When it comes to reliable candlestick patterns the ‘engulfing’ pattern lies in the same league as the mighty pin bar pattern in terms of popularity and reliability.
Picked at the right spots with sound knowledge of trading them safely, they can serve as perfect triggers to highly profitable ‘home run’ trades, allowing you to pick tops and bottoms and trend continuations timely.
A Look at the Engulfing Bar Pattern
An engulfing bar, as the name implies, is any bar that engulfs the bar just prior to it. That means the high and low of the engulfing bar itself will always as a rule, extend beyond the highs and lows of the bar prior to it.
Although an engulfing bar is technically valid if it engulfs just the immediate bar prior to it, note that the more prior bars that this bar engulfs the stronger it gets.
A bullish engulfing bar is one that closes higher than the open, while a bearish engulfing bar is one that closes lower than the open. It always helps to use different colors for up and down bars on your chart so you can clearly differentiate between bullish and bearish engulfing bars.
Let’s take a look at a bullish engulfing bar:
On my charts, I use a dark green fill for bullish bars and red fill for bearish bars. Marked in yellow, you can see the bullish engulfing bar engulfing not one, but three prior bars – all are marked on the chart above. Note that the close of our bar is higher than the open, giving it the bullish characteristics.
Conversely, a bearish engulfing bar closes lower than the open, as you can see the red colored bar highlighted in yellow in the chart above. This one engulfs two prior bars that are marked on the chart.
Trading Engulfing Bars
Now that we know what engulfing bars really are, let’s get into actually trading this fantastic bar pattern.
The most practical and widely used way to trade these bars is to simply place a pending entry order a few pips above the high of a bullish engulfing bar and a few pips below the low of a bearish engulfing bar.
The safest position for a stop loss is a few pips above the opposite end of the bar. That means that for a bullish engulfing bar an ideal conservative stop would be a few pips below the low of the bar, while for a bearish engulfing bar the ideal stop would be a few pips above the high of the bar itself.
The above mentioned stop loss placement serves a very important purpose. It leaves ample space for the trade to “breathe”. It is not uncommon for price to retrace a little bit back into the engulfing bar before continuing in our expected direction without really threatening to take out the entire bar by breaching the other end.
Similarly, an entry a few pips beyond the bar also helps add a buffer against an immediate pullback into the bar that can be stressful for a trader. Let’s face it: no one likes their trade running in the red early on!
Let’s see how an ideal entry and stop loss position for bullish and bearish engulfing patterns would look like on a real chart:
Notice that the entry point marked on the chart above would have safeguarded the trader from the immediate pullback into the bullish engulfing bar, because never hit the entry point until it really wanted to move (i.e on the fourth bar after the bullish engulfing bar formed).
Take note again that the bar following the bearish engulfing bar also pulled back slightly, although this time it would have taken us with it (entry point was hit on the same bar). For a trader with a stop any tighter than the recommended position, this would be an anxious moment to say the least!
Advanced Trading Methodologies
Outlined above is the most conservative way of trading engulfing bars. Some would argue however that for the larger-sized engulfing bars the poor risk:reward ratio on the trade stemming from the huge stop loss could destroy the profit potential.
These traders have went on and successfully tested advanced methodologies that do in fact allow a tighter stop placement or better still, an entry at a pull back to the engulfing bar, rather than at the break of these bars.
A tighter stop will of course boost the risk:reward ratio making you look cool and sexy when everything goes right. It can also make you look extremely foolish when you get burned with a full loss on the trade due to a tighter stop, while a more conservative trader would perhaps still have milked the trade for some profit.
Discussing these advanced strategies are beyond the scope of this article, but the point is to simply help you understand that there are other more advanced ways to trade these bar patterns too – and that being conservative with your trading is always a good idea. “Better safe than sorry” is a lesson in trading most traders learn the hard way – and I am no exception!
3 Tips to Select the Best Engulfing Bar Patterns
Finally, let’s look at a few tips you can use to really nail down your engulfing bar trades for the highest likelihood of profit.
#1 Trade them at Swing Points
Engulfing bars serve their best purpose when located at swing points – that is the top and bottom of your chart. Ideally you want to be trading a bearish engulfing bar at the top of your chart at resistance, or at the top of a dragging up trend (hint: look at MACD divergence!). A bullish engulfing pattern is best traded at a swing low – that is at the bottom of your chart at support, or during a dragging down trend.
#2 Big bars are good, very big bars are bad:
We talked about large authoritative engulfing bars that engulf more than just the prior bar. As a general rule of thumb, we want our engulfing bars to stick out like sore thumbs on the chart. They are the most conspicuous when they are larger than previous bars and engulf multiple prior bars.
However, we also do not want them to be super large. Not only does that mess up the risk:reward to a noticeable degree (assuming the conservative trading method outlined above), it also leaves you missing part of the actual move itself. The best engulfing bars will trigger a move, not form the bulk of it.
Let’s look at an example to clarify what I mean:
Look at this bullish engulfing bar that represents a breakout of the prior wedge patterns marked on the chart. Notice that instead of just triggering the move, it contains within it, the bulk of all that initial momentum you want to use for a breakout trade. Entering at the break of the bullish engulfing bar would have caused much pain. In essence this would have been like trying to jump on a running train.
It is always best to avoid the super large engulfing bars that quite obviously contain a good part of the expected move within their range.
#3 Look for Strong Closes
It is fairly common for engulfing bars that close strongly (leaving little to no wick) to break in the expected direction fairly quickly too. You can safely assume that if an engulfing bar closes strongly near or at the end that it is expected to break from, is a much stronger bar.
Here is an example of a weak bearish engulfing bar:
Notice that it leaves a wick on the lower side – the side you would expect the bar to break from. As expected it does not yield much and price loses momentum straight away at the marked support and resistance area in green on the chart. The weak momentum had already been hinted via the weak close on the bearish engulfing bar – if you had the eye to spot it!
Now let’s look at what a strong-closed engulfing bar can do:
Notice the near non-existent wick on the upper side of the bullish engulfing pattern – that is the side we expect the bar to break from. It also engulfs 11 bars prior to it – all the indications of a strong bar. And well…what it yields should be of little surprise.