Bullish and Bearish Engulfing Pattern: Explain Overview, Trade Entries, Reversal Candlestick Pattern

THE ENGULFING CANDLESTICK PATTERN

The hammer and hanging man are individual candle lines. As previously seen, single candle lines through the color, length, and size of the real bodies and the shadows can send important signals about the market's health. Most candle signals, however, are based on combinations of individual candle lines. The engulfing pattern is the first of these multiple candle line patterns. The engulfing pattern is a major reversal signal with two opposite color real bodies composing this pattern.

Exhibit 2.13 shows a bullish engulfing pattern. The market is falling. Then a white bullish real body wraps around, or engulfs, the prior period's black real body (hence its name). Another nickname is a "hugging line" for obvious reasons. (Maybe on Valentine's Day I will refer to the engulfing pattern as a hugging pattern.) This shows buying pressure has overwhelmed selling pressure. 

Exhibit 2.13. Bullish Engulfing Pattern

Exhibit 2.14. Bearish Engulfing Pattern

Exhibit 2.14 illustrates a bearish engulfing pattern. Here the market is trending higher. A white real body engulfed by a black real body is the signal for a top reversal. This shows that supply has overwhelmed demand.

There are three criteria for an engulfing pattern:

1.  The market has to be in a clearly definable uptrend (for a bearish engulfing pattern) or downtrend (for a bullish engulfing pattern), even if the trend is short-term.

2.  Two candles comprise the engulfing pattern. The second real body must engulf the prior real body (it need not engulf the shadows).

3.  The second real body of the engulfing pattern should be the opposite color of the first real body. (The exception to this rule is if the first real body of the engulfing pattern is a doji. Thus, after an extended fall, a doji engulfed by a very large white real body could be a bottom reversal. In an uptrend, a doji enveloped by a very large black real body could be a bearish reversal pattern).

The closest Western analogy to the Japanese engulfing pattern is the outside reversal session. In classic Western technicals, this occurs when, during an uptrend (or downtrend), a new high (or low) is made with prices closing under (or above) the prior day's close.

Some factors increasing the likelihood that an engulfing, pattern could be an important turning signal are:

1.  If the first day of the engulfing pattern has a very small real body (i.e., a spinning top) and the second day has a very long real body. The small first real body candle reflects a dissipation of the prior trend's force and the large second real body proves an increase in force behind the new move.

2.  If the engulfing pattern appears after a protracted or very fast move. A fast or extended move creates an overextended market (either overbought or oversold) and makes it vulnerable to profit-taking.

3.  If there is a heavy volume on the second real body of the engulfing pattern.    

Exhibit 2.15. Resistance to Bearish Engulfing Patterns

Exhibit 4.16. Support for Bullish Engulfing Patterns

A prime use of the engulfing pattern is utilizing them as support or resistance. This is illustrated in Exhibits 2.15 and 2.16. In Exhibit 2.15 use the high of the two candle lines that make the bearish engulfing pattern. That high becomes our resistance (based on a close). As shown in Exhibit 2.16, the same concept is used for the bull engulfing pattern. With that I have found that the lowest low of that pattern should become support.

This technique of the bearish engulfing pattern as resistance and support is especially useful if the market has moved too far from the lows (with a bullish engulfing pattern) or highs (with a bearish engulfing pattern) to be comfortable selling or buying. For example, by the time a bullish engulfing pattern is completed (remember, we need to wait for the close of the second session before we know it's a bullish engulfing pattern), the market may be well off its lows. As such, I would feel that it has gotten away from an attractive buying area. In such a scenario, we can wait for a possible correction to our support area at the lows of the bullish engulfing pattern and then consider stepping in from the long side. The same would be true, but in reverse, for a bearish engulfing pattern.

In Exhibit 2.17 we see that the first white candle after six sessions of black descending candles emerged early on May 5. This white candle completed the bullish engulfing pattern. We then use the low of the bullish engulfing pattern (the lowest low of the two sessions that comprise the pattern) as support near $56. Lucent rallied from this bullish engulfing pattern and then stalled at a bearish engulfing pattern. Note how the high of this bearish engulfing pattern became resistance the next session. With the descent from this bearish engulfing pattern, a doji sent a tentative clue that the stock was trying to stabilize near the potential support at the bullish engulfing pattern. The stock rallied from this successful test of the bullish engulfing 

Exhibit 2.17. Lucent-60 Minutes (Bullish Engulfing Pattern)

pattern's support, hesitated for a few sessions at the bearish engulfing pattern's resistance, and then continued its ascent along a rising support line.

In Chapter 1 addressed the significance of real bodies, but shadows should be a pivotal part of your analysis. We look at an example of this aspect in Exhibit 2.18.1 A series of long upper shadows—otherwise known as bearish shadows—arose during the weeks of November 2 and 16. These long upper shadows sent a strong visual clue that the market was rejecting the 1.1850 area. The decline that began after the second set of long upper shadows ended with a hammer (a candle with an extended lower shadow—another example of the shadow's significance). A few days after the hammer, the stock pulled back via a long black real body (that marginally broke the hammer's support). The next day a tall white candle completed a bullish engulfing pattern. The rally that began from the bullish engulfing pattern terminated at the doji at 1.1950. Note how the doji confirmed a resistance area defined by the late October's series of long upper

Exhibit 2.18. Euro/Dollar-daily (Bullish Engulfing)

Exhibit 2.19. Crude Oil-Weekly (Bullish Engulfing Pattern)

shadows. Remembering the concept of the bullish engulfing pattern as potential support, we look to the November 27 and 28 bullish engulfing pattern near 1.1470 as support. A successful test at this area occurred the week of January 11.

A major low in crude oil came with a classic bullish engulfing pattern as shown in Exhibit 2.19. This was a classic pattern insofar as the first real body was a small black real body (this showed the bears were losing a foothold) and the second candle was a vibrant long white real body that opened on its low and closed near its high. What was so significant about this particular bullish engulfing pattern was that the white real body engulfed not only one black real body, but three black real bodies. Keep in mind that while this clearly showed the bulls had taken full control from the bears, it does not signify the extent of the move following the bullish engulfing pattern. Candles, while unexcelled at sending out early reversal signals, do not provide price targets. This is why Western technicals are so important, as they can be used to help forecast price targets.

Exhibit 2.20 Citibank-daily (Bearish Engulfing Pattern)

In Exhibit 2.20 a rally that began at area A hesitated for a few sessions in late March near $43.50 with some long upper shadows and a doji. With a push over this five-day resistance area, as the Japanese would say, "The dirt was blown away." The rally resumed in earnest until it was short-circuited at the bearish engulfing pattern on April 13 and 14. Note the extreme size of the black real body of that pattern. This underscored how the bears had wrested control of the market from the bulls. This bearish engulfing pattern was confirmed as resistance a few weeks later with the emergence of another bearish engulfing pattern. This echoed the fact that each time the bulls were able to propel the stock toward $51.50, they couldn't hold control of the market.

Let's look at these two bearish engulfing patterns and compare them to a Western outside reversal session. In a Western outside reversal session (I'll focus on a top outside reversal session), the market makes a new high for the move and then closes the next day under the previous day's close. The first bearish engulfing pattern, if in bar chart form, would also be a traditional Western outside reversal day since the stock made a new high for the move with the top of the black candle session and then closed under the prior day's close.

Now, let's look at the second bearish engulfing pattern in late April. Note how the second candle in that bearish engulfing pattern failed to obtain a new high (its high was $51 and the prior session's high was $51.75). Consequently, if this was a traditional bar chart, it would not have been a reversal signal via an outside reversal session (since it didn't make a new high). But with a candle chart, all that is needed for the bearish engulfing pattern is for a black real body to wrap around a white real body, which is what happened in this instance. This is a good example of how the candles will provide a timing advantage on those who just use traditional bar chart analysis.

In Exhibit 2.21 a bearish engulfing pattern in early July took the force out of the preceding rally. This bearish engulfing pattern became resistance for the next week and a half. Once Cisco closed over the highs of this bearish engulfing pattern on July 15, it was a bullish breakout (even though it was a doji, the fact that it was a new high close is a positive). For those who are momentum players, the break above a bearish engulfing pattern could

Exhibit 2.21 Cisco-Daily (Bearish Engulfing Pattern)

be viewed as an indication of a new upleg and a time to consider buying. To confirm a breakout, I recommend waiting for a close over that resistance area, not just in intraday break. Another bearish engulfing pattern was completed on July 21 became resistance that was tested in late August. Notice as prices approached the bearish engulfing pattern's resistance area, a group of small real bodies reflected hesitation.