Simple Tactics for Trading the Engulfing Candle Pattern

 Justin Paolini

Focus on bullish & bearish engulfing patterns for a simple & effective way to engage with the markets - perfect for people that trade around their day job!

 

Aspiring traders often make life too difficult for themselves, researching complex strategies or clotting their charts with a myriad of indicators. Good trading is not about creating attractive charts. Some of the best traders in the world do not have great chart reading skills.

Engulfing Candle Pattern

This kind of over-analysis is typically not effective.

You need to know the truth:

  • Indicators do not enhance the probability of having a winning trade.

  • Effective analysis is usually best kept simple, because nobody can know what the market will do next.

  • Successful trading is about sticking to a model you believe in, understand, and enjoy.

  • Successful trading is about becoming a specialist of your model, not a jack of all trades.

  • Successful trading is about stacking the odds in your favour, which means cutting losses short and letting your profits run.

A simple and effective way to engage with the markets, which is also perfect for people that trade around their day job and cannot spend much time following the market, is to focus on Bullish Engulfing Patterns and Bearish Engulfing Patterns.

The Engulfing Candle Entry Pattern

The engulfing candlestick pattern is made up of two consecutive candles and essentially indicates a reversal in momentum. A picture is worth a thousand words, so here are two pictures that illustrate the pattern:

 

Bullish & Bearish Engulfing Candlestick pattern

The essence of the engulfing candle entry pattern is that the second candle's body covers the entire body of the previous candlestick. Of course, if both the body and wick of the first candlestick are covered by the engulfing candle, the signal is even stronger.

However, the financial markets rarely adhere to precise criteria. So, in practice, you will need to bend the rules slightly, to spot and trade engulfing candle patterns that remain valid although they may not be perfect. Here are some guidelines:

  • Wicks: engulfing candles must have short wicks. The total length of the wicks should be no more than 33% of the entire candle’s length. In other words, most of the candle must be real body. Long wicks represent indecision rather than sustained direction. Some traders prefer to use a stricter definition of wicks being no longer than 25% or even 20% of the entire candle’s length.

  • Bodies: we accept a setup if at least 90% of the first candle’s body is covered by the engulfing candle’s body.

Understanding Candlestick Jargon

Japanese candlesticks are useful ways of representing the Open-High-Low-Close information of time periods (Minutes, Hours, Days, Weeks, Months, Quarters, and anything in between).

Each candlestick represents one period of price activity from the chosen periodicity. Candles can be bullish or bearish. A bullish candlestick shows a higher close than its open and is usually shown without color or filled in with a typically “positive” color such as green. A bearish candle has a lower close than open and is usually colored black or with some other “negative” color like red.

Each candlestick consists of two components: the candlestick real body and the shadow. The real body is the thick part of the candlestick that represents the open and the close. The thin lines above and below the real body are the shadows (also called wicks). These shadows represent the session's price extremes (high and low).

Examples of Real-World Engulfing Candlestick Patterns

Now we know the theory behind engulfing candlestick patterns, and we know when and how to bend the rules. Now we can dive into real-world engulfing candlestick patterns, taken in a live simulation with ForexTester during 2020, trading the EUR/USD currency pair.

EUR/USD Bearish Engulfing Pattern

The first example is from November 2020. It shows the perfect kind of bearish engulfing candlestick pattern…even though the trade ended out with a loss. However, this example is useful to illustrate the key behind the engulfing theory:

  • On day 1, the market posts a strong bullish day.

  • On day 2, the market attempts to push through the prior day’s high, but fails, and sellers enter the market from the highs and aggressively push price downwards.

  • On day 2, sellers can post a strongly bearish close, where buyers are not able to defend the prior day’s low.

This is the essence of the engulfing candlestick pattern: a clear failure to overcome a prior day’s high, and daily close at or near the prior day’s low (for a bearish engulfing candlestick pattern, so just invert for a bullish engulfing candlestick pattern).

Here is another bearish engulfing candlestick pattern example, taken from the 20th of October 2020. This time you will notice how only the prior day’s body was engulfed. And yet, the outcome was extremely favourable.

EUR/USD Engulfing Pattern

The bottom line is that bullish engulfing candlestick patterns and bearish engulfing candlestick patterns should “stick out like a sore thumb”. The following conditions are what you are ideally looking for with this pattern:

  • The body is almost totally engulfed.

  • The wicks are small compared to the body.

  • The candle sizes are large compared to the preceding candles.

Engulfing patterns meeting these criteria are usually self-evident and as such, represent tradable opportunities.

Trading the Engulfing Candlestick Pattern in EUR/USD in 2020

At DailyForex.com, we like to show you how to walk the walk. So, for this article, we traded daily Engulfing Candlestick Patterns on the EURUSD currency pair during 2020. This was conducted using ForexTester in forward-only mode (making it as close to live conditions as possible).

Here are how the trades were taken:

Setup = Bullish or Bearish Engulfing Candlestick Pattern on the daily (D1) chart

Trigger = break of the Engulfing day’s high/low

Stop loss = very close to the high or low of the Engulfing day

Trade Management = Scale ½ position at 1R or better; trail the remainder behind 4H swing highs (for short trade) or lows (for long trade).

Money Management = Fixed Fractional 0.5% per trade; 0.25% if adding to an existing position.

Here are the daily charts of trades taken during Q1, Q2, Q3 and Q4 2020.

EUR/USD Daily Engulfs

EUR/USD Daily Engulfs 2020

EUR/USD Daily Engulfs

EUR/USD Daily Engulfs

Here is a statistical analysis of the results obtained:

Avg. Profit = 0.39%

Avg. Loss = -0.28%

Avg Profit/Avg Loss = 1.4

 

Win Rate = 0.74%

Max Win = 1.9%

Max Loss = -0.5%

 

MaxDrawDown = -1.25%

Total Return = 11.96%

Expectancy = 0.36%

 

More detailed data is shown within the below graphical representation of this back test:

EUR/USD Daily Back Test Data

 

Commentary: Back Test Results

The engulfing candlestick pattern is a reliable Forex trading signal, especially if taken in the following scenarios:

  • A Bearish Engulfing Candlestick Pattern after a clear sequence of bullish days.

  • A Bullish Engulfing Candlestick Pattern after a clear sequence of bearish days.

  • A Bearish Engulfing Candlestick Pattern that false breaks current/prior month highs.

  • A Bullish Engulfing Candlestick Pattern that false breaks current/prior month lows.

  • A Bullish Engulfing Candlestick Pattern in the context of an uptrend, after a pullback.

  • A Bearish Engulfing Candlestick Pattern in the context of a downtrend, after a pullback.

Instead, losses will start to mount if the engulfing pattern is traded within a sideways market (as evidenced by the worse performance during Q3 and Q4 2020 in our test, where the EUR/USD began a period of ranging consolidation).

The main issue with the engulfing pattern at the level of the daily time frame or higher is the reward to risk calculation. By triggering the trade through the engulfing day’s high or low, and placing the stop loss on the opposite side of the days’ range, we can frequently have a stop loss that is equal to, or larger than, the 20-day ATR (average true range).

The large stop loss involved means that achieving multiple-R trades is challenging. In our test, we only experienced 3 multiple-R trades over the course of 1 year. However, we must remember that the mathematics of sustainable long-term trading performance requires the average win to be larger than the average loss. Therefore, the key in successfully implementing this kind of trading strategy is to maximise any positive run-in price by either trailing the stop loss (which will reduce risk and lock in gains as the trade progresses) or utilizing the engulfing signal as a setup, but entering the trade using different entry tactics on smaller timeframes, to achieve larger returns relative to risk.

There is no “best fit” scenario, however. By using a wider stop loss, you will have a higher win rate, but smaller gains and a more gradual equity curve overall. By adopting smaller timeframe entry tactics alongside the daily engulfing candlestick pattern, you will have a lower win rate, but larger gains and a steeper equity curve overall.

Final Thoughts

The Bullish and Bearish Engulfing Candlestick Patterns are simple and reliable ways to trade the markets as they both represent a strong shift in momentum. But not all Engulfing Patterns possess the same potency, so before trading it may be wise to study where the more evident engulfing patterns tend to appear and become a specialist at spotting them.

Dedicate time to the trade management component of the strategy. Surviving in the markets for more than a season requires maintaining a positive expectancy. This essentially means having at least a 50% win-rate with wins that are 1.2 to 2 times larger than losses.

Perhaps the best thing about Bullish and Bearish Engulfing Candlestick Patterns is the clarity they provide. There is very little discretion required from the trader, and no indicators are required.

FAQ

How do you trade engulfing candles?

The default way to trade engulfing candlestick patterns is to place a stop entry order above the engulfing candle high (for bullish engulfing patterns) or below the engulfing candle low (for bearish engulfing patterns). However, the risk-reward of this kind of entry will not always be appropriate. As such, especially when triggering daily, weekly or monthly engulfing patterns, using a smaller timeframe trigger (hence allowing for a tighter stop loss) can stack the odds more firmly in your favour.

How reliable is a bullish or bearish engulfing pattern?

From a purely statistical point of view, it is hard to find any kind of technical pattern that is much better than a coin-toss. Bullish and bearish engulfing patterns follow the same rule: without any additional filter (such as the ones discussed in this article), the odds of success are around 50%. However, the odds of a pattern working are just one side of the story. In trading, you do not need to be right more than 50% of the time to make money. For example, what if every time you trade a Bullish or Bearish Engulfing Candlestick Pattern, you can achieve 3R? Even if you win only 50% of the time, you will still be making money. So, by all means, filter out the best engulfing patterns, but at the end of the day it is the reward to risk ratio of your trades that will determine your success.

What does an inside day candle mean?

The term “inside day” refers to a sequence of 2 daily candles where the second day’s high-to-low range is completely contained within the previous day’s range. Stated otherwise, the inside day is a form of range contraction or consolidation. From a psychological point of view, an inside day shows a certain degree of indecision. A couple of important points: as with other candle patterns, you should not take the inside day as a trading signal by itself. Despite showing a pause in the market, the inside day gives no indication of future direction. Hence, using other filters is crucial when creating a trading strategy that uses the inside day.

What is a bear candle?

A bear candle, broadly speaking, is a candle that has experienced downwards price movement. In other words, the candle’s closing price is lower than the candle’s open. The larger the decline in price from the open to the close, the stronger the signal is.

 Justin Paolini

Justin Paolini helps traders succeed through 1-on-1 coaching at BuildingaTrader.com. He is also Head of Trader Development at FCI Markets UK. Justin has over 15 years of experience trading Forex of which 3 were spent as a Sales Trader and as a Broker. Previously, he was an analyst at 3CAnalysis.com, producing institutional grade directional calls. His market commentary has been published on FXRenew.com, Yahoo! Finanza, Trend Online, FX Street, OrderFlowtrading.com, and ForexTell.com. For the past 8 years, he has dedicated himself to helping others succeed, and has been a guest lecturer at the University of Ancona on Trading and Market Dynamics.

Justin holds a B.A. in Economics & Finance from UNIVPM, Ancona, and a Masters in Finance, Banking & Insurance.

Did you like what you read? Let us know what you think!

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Please make sure your comments are appropriate and that they do not promote services or products, political parties, campaign material or ballot propositions. Comments that contain abusive, vulgar, offensive, threatening or harassing language, or personal attacks of any kind will be deleted. Comments including inappropriate will also be removed.

2 User comments
aristid
2012-12-24 15:10:12Z

thank you for this article,
it is a bit confusing as I believe you are using the word "body" in two different ways.
you mention majority of the candle must be body (you obviously mean open to close distance here)
then you say you need at least 90% of body covered, I am assuming you mean range (low to high).
your example shows that the bearish candle is not completely engulfing the previous candle.
I just want to verify that you are taking trades even if the first candle is not completely engulfed by the second one, which would be new information to me.
thanks again and merry Christmas.

derrick.dike.9
2012-07-11 00:38:30Z

Nice article


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Please make sure your comments are appropriate and that they do not promote services or products, political parties, campaign material or ballot propositions. Comments that contain abusive, vulgar, offensive, threatening or harassing language, or personal attacks of any kind will be deleted. Comments including inappropriate will also be removed.

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