Bullish Engulfing Pattern

ENGULFING PATTERNS 

BULLISH ENGULFING

Description

The Bullish Engulfing Pattern Is a very easy signal to identify. At the end of a down trend, it becomes evident that the Bulls are now involved. The Bullish Engulfing pattern is a major reversal pattern comprised of two opposite col­ored bodies. It opens lower than the previous day’s close and closes higher than the previous days open. Thus, the white candle completely engulfs the previ­ous day’s black candle body. This produces a clear visual graphic that in the early part of the trading, the Bears were still in control. As the time frame moves on, the Bulls started stepping in and continue to buy all the way past the open of the previous day. The graphic itself illustrates that there is now strong bullish sentiment in the price at these levels. The Engulfing Signal can be formed with the open and the close of one end of the pattern being equal but not open and close of both days being equal.

Engulfing patterns are considered major signals for two reasons. First, they occur often and second, they produce a high probability that the trend has reversed. Not only has the trend reversed, but the buyers have come in with enthusiasm. The most obvious element of the engulfing signal is a candle body color that is completely opposite of the previous trend.

Criteria

The body of the second day completely engulfs the body of the first day. Shad­ows are not a consideration. Prices have been in a definable down trend, even if only for a short term. The body of the second candle is the opposite color of the first candle, and the first candle is the color of the previous trend. The exception to this rule is when the engulfed body is a Doji or an extremely small body.

Signal Enhancements

1.     A large body engulfing a small body. The small body shows the trend is running out of steam. The large body indicates the new direction has started with good force.

2.    When the engulfing pattern occurs after a fast move down, there is less supply of stock to slow down the reversal move. A fast move makes a stock price over-extended and increases the potential for profit taking. Large volume on the engulfing day increases the chances that a blow-off day has occurred.

3.    An engulfing body which engulfs more than one previous body demon­strates power in the reversal. If the engulfing body engulfs the body and the shadows of the previous day, the reversal has a greater probability of working.

4.    The greater the open price gaps down from the previous close, the greater the probability of a strong reversal.

The appearance of a Bullish Engulfing signal when stochastics is in an over­sold condition produces an extremely high probability that the trend will move to the upside. Some features of the engulfing body can make it more convinc­ing. The bigger the engulfing body is compared to the last down trending body, the more likely the uptrend will move with significant force.

The Alliance Gaming Corp. Chart Fig. 2-22 (following page), is a prime example of a reversal signal. A large bullish engulfing signal occurring with oversold stochastics and an inordinate amount of volume. This clearly repre­sents that the existing negative sentiment of the trend has been completely altered.

The further the engulfing body opens below the close and/or the trading range of the previous day, and then closes above the previous days open, the higher the probability and the more forceful the uptrend will be. This incorporates the common-sense aspects that candlestick analysis conveys. Where do most inves­tors sell? Panic selling at the bottom! That is where the Bullish Engulfing signal starts its formation. The deeper the selling, starting the Bullish Engulfing for­mation, the more convincing that all the weak stock has finally been sold into the strong hands. The further a Bullish Engulfing signal closes above the previ­ous day’s candle, engulfing one, two, three or more previous candles, the more compelling the reversal signal.

Stochastics are Excellent Indicators for Overbought and Oversold Conditions

When are you near a bottom? When your indicators, such as stochastics, tell you the trend is in an oversold condition. Also, when you can identify selling at the bottom. Keep in mind, the oversold condition can last for a long period of time as shown in the Alliance Gaming Corp. chart. A gap down at the bottom, then the formation of a strong bullish engulfing signal bringing the stochastics of the oversold condition becomes a very relevant reversal signal.

Fig. 2-23, the Digene Corp. chart illustrates the classic reversal signal. The last day of the downtrend shows aggressive selling. This should be the first alert for watching for a candlestick “buy” signal. The following day forms a Bullish Engulfing signal. A Bullish Engulfing signal has more significant ramifications when both candles have “long days”.

(Long days are identified when the size of the candle is larger compared to the majority of the other candles within the immediately preceding area on the chart. Generally, two or three weeks of previous candle formations are sufficient to judge the average candle size.) Simply stated, the sellers were in a hurry to get out of the trade. The next day, the Bulls clearly demonstrated that they were getting into the trade.

The Taro Pharmaceutical Industries Ltd. Chart Fig. 2-24, is an example of in­vestors wanting to get out, no matter what. After nearly a month of selling, the final gap-down demonstrates the extensive desire for investors to get out of the position. The fact that once the price opened, started moving up, and finished above the previous day’s trading, clearly signifies the Bulls had stepped into this position. The previous day was not a black candle and therefore, techni­cally not a Bullish Engulfing signal, nonetheless the fact that you had a huge Bullish Engulfing signal drat actually engulfed the previous four days of trading provides a significant message. The buyers had stepped in at the bottom.

Does identifying a candlestick reversal signal always foretell that a new trend is starting? Not all the time! But the “probabilities” are extremely high a rever­sal will occur. Will that new trend start up immediately? Not necessarily, but the signal occurring in the correct conditions increases the likelihood a new trend should be starting. If not immediately, very soon.

Witnessing a bullish signal in oversold condition conveys the information an investor should be looking for. The buyers have started moving into the posi­tion. The uptrend may not start immediately. As witnessed in Fig. 2-25, the IXYS Corp. chart, the first Bullish Engulfing signal occurred with stochastics in the oversold condition. The uptrend fizzled. However, that did not negate the fact that a bullish signal formed in an oversold condition. Even though that uptrend did not get started, the oversold condition was still in existence.

If the first Bullish Engulfing signal failed, the second Bullish Engulfing signal will be more significant. The Bears see the buying from the first bullish signal. They are relieved when there is no follow-through buying. However, when they see the second Bullish Engulfing signal, the Bears realize that the Bulls are back again. They finally step out of the way. If one Bullish Engulfing signal indicates the buyers are stepping in, then two Bullish Engulfing signals indicate the buyers are serious.

It makes good sense that when a Bullish Engulfing signal is witnessed in an oversold condition, a trend reversal is likely to occur. But what happens if you see a bullish engulfing signal occurring in an overbought condition? As a Bull, that would be a comforting event. However, the Japanese Rice traders used a Bullish Engulfing signal in overbought condition as an ‘alert’ to start watching for candlestick “sell” signals. The rationale is that the Bullish Engulf­ing signal, at the top of a trend, is usually the last gasp buying.

How can this information be used to the candlestick investor’s advantage? First, if long a position and you observe some toppiness with a Bullish Engulf­ing signal, be prepared to close out the position. If short a position, based upon a candlestick sell signal, such as a Bearish Harami, followed by a Bullish En­gulfing signal, you should be less inclined to cover the short position. The trend would require further buying after the Bullish Engulfing signal to indicate the uptrend is still in force. Otherwise, be prepared for the price to start heading down.

Fig. 2-26, The Wyeth chart illustrates the Bullish Engulfing signal occurring in the overbought condition acting as the last gasp buying. The logical stop loss in this trade, if long, would have been at the low of the Bullish Engulfing signal day. The logic being; that if this stock was still in an uptrend, it should not be coming back down through the low of the last bullish candle.

The Bullish Engulfing signal has graphic characteristics that make it easily iden­tified. As a major signal, a Bullish Engulfing signal will be viewed often during scans. They will appear every single day somewhere. They work very effec­tively when stochastics is in oversold conditions. They also work effectively at important support levels such as a trend lines or major moving averages.

The information conveyed in a Bullish Engulfing signal is very simple. The Bulls have come into a position with reasonable force. That buying force more than negated the previous day’s trading. Use that knowledge to your advan­tage.