Engulfing Candlestick Pattern: Overview with Trading Setup

The price movement of stock has always been a mystery for a trader. In order to solve this mystery, different traders or analysts have come up with different rational methods and tried to explain why prices moved in a particular direction.

The candlesticks were probably the first and most acceptable rational pictorial representation of price movement.

What are Candlestick Patterns?

As early as in the early 1600s, it was the Japanese people who developed a method of explaining the price movement in rice contracts prevailing at that time. Later Steve Nison made it popular. He is still considered one of the best persons to interpret candlestick patterns.

OHLC

The candlesticks are based on the OHLC data for a specific period of time. The data of opening price (O), highest price (H) for that period, lowest price (L) for the same period and closing (C) price for the same period.

The time period can be of any time, say 5 min, 10 min, 15 min, day, month – any time span.

Using these price data a candle is formed which are commonly known as candlesticks. As already discussed, a candlestick has four price components – the opening price, the highest price, the lowest price and the closing price.

When the opening price is lower than the closing price, the candle turns green and when the opening price is higher than the closing price, the candle turns red.

The candlesticks in themselves do not involve any calculation. The candlesticks are a true pictorial representation of price behavior for a particular time period.

Must read: List of Candlestick Patterns

Engulfing Pattern: The Basics

The word ‘engulf’ means to swallow something or to surround or cover something completely. As the word meaning implies, the engulfing pattern appears when one candlestick is so large that it completely covers the body of the other candlestick.

So in any candlestick chart, when we can see, between two consecutive candles, that the body of the bigger candle is so big that the length of the body of the shorter candle is well short of the length of the body of the bigger candle, we can say an engulfing candlestick pattern has been formed.

There are generally two types of basic engulfing patterns.

In the diagram above, we can see the body of the green candle is bigger than the previous red candle. So it is the green candle engulfing the red candle. This is a bullish engulfing pattern.

There is another type of engulfing pattern. Let’s see what it is.

In this diagram, we can clearly see, that it is just the reverse of the previous diagram. Here, the red candle completely engulfs the body length of the next green candle. This is a bearish engulfing pattern.

As they are opposite in nature, their interpretations will also be different.

Both of these are candlestick patterns. But they have different meanings. In the coming section, we will discuss the significance of these two types and where and when they can be used.

The engulfing patterns that we saw just now, are of two different types. One is known as the Bullish engulfing pattern and the other is the Bearish engulfing pattern.

The Bullish Engulfing Pattern

1. What is a Bullish engulfing pattern?

The bullish engulfing pattern is a combination of two candles. A red candle followed by a green candle.

The red candle is a bearish candle where the opening price of the candle is higher than the closing price of the candle.

As you can see, this pictorial diagram of the price trend suggests that there are a few characteristics by which one can identify the bullish engulfing patterns.

2. When the bullish engulfing pattern may occur?

There are a few prerequisites for this pattern to happen. They are –

1. The prior trend has to be a downtrend.
2. The opening price of the green (bullish) candle has to be below or near the closing price of the red (bearish) candle.
3. The body of the green candle should engulf the red candle. It means that the closing price of the green candle should be much higher than the opening price of the previous (red) candles.

3. How the bullish engulfing pattern occurs?

In this bullish engulfing candlestick pattern, there is a thought process that creates the background. Let us discuss them.

1. We take it as a precondition that the market is in a continuous downtrend. And the price steadily moves downwards.
2. On the way downwards, on the first day of the bullish engulfing pattern, the price makes a new low and closes further below, forming a new red candle.
3. Now, on the second day of the engulfing pattern, the stock opens near or below the price of the previous day’s red candle. After the stock opens, the stock price goes further below – showing that the bears are still strong and want to take the stock further below.
4. Interestingly, on the second day itself, at some point in time, the bulls return strongly. Bulls take the price far above the opening price of the previous day. The action of the bulls is very evident in the strong green candle.
5. Bulls charge fast and take the price strongly upwards, breaking the shackles of the bears.
6. Such strong and fast action makes the bear lose confidence in its action. Therefore they couldn’t bring the price down. That is the reason which makes the green candle very strong.
7. The strength of the bulls is such that the uptrend continues for a few successive trading sessions.

4. The trade setup for bullish engulfing pattern

If a trader can identify the bullish engulfing pattern and can interpret it correctly, there is a scope for a good trade setup. Let us discuss that.

1. It takes consecutive two full trading days for a bullish engulfing setup to emerge. Let us identify the first trading day when the candle is red as P1. And mark the other trading day, i.e. day two, the day with a green candle as P2.
2. On the second day, i.e. on P2, the closing price is much higher. The buying price of the stock should be near the closing price of P2.
3. The trade stop loss should be the lowest of the lows between P1 and P2.
4. Normally the trade is initiated on the third day after the engulfing candlestick pattern is confirmed.
5. A general thumb rule when trading candlesticks is – to buy on strength and sell on weakness.
6. If on the third day, the stock starts trading in the red, usually the risk-averse traders do not initiate trades. But, if the pattern develops and is confirmed over 2-3 days, it is worth taking a risk.
7. As already advised, the stop loss should be at the lowest low of these two days.
8. Once the trade has been initiated, a trader waits till the target is achieved or the stop loss is triggered. But yes, one can trail the stop loss to book profit early.

5. A practical example of the Bullish Engulfing Pattern

Now, we will see how a bullish engulfing pattern works practically. Shown below is the example of this candlestick pattern setup.

This is the chart of Nifty 50 on 28.04.2022. This is a 15 minutes chart of Nifty 50. The engulfing pattern developed between 10:30 to 10:45 hours.

The pattern has been shown by drawing a black circle over the pattern. As you can see, on the first candle, i.e. on P1, there is a red candle. But on P2, the move was strong. A big candle, which started just below the body of the red candle.

The P2 candle was so big that at one go it crossed the full body of the red candle and closed far above it.

This is a confirmed pattern. As can be seen from the picture, after the third candle, the uptrend continued and never did hit the stop loss.

On the third candle, there was a red candle. But the candlestick was small and never went below the low of previous candles. The third candle opened near the closing price of the candle of the second candle, the P2 candle.

The trader would initiate buy on the third candle when the price opened near the high of the previous candle.

After initiating trade near the high of the third candle, the traders wait. As this is a confirmed uptrend or bullish trend, the trader waits for the stop loss. Else a trailing stop loss can be maintained till it is breached.

Here is another example of the bullish engulfing pattern. It is a daily chart of Reliance Industries Limited. We can see the candlestick chart and the RSI below it.

Trend reversal indicator

Here the bullish pattern develops after a long downtrend. RSI also shows that after the long-selling spree, the price enters into an oversold zone. During that period itself, the bullish engulfing pattern occurs. Here also, the second candlestick engulfs the body of the red candlestick, the P1 candle.

Here, in the second example, after the trader takes up a buy position, the stop loss was never hit. The trader can easily maintain a buy position with peace and take profit after the uptrend is broken decisively.

There is one important point to note. If we watch both charts closely, we can see the bullish engulfing pattern occurs after a downtrend. This indicates a trend reversal for the short term. This can be also used as an important indicator for short-term trends reversal indicator or downtrend reversal indicator.

The Bearish Engulfing Pattern

The bearish engulfing patterns are just the reverse of the bullish reversal patterns we discussed earlier.

1. What is a bearish engulfing pattern?

The bearish engulfing candlestick pattern is also a combination of two candles. Here, a green candle is followed by a red candle. The first green candle is a bullish candle. The second candle is a red candle. It is a bearish candle where the opening price of the candle is higher than the closing price of the candle.

As it can be seen, this pictorial diagram of the price trend suggests that there are a few characteristics by which one can identify the bearish engulfing patterns.

The key point of a bearish engulfing pattern is that it suggests that a bearish trend is about to come in short term. It is more effective when this pattern occurs at the very end of an uptrend. But in a choppy market, such a pattern has not much significance.

2. When the bearish engulfing pattern may occur?

There are a few prerequisites for this pattern to happen. They are –

1. The prior trend has to be an uptrend.
2. The closing price of the green (bullish) candle has to be below or near the opening price of the red (bearish) candle.
3. The body of the red candle should engulf the body length of the green candle. It means that the closing price of the red candle should be much below the opening price of the previous (green) candles.

3. How does the bearish engulfing pattern occur?

As already discussed, we consider some preconditions for this pattern to occur.

1. The market should not be choppy. Because in choppy conditions, the pattern doesn’t have much significance.
2. The pattern is most effective when the market is in a continuous uptrend. The price of the stock was moving steadily upwards.
3. On the first candle, on P1 there is a green candle.
4. On the second day/ candle, i.e. on P2, there is a big red candle that engulfs the body of the green candle.
5. From this point, the market trend reverses and a new downtrend may occur.

4. The trade setup for bearish engulfing trade

As in the previous case, a trader has to identify the bearish engulfing pattern and interpret it correctly, before making a good trade out of it. Let us discuss.

1. This pattern, if occurs at the end of a good bull run, it is most effective. So, we look for the P1 candle after a number of consecutive green candles.
2. The next candle has to be red and so big that the body engulfs the body of the previous green candle.
3. The trader enters the short/ sell trade on the third day, near or below the low of the P2 candle.
4. The trade stop loss should be the highest of the two highs of P1 and P2.
5. Normally the trade is initiated on the third day after the engulfing candlestick pattern is confirmed.
6. A general thumb rule when trading candlesticks is – to buy on strength and sell on weakness.
7. If on the third day, the stock starts trading in the red, usually the risk-averse traders do not initiate trades. But, if the pattern develops and is confirmed over 2-3 days, it is worth taking a risk.
8. As already advised, the stop loss should be at the lowest low of these two days.
9. Once the trade has been initiated, a trader waits till the target is achieved or the stop loss is triggered. But yes, one can trail the stop loss to book profit early.

5. A practical example of the Bearish Engulfing Pattern

Now, we will see how a bearish engulfing pattern works practically. Shown below is an example of this candlestick pattern.

The diagram shows the daily candlestick chart of Reliance Industries Limited. As indicated by the blue box, we can see that RELI was in an uptrend. There was a long bullish run. In the end, on the day of the P1 candle, there was a small green candle.

On the second day, the day of P2, the price opened higher. The price came down sharply and went far below when the bears became active. Though ultimately the price closed far below the opening price of the green candle, the previous day.

On the third day, in this case, the price opened in red and far below the closing price of the previous day, the P2 day. The trader should sell near or below the closing price of P2. So the trader creates a short sell position after the opening of the third day.

The stop loss should be, in this case, just above P1, which is the highest of the two. After the trader initiates the sell/ short position, we can see. the price never breached the stop loss in the range shown in this chart.

Here the trader can have two options. Trail the stop loss and exit when the stop loss was breached. Else, the trader can wait till the next uptrend begins and exit at the beginning of the uptrend.

Trend reversals indicator

In the example above, RELI stock had a long bullish run, before this bearish candlestick pattern developed. Only on the day of P2, we find one single long red candle. This candlestick was big and decisive. This candlestick pattern stopped the long bull run. The pattern was developed by the combination of two consecutive candles, one green and then a big red.

This combination showed us candlestick patterns that helped us to identify that a downtrend is imminent. This is a bearish engulfing pattern that gave a decisive indication of a trend reversal.

There is the most important point to note. This indicates that such candlestick patterns indicate trend reversal for the short term. This can be also used as an important indicator for short-term trends reversal indicator or uptrend reversal indicator.

Limitations of Engulfing Candlestick Patterns

We have seen explanations of engulfing patterns with good examples. From the diagrams of live market conditions, it is evident that these candlestick patterns gave us good indications of trend reversals and the development of new trends.

Also, good traders can benefit well from such signals. But there are times when these candlestick chart patterns do not behave rationally and give us false signals. Such signals occur when the market is choppy and volatile. Or there is no specific trend and the market is not moving much. These signals behave well in trending markets.

The chart above is the current chart of Reliance Industries. It is a 15 minutes chart of RELI. The false signal was generated at around 14:30 hours on 28.04.2022. It appeared to be a perfectly alright bearish engulfing pattern. But on the morning of 29.04.22., the stop loss was breached.

What should a trader do? As the chart was a 15 min. chart, the trader should have closed the trade and should have taken profit on 28th April, ’22 itself. A 15 min chart signal is not to be carried overnight. The signal may not hold true on a daily scale.

In addition, the stock looked choppy from the chart. A trader should avoid taking trades on a choppy market using engulfing pattern signals. Or should have taken trade confirmation from another technical indicator.

Modifications

Some technical analysts have researched extensively on candlesticks. They are trying to find loopholes in the strategies. They have come up with new methods and modified strategies.

For trading bitcoins, some researchers have come up with an optimization of these strategies. The article can be found here.

One such new strategy involved using fuzzy logic to solve the problems lying with engulfing candlestick patterns strategies. The full article can be found in the google archive. They have shown ways to trade S&P CNX Nifty 50 Index using the engulfing pattern.