A bearish engulfing pattern is one of numerous different candlestick patterns used by day traders in a diversity of markets in setting up trading strategies. They are a key tool to have in technical analysis to identify a reversal and are most commonly used by traders in forex markets. As with most other candlestick patterns, the important aspects are how the pattern behaves, what it indicates to traders, how to use it in trading and what its limitations are. All of these are addressed in this ensuing.
What is Bearish Engulfing Pattern in Candlestick Trading? A bearish engulfing pattern is a candlestick reversal pattern composed of a small upward signaling candlestick followed by a much larger downward signaling candlestick. It is said that the second candlestick has “engulfed” the first one. As its name implies, the bearish engulfing pattern indicates to a trader that a reversal has occurred: the pressure of sellers in the market has overcome the force of buyers, and prices are pushed downward into a bearish pattern.
If you’re interested in learning more about the bearish engulfing pattern in candlestick trading, this article is for you. Keep reading for the complete guide to the bearish engulfing pattern in candlestick trading.
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Table of Contents
How to Identify Bearish Engulfing Pattern in Candlestick Trading?
To identify a bearish engulfing pattern on a chart, take note of the following components and key characteristics:
Construction of Bearish Engulfing Pattern
Listed below are the constructional components that constitute the bearish engulfing pattern –
- An Upward trend: A bearish engulfing pattern always appears at the end of an upward trend in price. The upward trend is followed by two candlesticks that are opposite to each other in nature and size.
- A small bullish candle: This candle is also upward trending. It is the last candle of the uptrend that precedes the pattern. It has both a small body and small shadows, indicating that the opening, closing, high and low prices are all close to each other. Its size indicates that the upward action in price has been exhausted.
- A large bearish candle: The bullish candle is followed by an overshadowing bearish candle. This candle has a much larger body and longer wicks than the previous one. It indicates enough momentum in the downward direction to support the prediction that the price pattern will reverse and head downwards.
Key Characteristics of Bearish Engulfing Pattern
Listed below are the key characteristics of a bearish engulfing pattern –
- Prior upward price trend: The upward movement price trend that comes before the two candlesticks that form the bearish engulfing pattern must not be choppy (it should be clearly be moving strictly upward) otherwise the significance of the engulfing pattern’s reversal indication is diminished because there is no clear indication that it is a change in trend or just a false signal indicted by the unclear movement of price.
- Color: The first candlestick is green, this indicates that the candlestick closes at a price higher than its opening price and the price is upward trending. The second candlestick has a red color because it closes at a price that is lower than its opening price and is bearish in nature.
- Closing and Opening Prices: The pattern is said to be significantly more reliable when the opening price of the second candle is above the close of the first candle and its closing price is far below the opening price of the previous candle.
How to Interpret Bearish Engulfing Pattern?
When trading the bearish engulfing pattern, below is how you should interpret its various components –
- Uptrend: Bullish pressure in the market leads to the market being overbought. There is strong demand and supply is weak in comparison. As the commodity becomes more difficult to purchase, its price continues to increase. In response, investors begin to hoard their shares trying to maximize profit by selling at the highest price.
- Day 1: By the first day of the bearish engulfing, the market reaches an upper limit.
- Day 2: After the first day and the first candlestick in the pattern, investors, assuming that the market has reached overbought levels (which is true) will scramble to sell to maximize profit. Selling pressure will push prices down in a bearish manner. The bearish activity of this day will supersede the bullish activity of the previous day.
How to Improve the Reliability of Bearish Engulfing Pattern in Candlestick Trading?
Similar to all other candlestick patterns, the bearish engulfing pattern cannot be effectively used in isolation of other trading tools in a trading strategy.
Using this candlestick pattern in isolation, firstly makes it difficult to determine the stop loss and take profit points in trading, and secondly is susceptible to false signaling without other indicators confirming the signals given by this candlestick pattern.
To address these limitations, consider the following:
- Momentum indicators, such as the Relative Strength Index (RSI) can be used to validate the market trend and the strength of that trend. With the bearish engulfing pattern, you want to see an RSI at or above 70, indicating that the market is oversold and then has reversed below 70, indicating a reversal.
- A volume indicator can also show the changes in the market from the perspective of the number of trades made. On the first day of the pattern, the trade volume should be significantly lower than on the second day, where the trade volume is expected to increase significantly. A good volume-based indicator to use in this circumstance is the on-balance volume (OBV) indicator which shows the running total of an asset’s trading volume over a period of time.
- Lastly using a trend indicator can help determine good stop loss and take profit points for the given market by giving clearly defined support and resistance lines. Good trend indicators for this role are Bollinger Bands, Donchian Channels, or even Fibonacci retracement levels.
How to Trade Bearish Engulfing Pattern in Candlestick Trading?
While there are many strategies to trade the bearish engulfing pattern, combining it with the RSI readings is widely considered an effective method to trade this pattern.
Described below are a few things to consider when trading this pattern in conjunction with the Relative Strength Index –
Before entering trade, ensure that the following characteristics are present:
- There should be a strong upward trending market prior to the forming of the bearish engulfing pattern.
- On day 1, when the bearish engulfing pattern began, the RSI should be >70 indicating the market is overbought.
- On day 2, after the bearish engulfing has occurred, the RSI should revert back below 70.
Determine Trade Entry, Stop Loss and Take Profit Levels:
- Enter trade in a short position after the pattern has fully formed.
- Set the stop loss point below the highest price in the candlestick pattern.
- Set your take profit point at an RSI of 30 where the market is oversold to maximize profit.
Execute and Manage Trade:
This strategy is at its optimum when longer time frames are used to establish the nature of the preceding uptrend that leads into the pattern. False signaling can occur, be cautious of this.
Advantages and Limitations of Trading Bearish Engulfing Pattern
Now that we have covered the basics, let us discuss several key advantages and limitations of the bearish engulfing pattern.
Advantages of Trading Bearish Engulfing Pattern
Listed below are the primary advantages of trading the bearish engulfing pattern –
- This pattern is easy for traders to identify.
- The pattern occurs commonly, especially in the forex market. This means more trade opportunities.
Limitations of Trading Bearish Engulfing Pattern
Listed below are the primary limitations of trading the bearish engulfing pattern –
- If the pattern does not follow a clear upward price trend, the significance of the pattern decreases because false signaling can occur.
- When the second candlestick is too large, the trader may have a very large stop loss, meaning the risk of the trade could outweigh the potential profit it could yield.
- Without another tool to complement it, setting a profit target and stop-loss are difficult.
Candlestick Pattern Opposite to Bearish Engulfing Pattern
The opposite of the bearish engulfing pattern is called the bullish engulfing pattern. Similar to its inverse, this pattern is also composed of two candlesticks, a small downward trending bearish candle, followed by a larger bullish candle.
The bullish engulfing pattern is a reversal indicator of a bullish trend in price (an upward moving price trend). For more information on this pattern check out this link.
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Conclusion
In conclusion, the bearish engulfing pattern is a two-candlestick reversal pattern that traders use to signal potential reversals in the market and make trading decisions based on.
While the pattern is easy to identify and use for all levels of traders, it is most effective when combined with complementary trading tools such as the RSI indicator or Donchian Channels and should not be used in isolation.
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