Bullish Engulfing Pattern
In this segment of our series on technical chart patterns, we delve deeper into the intricacies of the Bullish Engulfing Pattern. This pattern, regularly featured in technical analyses, is a tool often employed to forecast potential price declines.
This pattern, a critical indicator of potential price increases, is formed by a downward (black or red) candlestick immediately followed by a larger upward (white or green) candlestick that entirely 'engulfs' the former. This formation represents a scenario where the buyers have outpaced the sellers, pushing the price upwards more powerfully than the sellers were pushing it downwards. Notably, the size of the candles and the broader price context can influence the pattern's significance.
What Does It Tell You?
The Bullish Engulfing Pattern typically appears at the conclusion of a downward price movement. The first candle, representing downward momentum, is overtaken or 'engulfed' by a larger second candle, suggesting a shift towards higher prices. The pattern's reliability strengthens when the open price of the engulfing candle is considerably lower than the close of the first candle, and when the close of the engulfing candle is significantly above the open of the first candle. A much larger up candle shows more strength than if the up candle is only slightly larger than the down candle.
The pattern is generally more dependable when it follows a clean move lower. If the price action is choppy or ranging, many engulfing patterns will occur, but they are unlikely to result in significant price moves since the overall price trend is choppy or ranging.
Before acting on the pattern, traders usually wait for the second candle to close, and then take action on the following candle. Actions include buying a long position once a bullish engulfing pattern occurs, or potentially exiting a short position.
Practical Application: Using the Bullish Engulfing Pattern
Let's consider a hypothetical trading scenario that illustrates the use of a bullish engulfing pattern.
In the stock market, we may observe three bullish engulfing patterns over a certain period. The first bullish engulfing pattern occurs during a pullback to the downside within a larger uptrend. The price proceeds higher following the pattern.
The subsequent two engulfing patterns are less significant considering the overall picture. The price range of the stock starts to narrow, indicating choppy trading, and there is very little downward price movement prior to the patterns forming. A reversal pattern has little use if there is little to reverse. Within ranges and choppy markets, engulfing patterns will occur frequently but are not typically good trading signals.
In such a scenario, traders might opt to take a long position after the first bullish engulfing pattern, expecting the price to increase based on the pattern's formation. As the price proceeds higher, they could potentially lock in profits, keeping an eye on the market for any further bullish engulfing patterns to guide their future trading decisions.
Comparing Bullish and Bearish Engulfing Patterns
While they might seem similar at first glance, they signal opposite market directions.
A bearish engulfing pattern typically occurs after a price move higher and indicates lower prices to come. The first candle, in the two-candle pattern, is an up candle. The second candle is a larger down candle, with a real body that fully engulfs the smaller up candle.
On the other hand, a bullish engulfing pattern forms after a price move lower and suggests higher prices are likely. The first candle is a down candle, and the second candle is a larger up candle, with a real body that fully engulfs the smaller down candle. Understanding these differences can assist traders in making informed decisions about their trades, whether they are considering going long or short.
Recognizing the Limitations of the Bullish Engulfing Pattern
Like all trading indicators, the bullish engulfing pattern has its limitations. It is most useful following a clean downward price move as the pattern clearly shows the shift in momentum to the upside. If the price action is choppy, even if the price is falling overall, the significance of the engulfing pattern is diminished since it is a fairly common signal.
The engulfing or second candle may also be very large, which can leave a trader with a very large stop loss if they opt to trade the pattern. The potential reward from the trade may not justify the risk.
Determining the potential reward can also be challenging with engulfing patterns, as candlesticks don't provide a price target. Instead, traders will need to use other methods, such as indicators or trend analysis, for selecting a price target or determining when to get out of a profitable trade.
As with any trading indicator, it's essential to use the bullish engulfing pattern in conjunction with other technical analysis tools and to take into account the overall market conditions and fundamental factors when making trading decisions.