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Chart Patterns - Engulfing Pattern

Type: Reversal Pattern

Appearance: The engulfing pattern is a major reversal signal composed of two candles with opposite color bodies. From this point on, we will consider "white candles" to be up and "black candles" to be down. A Bullish Engulfing Pattern occurs in a down-trend and consists of a white candle whose body completely engulfs the body of the previous down-candle. A Bearish Engulfing Pattern is the exact opposite: It occurs in an up-trend and consists of a down-candle whose body completely engulfs the body of the previous up-candle.

Typical Duration: 2 candles

Description: The reasoning behind the Engulfing Pattern is fairly simple. The bulls (or bears) are running out of steam during the first candle, and the opposite side of the market makes a strong move during the second candle.There are 3 main criteria that must be met in order for a pattern to be considered an acceptable Engulfing Pattern.

  1. The market has to be in a clearly defined trend prior to the emergence of the pattern.
  2. The body of the second candle must completely engulf the body of the first candle. It does not need to engulf the previous candle's shadows.
  3. The the first candle must be in the direction of the trend, and the second "engulfing" candle must be in the opposite direction. That is, in an up-trend, the first candle must close higher than it opened, and the second candle must close lower than it opened, and vice versa in a down-trend.

In addition to these necessary criteria, there are two other criteria which can improve the Engulfing Pattern's performance.

  • The bigger the difference between the body sizes of the two candles, the more likely it is that the pattern is a significant reversal point.
  • Seeing the engulfing pattern after a long trend as opposed to a quick burst increases the chances that all the forces pushing the trend have indeed been exhausted, and that the trend is ready to reverse or retrace.

Strengths: The engulfing pattern is one of the most reliable reversal patterns available, particularly when the extra criteria are applied.

Weaknesses: Having said all that about the pattern's strengths though, it often does not result in an actual reversal of the trend, but can often result in a consolidation or a retrace instead. The buying/selling pressure that causes the engulfing candle may come spontaneous events such as large non-speculative flows, or profit taking near a significant support or resistance level.

How to Trade It: Simply wait for the engulfing candle to close, ensure that it does in fact form an Engulfing Pattern according to our criteria above, and enter the trade accordingly. Stop losses can be placed just beyond the top of the formation for Bearish Engulfing Patterns, or just below the bottom of the formation for Bullish Engulfing Patterns. Engulfing Patterns in general have no inherent take profit level. Take profit orders should be placed according to results of other analyses.

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