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How to Trade Bullish and Bearish Engulfing Candlestick Patterns?

Bullish and bearish engulfing candlestick patterns are powerful reversal formations that generate a signal of a potential reversal. They are popular candlestick patterns because they are easy to spot and trade.
 

Structures


A bullish engulfing candlestick pattern occurs at the end of a downtrend. It consists of two candles, with the first candle having a relatively small body and short shadows, also known as wicks. The second candle, on the other hand, has longer wicks and a real body that engulfs the body of the previous candle.

Bullish and bearish engulfing patterns

As seen in the illustration above, the second candle completely overwhelms the prior candle. For a pattern to qualify as bullish engulfing, the high of the second candle should hit higher prices than the high of the prior candle. The same scenario applies for the low. 

 

Ideally, the closing price (top of the body) should also be higher than the highest point of the wick of the prior candle. This scenario gives further significance to the second candle and shows that the bulls have control over the price action now. 

 

The bearish candlestick pattern follows the same line of thought, the only difference is that it is a bearish reversal pattern that occurs at the top of an uptrend. The first candle is a bullish candle that signals the continuation of the uptrend, before the appearance of the powerful bearish candle that completely shuts down the prior candle.

 

Moreover, if the second candle is huge and long, it can practically close the door for you to open a trade, as your stop would be placed far away from the entry price i.e. high risk and not such high reward.

 

The best way to learn the strengths and weaknesses of the bullish and bearish engulfing patterns, as well as other candlestick formations, is to use the MetaTrader 5 trading platform and pay close attention to when these formations are created and how the price action behaves.

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The importance and limitations of engulfing patterns

 

The significance of engulfing candles in trading is high. As traders, we aim to capitalize on new trends when markets change direction. Reversal patterns, such as bullish and bearish engulfing patterns, signal an impending change in the price direction, as the so far dominant force has started losing momentum, which allows the other force to capitalize. 

 

Both patterns take place at the end of a strong trend. The idea behind the bullish engulfing pattern signals that the second candle is powerful enough to initiate a new trend. Since the low of the second candle is lower than the one of the first candle, it signals that the bulls were able to push the price action from the session lows to higher prices, which is not seen during the first prior session. 

 

However, as other candlestick patterns, engulfing formations have their own limitations. While they are quite powerful when they occur at the end of a strong trend, they are almost non-tradeable when they appear in choppy trading. 

How to trade the bullish engulfing pattern


In the chart below, we see a AUD/USD daily chart. The price action had been putting in a series of lower highs and lower lows to ultimately create three swing lows. Following a new short-term low, the price action suddenly presses higher to create a strong, powerful bullish candle.

patterns on the graph
 
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All elements are in place, and the bullish engulfing formation is formed. Investors recognize this pattern and use this opportunity to capitalize on the imminent change in the trend direction. The price action then pushes higher to record two swing highs, and ends up in ultimately trading at higher levels. 

 

In this particular example, we see the power of a bullish engulfing pattern. The trend reversed after the second candle generated a signal that the bulls have taken control over the price action, and the downtrend may be finished.

 

How to trade the bearish engulfing pattern


The second example that we show here is a great opportunity to see the engulfing pattern at its best. The USD/CAD price is trading lower on a daily chart. At one point, the price rebounds strongly before it reverses again to continue trading lower, and ultimately printing the new short-term low. 

MT5 graph

 
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Situations like this bring out the best of the bearish engulfing pattern. Although the bearish engulfing pattern occurs at the top of an uptrend, the prevailing trend is to the downside. Hence, the short uptrend is actually a correction of a bigger move to the downside.

 

How do you trade such situations? Well, the majority of the trading community prefers to ride the trend and not counter it. By performing a basic technical analysis, you take notice of a downtrend. Hence, you are looking to get on the short side of a rebound higher. But the main question is, as always, where to do it?


This is when different patterns and formations enter the equation. Since we are waiting for a reversal to get on the short side, we start paying more attention to the price action. The bearish engulfing pattern appears at a great moment, as we are still trading in the overall downtrend, but the rebound was strong enough to offer us a good price.

Therefore, we decide to short the USD/CAD due to: 1) the price action being in a downtrend, 2) the bearish engulfing pattern signaling that the rebound is done. Our entry is a level where the formation is created i.e. the closing price of the engulfing candle. The stop-loss order should be placed above the most recent top, leaving enough room to protect against the intraday whipsaw. 

Take profit orders are determined based on other indicators. You can either use Fibonacci retracements or extensions, trend lines, moving averages etc. In this case, we used the previous low as a horizontal support to aim for. Finally, the price action hits the take profit order on the third day after we opened the trade. 

Looking at the numbers, the distance between a stop loss and our entry price was around 70 pips. On the other hand, the price banked us 130 pips by hitting the take profit, meaning that the risk-reward ratio was almost 1:2.

As always, we advise you to first open a demo account before you start risking your own capital trading live accounts. By doing so, you protect your own capital and leave enough time for yourself to get up to speed with the live markets.

 

Summary

 

Bullish and bearish candlestick formations are reversal patterns that take place at the end of a strong trend. Both patterns signal that the reversal is imminent as the dominating force has lost momentum, which opened the space for the opposite side to push the price action in the desired direction. 

 

These patterns consist of two candles, with the first one continuing the same trend while the second one strongly correcting in the opposite direction to completely engulf the first candle, signaling imminent change in the trend direction.

 


 

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