The Engulfing Candle Price Action Pattern

After going through last weeks survey results, it is clear that you want more price action strategies. So today’s topic will cover just that. Introducing the Engulfing Candle Price Action Pattern.

For those who don’t know what Price action is, in a nutshell, it is how the price will react at certain levels of resistance or support.

The idea is to interpret market behavior visually and use this information to profit from the inevitable reaction of other market participants.

There are many different ways to use price action, but today I want to focus on using candlestick formations.

Candlestick charts can be a powerful addition to your trading repertoire if used correctly.

If you are unfamiliar with candlesticks at all, then I suggest you check out my previous article here: A complete guide to trading pin bars.

What is the engulfing candle pattern?

Engulfing candlestick patterns take two candlesticks to be identified.

These patterns occur when the body of one candle completely covers or “engulfs” the body of the of the candle directly before it.

They are also one of the simplest candlestick reversal patterns to identify.

Here is an example of what I mean:

As you can see in the image above, the circled candlestick is so big, that it completely surrounds the previous candle from top to bottom.

This does not apply both ways however.

The image below does not meet the specifications of an engulfing candle because it does not come after the smaller, red candle.

Identifying the different types

There are two different types of engulfing candles: Bullish and Bearish.

To know the difference all we have to do is look at how the engulfing candle is behaving.

For a bullish, the engulfing candle needs to heading in the upward direction from the previous candle

Like this:

Bullish Engulfing Candle
For a bearish engulfing pattern, the engulfing candle needs to heading in the downward direction from the previous candle.

Like this:

Bearish engulfing candle
The setup

Identify the Trend

The very first thing we need to do is identify our trend.

This setup requires that the market be either in a upward or downward trend. If the market is consolidating, then this strategy should not be applied.

Since we are looking for a reversal, the engulfing candle must be opposite of the trend.

So, if you are in a downward trend you should be looking for a bullish engulfing candle.

It should look similar to this:


As you can see the market is in a downward trend, meaning we needed to look for a bullish engulfing candle to tell us the market was getting ready to reverse.

Entry/Exit Points

The entry to this strategy is a simple one.

As soon as the engulfing candlestick closes, then you enter in the trade on the very next candles open.

*Note The bigger the engulfing candle, the smaller the profits will be. So just be sure that your RR is worth your while when you are looking for a potential trade.

Entry_bullish

The next thing you’ll want to do is place your stop/loss.

For a bullish engulfing candle it should be placed at the bottom of the wick.

For this reason you want to be very careful when placing trades on engulfing candles that produce long wicks.

Here is an example of a long wick:

Long_wick engulfing candle
For a bearish engulfing candle it should be placed at the bottom of the wick.

Finally your take/profit should be placed at a previous high/low depending on what trend you’re trading.

If it’s a downward trend then you should be looking for a previous high and if it’s a upward trend you should look for a previous low.

Now that we’ve covered the setup, let’s look at how a real trade should play out.

Rules for the Engulfing Candle Pattern

Before we begin let’s review the rules in a nutshell:

  1. Identify whether we have an upward or downward trend.
  2. Identify an engulfing candlestick that does not have a really long wick and completely covers the previous candle
    1. For a downward trend look for a bullish candle
    2. For a upward trend look for a bearish candle
  3. Place your entry on the candle directly after the engulfing candle (remember to watch your RR).
  4. Place your stop/loss
    1. For a bullish candle it should be at the bottom of the engulfing candles wick.
    2. For a bearish candle it should be at the top of the engulfing candles wick.
  5. Place your take/profit.
    1. For a bullish candle it should be at a previous high in the trend
    2. For a bearish candle it should be at a previous low in the trend.

Example

For my example I am using the Euro/Dollar Currency pair on a 30 minute chart, but this strategy can fit any time frame.

The first step I take is to identify that I am in a downward trend.

Example_1 of engulfing candle

Because I am in a downward trend and want to implement this strategy my next step was to identify a bullish engulfing candle.

I find one in that engulfs the previous red candle and wait to see if it is still engulfing it when the candle closes.

Example of bullish engulfing candle

It does exactly what I need it to do.

So the next step is to place my entry at the candle directly after the bullish engulfing candle.

The blue horizontal line will represent my entry point at 1.06491.

example_3

Next I place my stop/loss at the bottom of the engulfing candles wick.

I have marked my stop/loss with a red horizontal line.

example_4
The final step is to place my take/profit.

I need to find a previous high in the trend that will signify a good profit margin.

I find it at 1.07015 and place my take/profit for potential gain of 52 pips.

It also gave me a nice Risk/Reward of 5.7 (52 pips/9 pips) as shown in the picture below.

example_5

Here’s how it played out:

example_6

Conclusion

If you’re looking for a good price action pattern to start practicing, then I highly suggest you start with this one!

It’s simple and effective.

However, do not trade every engulfing candlestick you see that forms.

Always gather important information from the charts, and form a solid conclusion to determine if you should enter the trade based on my pattern rules.

Hope you enjoyed this strategy on the Engulfing Candle and let me know what you think!

-J

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