Learn about Bullish and Bearish Engulfing Candlestick Patterns

BULLISH AND BEARISH ENGULFING CANDLESTICK PATTERNS

BULLISH ENGULFING

The hammer and hanging man candlestick patterns occur in a single day. Engulfing patterns take two days to form and focus on the relationship between the candlestick bodies of both days. The candlestick shadows are not important to defining the pattern. A bullish engulfing pattern occurs when the white body of the second candlestick engulfs or covers the black body of the first candlestick in the pattern as shown in Figure 1.5. A bearish engulfing pattern occurs when the black body of the second day engulfs or covers the white body of the first day.

FIGURE 1.5: BASIC ENGULFING PATTERNS

The bullish engulfing pattern is a reversal pattern formed when the stock is in a downtrend, and often signals a short term reversal or bounce in the stock price. The first candlestick in this two day pattern has a black body, indicating the bearish downtrend is still intact. Black bodies indicate the stock closed down for the day. The second candlestick has a white body extending below the first day’s body, indicating the stock gapped down at the open. The lower end of a black body is the day’s closing price, and the lower end of a white body is the day’s opening price. Thus, when the second day’s white body engulfs or covers the first day’s black body, the price gaps down in the morning indicating more bearishness, then reverses to close above the previous day’s opening, indicating a reversal in sentiment for the second day that often continues in the short term.

Figure 1.6 shows a four-month candlestick chart of ZION. During late June and early July of 2006, ZION was in a clear downtrend. On July 13 and July 14, it formed the two day bullish engulfing pattern as marked by the up arrows. During the five days following the formation of the bullish engulfing pattern, ZION ran up more than seven points.

FIGURE 1.6: ZION BULLISH ENGULFING PATTERN OF 7/14/06

The bullish engulfing pattern does not always mark the end of a downtrend, but often does. Trading is a statistical business and patterns do not work all the time. Some trading patterns yield positive results a significant percentage of the time. Using trading patterns that win more often than they lose can be profitable in the long run. One of the keys to trading is to understand which patterns and techniques to use and in what market conditions they will be effective. That’s what this book is all about. Traders need to understand how often a pattern produces profits and how often it generates losses, and then fill their trading toolboxes with techniques that are profitable more often than random chance.

BEARISH ENGULFING

A bearish engulfing pattern may occur after a stock has been in an uptrend. The first day of this two day pattern shows a white body, indicating the stock was still moving up. The second day of the pattern has a black body that completely covers or engulfs the body of the previous day. The top of the black body represents the opening price, which has gapped up, since it is above the top of the previous day’s body, which represented the closing price for the first day of the pattern. After the open on the second day, the stock may move up further depending on whether the second day’s candlestick has a top shadow or tail. Because the second day is a black candle, it means that at some point during the day the sentiment reversed and the price started declining. This change in sentiment could signal a further decline in the short term.

Figure 1.7 shows a candlestick chart for CRS, which was in an uptrend during February, March, April, and early May of 2006. It formed a bearish engulfing pattern on 05/11/06, as marked by the two down arrows. After the formation of the two day pattern, the stock dropped more than 25 points. The bearish engulfing pattern marked a clear and decisive end to the uptrend. In this case, traders would have profited by entering short positions in CRS after the bearish engulfing pattern formed and then covering just seven sessions later.

FIGURE 1.7: CRS BEARISH ENGULFING PATTERN OF 05/11/06

In addition to knowing how often a particular trading pattern produces profitable trades, traders should understand if there are observable parameters that can strongly influence results.