Bullish engulfing and bearish engulfing patterns

The hammer and the hanging man that were previously discussed in the previous article named Hammer and Hanging Man are the reversal signals that are very prominent and useful and they signal the reversals more often than not. But unlike the hanging man and the hammer patterns and a few others, that we will discuss in later articles, most of the setups in the candle stick analysis are combination of two or more candles. Although Mr. Steve Nison in his breakthrough book beyond candlestick has shown that if we can combine the price actions of all the patterns, obviously which include two or more candles, ultimately the resultant would taper down to hanging man or hammer and there about. It might seem confusing but we will get to that step by step as we move along. Now to start with the simplest explanation as to what is an engulfing pattern, try to picturise what the word engulfing bring to your mind. The engulfing patterns are a combination of two candles the second of two candles engulfs the first one and thus the pattern gets its name. Just like the hanging man and the hammer the engulfing patterns are major signals and give genuine signal of reversal of trends. Bullish engulfing pattern: As the name suggests this patten, the bullish engulfing, appears at the end of a down trend and it signals the end of the bear trend and the reversal. The prices are moving down in a consistent manner and it is an established down trend; the pattern is formed when on the day one, i.e. the first candle of the pattern is formed is red and is in accordance of the trend, being down, now on the following day the market opens below the previous close making it gloomy for the prices but then the buyers come into action and they take prices all the way up, above the previous day open. Look at the diagram and refer to it.

Ones you are able to picturise this you will understand the working of the pattern. The trend was established down trend and as a routine there was a red candle. Now on the following day the prices open below the previous close, which again is a negative sentiment and can force sell off (take a break here and remember the hanging man situation where the buyers are left with long positions) but since it is near bottom or bottom those long liquidations will not happen. Contrary to all the negative sentiments that the prices have been showing all the way, the buyers come into action and they start buying and they outwit the sellers or the bears in the market taking prices all the way up and above the previous day open (see the diagram again). Now this kind of activity on the charts establishes that the buyers or the longs have gained control over the bears by not just holding the prices to fall any further but also taking prices much above the previous open.

Certain aspects of the engulfing patterns that should be kept in mind while finding and checking the authenticity of those discoveries: As most of the candle chart patterns are reversal patterns it is again being emphasized here that there should be established trend in the market. The candle patterns whether single candle or multiple candle patterns will only signal reversals if there is a trend which is ripe enough to reverse which can be judged by other technical indicators at your diposal. In case of the engulfing patterns the there has to be two candles (at least). In case of a bearish engulfing pattern the first candle will be a blue one and the following candle will be red which will completely cover the blue candle. Similarly in case of a bullish engulfing pattern, the first candle will be a red candle followed by a blue candle which will engulf the red candle. Now as per the generally accepted rule and the Japanese theories, open and the close of the candle are more important and in case of the engulfing patterns the body of the candles are taken into consideration, i.e. the candle engulfing has to engulf only the body of the candle being engulfed. The following diagram of a bullish engulfing pattern will explain it better. The dotted blue lies mark the extent of the body of the red candle which falls completely within the extents of the bullish blue candle marked in the red dotted lines.

Here I would emphasize two points, first is that if the second candle engulfs either of the shadows or both the shadows it will add to the implication of the pattern but the cardinal rule is that the body should be fully covered and the bigger the second candle of the pattern the more meaningful it is. The second point is lookout for any increase in volumes accompanying the second candle. An increase in volumes will testify the move. The engulfing pattern pictorially depicts the various forces at work the resultant outcome of the interaction of the forces being talked about. Defying the established trend and taking charge of the new movement is what the engulfing pattern is all about. Volumes, I would again emphasis, if they accompany the second tick they have a meaning. They tell us that the top or the bottom is established and the prices will reverse here after. The engulfing pattern if they appear after a prolonged and steep uptrend or a downtrend, i.e. there were no corrections or setbacks in the trend and if any they were of small magnitude increases the chances of appearance of engulfing pattern and the revesal of the trend there after. This is so because in a trend if there are corrections they provide the longs to book profit and the trend itself doesnt move at a steep angle. Always remember it takes buying to keep the stock up, they crumble under their own weight. So in case of a step trend no new support can be expected in form of buying and generally these rallies get affected by profit booking of huge magnitude. Now coming to the concept of combining the price actions of two candles and finding the resultant, this method has been discussed by Steve Nison the father of the modern candle stick charts and by John J Murphy another great author of repute in field of technical analysis.

Now as we can see that on combining the two candles of the engulfing patterns we get our own hammer and shooting star patterns. Similarly if one can train himself to assess the resultant of the combination of the candles he will have an upper hand while analyzing the situations. Try it on with other candle stick patterns and see what happens. Bearish engulfing pattern:

The bearish engulfing pattern appears after a bull trend and signals the reversal of the trend into a bearish trend. There is a substantial bull run or there may be a steep unsustainable up move at the end of which the bearish engulfing pattern appears. The first candle of the bearish engulfing pattern is a red candle which is then engulfed by the red candle and this signals the reversal of the trend. In case of the bearish engulfing pattern a substantial increase in volume is generally not sought for to decide because in case of the reversal of the uptrend the prices come down under their own weight but the volume should be above average and no less than the previous day volumes. Contrary to the reversal of the uptrend the second candle of the bullish engulfing pattern should accompany increased volumes.

Above is an ideal example of the bullish engulfing pattern where the second candle of the pattern covers the entire body of the first candle. The second candle of the pattern is also accompanied by the increased volumes.