An engulfing candlestick is a powerful trade signal when used in the right context. A deeper look at this type of candlestick pattern is covered in A Powerful Candlestick Price Pattern. Here we’ll build on the basic engulfing pattern and apply it to a very basic trend following strategy in the EURUSD. The pattern combined with some other filter, such as a trend, or highly likely reversal points, creates a very powerful and easy to spot strategy.
When viewing a candlestick charts, there are two types of engulfing patterns, bullish and bearish.
A bullish pattern is when the body of an up candle completely envelops the body of the down candle just before it. In other words, a large down candle followed by a larger up candle.
A bearish pattern is when the body of a down candle completely envelops the body of the up candle just before it; a large up candle followed by a larger down candle.
How these patterns look will be become clear when viewing the trade examples below.
Using the Engulfing Pattern During Trends
An engulfing candle shows a strong shift in direction. Yet, these patterns show up quite often. A strong shift in direction is only relevant there is some type of context. I like to use engulfing pattern during trends for example. Once an uptrend has begun, if during a pullback (move lower within the overall uptrend) a bullish engulfing pattern occurs, this is a potential trade signal. The bullish engulfing pattern, during an uptrend, indicates the pullback is likely over and that buyers have jumped back into the market. That’s a trade I want to be in.
Similarly, in a downtrend, during a correction (move up within an overall downtrend) I’ll watch for bearish engulfing patterns. If one occurs, the pullback has likely ended and the downtrend is likely to resume as the pattern indicates sellers have aggressively jumped back into the market.
Strategy Entry Rules
The basic engulfing-with-trend strategy is to utilize bullish engulfing patterns within uptrends, and bearish engulfing pattern within downtrends.
In order for an uptrend to be in play, the price must have made a higher swing high and higher swing low.
In order for a downtrend to be in play, the price must have made a lower swing low and a lower swing high.
Here are some examples. The scales on the charts have been removed as this strategy can be used on any time frame. My preferred method is to use it as a day trading strategy, using a 1 or 5 minute chart.
Figure 1. Bullish Engulfing in Uptrend
Figure 1 shows the basic setup. Ideally you want both an engulfing bar, and the bar before it, to have some “substance.” In other words, both bars (the ones inside the box) shouldn’t be tiny little bars, as tiny bars indicate indecision, and therefore aren’t useful for gauging a strong shift in direction.
Figure 2. Bearish Engulfing in Downtrend
Figure 2 shows what you are looking for in a downtrend. During a pullback, you are looking for a strong shift in momentum back to the downside which indicates the trend will continue. The bearish engulfing pattern provides such a signal.
Engulfing bars can be quite large, which means if you wait for the bar to complete you may miss a chunk of the move you are trying to capture.
Therefore, you don’t need to wait for an engulfing to complete (bar to finish). Figure 3 shows how this could be done using the bearish engulfing trades above. Instead of waiting for the bearish engulfing pattern to complete, enter short as soon as the potential engulfing bar drops below the low of the prior up bar.
In the case of uptrend, enter as soon as the potential bullish engulfing pattern moves above the high of the prior down bar.
Figure 3. Bearish Engulfing Entry
We can enter in real-time and assume that the bar will in fact end up as an engulfing candle because we are trading with the trend. We expect the trend to continue, and therefore, don’t need to wait for a bar to complete just to provide confirmation.
If you aren’t trading binary options, then set a stop loss just above the high of the bearish engulfing candle, or just below the low of a bullish engulfing candle. This can be adjusted slightly based on how well you read the market (see: Should I Hold Through a Pullback or Get Out?).
Candlesticks do not provide a specific profit target, although often I will simply used a fixed reward:risk ratio target. If the risk on a trade is 10 pips, I will set a profit at 16 or 20 pips, which is 1.6:1 or 2:1 reward:risk. This again can be adjusted slightly based ability to read the market in real-time (see: EURUSD-Using Price Action for Entries and Exits).
Use bullish engulfing patterns during an uptrend to signal the end of a correction and the re-emergence of the uptrend. Use bearish engulfing patterns during a downtrend to signal the end of a correction and re-emergence of the downtrend. Most importantly though, always control risk; it is recommended that no more than 1% of trading capital is risked on a single trade.