The engulfing trading strategy will give you the skills you need to become a better trader. Through this guide, we’re going to take a deeper look into what exactly is the engulfing pattern and how understanding this particular pattern can improve your outcomes as a trader. Furthermore, we’re going to show you how to master the engulfing bar trading strategy with a simple twist.
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Don’t worry if you already know how engulfing trading works, we have some additional information for you as well. This will strengthen your existing knowledge about the engulfing candle trading strategy and help you find new opportunities to succeed as a trader.
How we interpret the engulfing pattern can provide us with a further understanding of the current market sentiment, whatever form it might take. In return, this can help us better assess the probabilities of success behind each individual bearish and bullish engulfing pattern.
Let’s get the ball rolling and start with an explanation of what is the engulfing pattern, and then we’ll proceed forward and reveal the twist.
What is the Engulfing Pattern?
In technical analysis, the engulfing pattern is multiple candlestick patterns (2-candle pattern) that can signal a trend reversal or a trend continuation depending on where it develops in relation to the prevailing trend.
While you can find this candlestick price formation by using the engulfing pattern indicator, you can easily spot the pattern with your naked eye.
There are two types of engulfing patterns:
- Bullish engulfing pattern.
- Bearish engulfing pattern.
Being able to identify the engulfing pattern can help us time the market.
So, how do we identify the bullish engulfing pattern?
The bullish engulfing pattern is a combination of one bearish candlestick followed by a bullish candlestick that engulfs the entire body and wicks of the first candle. This shows that, generally, the broader market is moving in a positive direction.
Naturally, it signals a potential reversal of the prevailing trend.
On the other hand, the bearish engulfing pattern is the opposite of the bullish engulfing pattern. The bearish engulfing pattern can signal the possible start of a new downtrend. While these engulfing patterns do occur in the opposite direction, they are still governed by the same underlying principles.
Moving forward, let’s see the different ways how to trade the engulfing pattern.
How to Trade Engulfing Pattern
To exemplify how the engulfing pattern works, we’re going to showcase how to trade a bearish engulfing pattern. The opposite will be true for the bullish engulfing pattern. Understanding the difference between bullish patterns and bearish patterns will be key to leveraging engulfing patterns to your advantage.
As per the textbook rules, we first need to wait for the second candle of this price formation to close. A close below the low of the first candle shows a stronger bearish signal.
Secondly, the engulfing pattern gets confirmed once we break and close below the low of the second candle. The way we trade it can be broken down into two strategies:
- Either sell right away when we break below the low.
- Or, a more conservative approach would be to wait for a candle close below the low.
Note* As a general rule, only enter once the pattern is confirmed.
Using strict risk management rules, we can hide our stop loss above the high of the second candle. Usually, the engulfing pattern can boost attractive risk-reward ratios so you can capture profits at least 3 times your risk.
The real-time example below outlines why every engulfing pattern needs to be analyzed in the broader market context.
Now, before we reveal the better way to trade the engulfing pattern trading strategy, it’s important to understand what’s going on behind the scene.
What do we mean by this?
Simply put, we want to know the psychology behind the engulfing pattern.
Why the Engulfing Pattern Works?
How we interpret the psychology behind the engulfing pattern plays a big role in whether or not the pattern will work out.
Price Action Strategy is the ultimate indicator telling you what’s going on in the market. In terms of the market sentiment, it’s the only reliable source because the best technical indicators are all based on price action.
When we look at raw price action we can tell who is winning the bulls and bears battle.
The engulfing candle simply signals a big shift in the market sentiment.
So, let’s see what the bullish engulfing pattern is telling us from the supply and demand perspective.
The apparent shift in the supply-demand balance is revealed by the second candle, which shows that the buyers have stepped in and managed to overcome the sellers.
However, as we know it, the price can move higher even from a lack of sellers (supply-side is dry out). That’s the reason why you’ll see that, many times, the candlestick patterns failing more often than not.
The key idea here is that you need to be very selective and only trade the engulfing pattern when it develops at extreme ends of a trend. Truth to be told, the engulfing pattern rarely develops at the end of a trend. Most of the time, you’ll notice this chart pattern popping a lot of the time in the middle of the trend or in a sideways market where a lot of price manipulation happens.
But, what if we can use the engulfing bar trading strategy to take advantage of the price manipulation?
Engulfing Trading Strategy
The engulfing pattern is fairly regular in its occurrence. Appearing regularly means that a lot of the time, it simply won’t work. Statistically speaking, candlestick patterns have a high failure rate, which is why we come with the idea to fade the engulfing bar pattern. Of course, candlesticks can indeed be useful--but advanced trading strategies will require you to look beyond these basic charts and think deeper.
To develop an effective engulfing trading strategy, we need to establish a proper framework to stack the odds in our favor.
For this reason, we have created an easy-to-follow trading guide.
Step #1 Spot a Sideways Market
The first thing we want to look for is a sideways market where no one is in control.
See the forex chart below:
This is very important because it’s setting the stage for price manipulation. The premise behind the typical price manipulation is based on the core idea that smart money needs buyers when they want to sell and they need sellers when they want to buy.
In this regard, our goal is to identify price areas where the trading volume is flat.
Usually, in ranging markets, volume remains mostly flat.
Since the market is range-bound around 75% of the time, it will be easy to spot a sideways market, especially on the intraday charts which are prone to exhibit more noise.
The natural flow of the price dictates that sooner or later we’re going to see an expansion in volume, which brings us to the second step.
Step #2 Localize the Engulfing Pattern
The ranging price action needs to be followed by the engulfing pattern.
Going on with our GBP/USD chart, we can spot a bullish engulfing pattern.
See the chart below:
Since we’re still in a range the buyers of the engulfing pattern need to overcome a lot of resistance levels that were built-in during the consolidation phase. What happens is that the buyers who got tricked to enter the bullish engulfing pattern are now trapped inside a consolidation zone.
Now, the first sign that buying the engulfing pattern is a bad idea was that we didn’t have enough profit margins.
See the chart below:
Smart money love to create these types of price deceptions.
How these price deceptions work is very simple.
The smart money needs to create a sudden price movement so that it attracts the retail eye to enter the market. Once the retail trade bites the bullet, smart money only needs now to bid the market lower and cause everyone to panic. This in return will trigger more sell stops on the downside and subsequently, the downside move gets amplified.
Now, you might be asking yourself why all the fuss to trick the retail traders?
Well, it comes down to two things:
- The market is a zero-sum game, so every transaction needs to have a counterparty.
- And, secondly, smart money needs liquidity to execute their big trades.
Now, you get the idea of why smart money can use the textbook patterns to trick the retail traders.
Next, we need to establish how the engulfing trader strategy works.
Step #3 How to Fade the Engulfing Pattern
We have a clear signal to enter the market when to price breaks below the low of the bullish engulfing pattern. Normally, traders would buy at the break of the high so we’re doing the exact opposite.
See the chart below:
Once the price deception is completed, we can see smart money selling aggressively.
As a general rule, once we break the low of the bullish engulfing pattern, we should see momentum picking up to the downside. If we see this type of price behavior we’re almost sure we have got a good trade.
The next step is to establish how to manage risk, i.e. where to hide our protective stop loss and when to exit the market.
Step #4 Where to Place Stop Loss and Take Profit
The stop-loss strategy is quite simple.
We hide our protective stop loss above the bullish engulfing bar.
If this indeed was a price manipulation set by the smart money, then the price should not break above the bullish engulfing candle high. However, since we can’t be 100% in control of what the market does in the eventuality it breaks above the high we want to get out, which is the stop-loss order job to do for us.
Now, in terms of take-profit….
If you want to take your trading to the highest point of success, you need to be able to maximize your profits with each trading opportunity.
The good news is that our take profit strategy is quite easy to implement.
You’ll have to take profits along the way and scale-out of your position as the trend matures. This ensures you’ll benefit from the entire price move.
Conclusion – Engulfing Bar Trading Strategy
In summary, the engulfing pattern trading strategy gives you a chance to trade along with the smart money and profit from trapped retail traders. Most traders will lose money when trading candlestick patterns but with a little bit of twist, you can turn the odds in your favor. And, that’s precisely what our easy guide to trading the engulfing pattern is aiming for.
Here is a summary of what you have learned so far:
- The textbook engulfing pattern and how it works.
- How to interpret the price manipulation around the engulfing bar.
- How to trade along with the smart money.
- Only fade the engulfing pattern that develops inside a sideways market.
- How to maximize your profits by scaling out of your position.
Please let us know your first real profit using the engulfing bar trading strategy; we are always empowered when we read your success story.
If you'd like to learn about how following the DOW Jones Industrial Average (DJIA) can help you find winning positions, click here.
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