Trading risk assets is never an exact science, as the volatility and variability in the financial markets make it impossible to predict anything with certainty. However, there are several technical analysis tools and patterns traders can use to help them increase the likelihood of entering a profitable trade. One of these is the bullish engulfing pattern.
The bullish engulfing pattern in candlestick trading is a reversal signal used by traders looking to enter a long trade at the bottom of a downtrend. It is formed from two candles on the candlestick chart: a small red candle at the bottom of a downtrend, followed by a large green candle that covers the entire range of the previous red candle.
The bullish engulfing pattern is one of the most common technical analysis indicators used by traders who study candlestick charts, as the large, positive candle following a bearish run is a strong indication that momentum could be getting ready to trend in a positive direction.
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Table of Contents
How to Identify Bullish Engulfing Pattern?
The bullish engulfing pattern in candlestick trading is one of the easiest patterns to identify in all technical trading, as the trader only has to focus on two specific candles to confirm or deny that the pattern exists.
Construction of Bullish Engulfing Pattern
The bullish engulfing pattern consists of two candles:
- A small, red candle (or whatever color your software uses to denote that an asset closed lower than it opened) that is at the bottom of a downtrend
- A large, green candle (or whatever color your software uses to denote that an asset closed higher than it opened); this green candle will often have a tiny wick, if any at all, meaning that the asset closed very near its high price for the session.
To confirm the existence of the bullish engulfing pattern, the small, red candle must be able to fit completely inside the large, green candle with no overlap, if transposed over one another. Imagine a six-inch ruler to the left of a 12-inch ruler. If the six-inch ruler spans from the 3-inch to the 9-inch mark of the 12-inch ruler, this would be a bullish engulfing.
Key Characteristics of Bullish Engulfing Pattern
The bullish engulfing pattern has several unique characteristics to its construction:
- A downtrend must be identified, with the small, red candle that forms the first candle of the bullish engulfing pattern likely following a series of other red candles.
- The second candle that extends lower than the close of the first candle shows that there is still some bearish momentum, although that momentum is trickling.
- The long body of the second candle in the pattern shows that a potential reversal in momentum is powerful.
- The short wick at the top of the second candle reveals that the positive momentum garnered throughout the session is likely to continue at the open of the next session.
How to Interpret the Bullish Engulfing Pattern?
One of the classic drivers of market psychology is FOMO—fear of missing out—and the bullish engulfing pattern is arguably the best pattern to indicate that the market is in full-on FOMO mode.
Very simply, the bullish engulfing pattern forms when the bulls have sat on the sideline and waited for the bears to drive down a price for as long as possible. However, when the price becomes too good for the bulls to resist, they jump in and scoop up as much of the asset as they can.
This huge rush of buyers gives the second candle in the pattern its shape, with the high close a likely indication that even more bulls are going to come out and buy before the price goes even higher.
How to Improve the Reliability of Bullish Engulfing Pattern?
As with most technical analysis tools, the bullish engulfing pattern is not entirely reliable when used by itself, as bullish engulfing frequently takes place and does not always represent a true turnaround in a volatile market.
Therefore, it is essential to study the candlestick chart assiduously, as a bullish engulfing is most reliable when it occurs at the end of four or five consecutive red candles.
In addition, other reversal patterns, such as harmonic crabs, can be used in conjunction with the bullish engulfing. If the bullish engulfing takes place at the bottom of the second down leg of a W-shaped crab pattern, then there is a higher likelihood that the asset will go on a positive run.
Finally, and most importantly, the bullish engulfing can be confirmed as a reversal if it forms part of the three outward-up pattern. Essentially, the three outward-up is a bullish engulfing, followed by a second consecutive green candle. This second positive candle can help traders feel more confident in the reliability of the bullish engulfing.
How to Trade Bullish Engulfing Pattern in Candlestick Trading?
When trading the bullish engulfing pattern, it is almost always employed as part of a reversal strategy
Reversal Trading Strategy
Listed below are a few factors to consider when trading the reversal strategy using the bullish engulfing pattern –
- Market Environment – The asset must be in a downtrend. Bullish engulfing patterns are not reliable in volatile markets. The trader should look for a string of at least four or five consecutive red candles ahead of the bullish engulfing.
- Identify and Confirm Trade Opportunity – The completion of the large green candle (formation of bullish engulfing) will indicate an opportunity for trade.
- Determine Trade Entry, Stop-Loss, and Take Profit Levels – Traders should be ready to enter the trade at the opening bell of the session following the completion of the bullish engulfing. Stop-loss is difficult to set for this pattern, but a retreat to the opening price is a good estimate for most. A take profit level of 10% or more is acceptable, as a true reversal will bring hefty returns with it.
- Execute and Manage Trade – As mentioned, a bullish engulfing is a constituent of the three outward-up pattern. Therefore, if a second consecutive green candle does not form and the three outward-up pattern is not completed, it may be time to exit the trade, as a true reversal is not in the formation.
Advantages and Limitations of Trading Bullish Engulfing Patterns
As with all technical analysis tools and indicators, the bullish engulfing pattern has its strong points and areas where it is lacking. It is important to incorporate both these aspects when making trading decisions using this pattern.
Therefore, described in the following section are the primary strengths and limitations of the bullish engulfing pattern.
Advantages of Trading Bullish Engulfing Patterns
Listed below are the primary advantages of trading the bullish engulfing pattern –
- Are present for all forms of tradable assets
- Are easy to identify, as the large, positive candle at the end of a downtrend really stands out
- Has a strong track record of accurately predicting price reversals
- As it is a relatively simple pattern, it is a great option to pair with other technical analysis tools
Limitations of Trading Bullish Engulfing Patterns
Listed below are the primary limitations of trading the bullish engulfing pattern –
- As the second candle forming the pattern is so large, stop loss targets can be difficult to pinpoint
- Is not useful in volatile markets, requiring the presence of a sustained downtrend to be effective
- Bullish engulfing patterns form on a candlestick chart with high frequency, potentially diluting its value for those not adept at identifying trends
Candlestick Pattern Opposite to Bullish Engulfing Pattern
A bearish engulfing pattern is precisely like a bullish engulfing pattern and has the same strengths and weaknesses, only in the opposite direction.
A bearish engulfing would form at the end of a sustained uptrend in which a small, green bar is completely engulfed by a large, red bar, potentially indicating that a negative run is on the way.
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Conclusion
Of all the technical analysis tools and indicators used by traders, perhaps none is quite as prevalent as the bullish engulfing pattern in candlestick trading. A reversal signal that comes at the end of a strong downtrend, the bullish engulfing pattern is formed from two candles: a small, red candle that is followed by a large, green candle that completely covers it.
This pattern means that a strong bull run could be imminent, and when combined with other common reversal indicators, can help traders buy-in at favorable points for long trades.
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