily time frame in currencies.
The bars prior to the Bullish Engulfment Bar should have lower highs leading into the Engulfment bar. These lower highs can be compared to a coil, ready to spring as soon as previous day's high is broken. Likewise the bars prior to the Bearish Engulfing bar should have higher lows.
If the same pattern shows up on different time frames, it becomes a powerful confirmation signal.
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.
We examine this pattern next week.
Article as published in the Guppytraders.com weekly newsletter, October 28th, 2006 edition.