Bullish and bearish engulfing patterns are part of Japanese candlestick reversal patterns and they always use two candles. The name indicates to us where they form: the bullish engulfing pattern forms at the end of a bearish trend and the bearish forms at the end of a bullish trend.
The bullish and bearish engulfing patterns are quick reversal patterns that don’t predict what will happen next. The reason for this is that the first part of the pattern (the first candle) goes in the direction of the underlying trend. More precisely, in a bullish engulfing pattern the first candle is a strong bearish candle; a red candle with a big body, signaling no reversal conditions. In a bearish engulfing pattern, the first candle of the pattern has a strong, green body, in the direction of the bullish trend.
What defines Bullish and Bearish Engulfing patterns
If the first half of the pattern doesn’t offer any information regarding the potential reversal, the second half of the pattern does.
The second candle is an even stronger candle. A mandatory criterion of bullish or bearish engulfing patterns is that the second candle must completely engulf the previous candle’s body.
However, there’s a catch.
One important rule that many retail investors fail to follow is that the second candle’s body must not also engulf the shadow of the previous candle. If this occurs, the pattern is not considered a bullish or bearish engulfing pattern.
Here are some examples of similar patterns that don’t fit into the category:
From left to right, the first example is not a bearish engulfing for the simple reason that the second candle’s body does not engulf the previous candle’s body. Moreover, it doesn’t appear at the end of a strong bullish trend, but merely at the end of a pullback.
The second example shows the second candle engulfing both the real body and the shadow of the first candle. Instead of confirming the pattern, this discounts it.
How to trade Bullish and Bearish Engulfing patterns
Trading bullish and bearish engulfing patterns is like trading a Hammer or a Shooting Star, apart from a small difference. Because the second candle is so large that it engulfs the previous candle’s body, the market’s pullback is not as strong as in the case of the Hammer or Shooting Star.
Therefore, instead of looking at retracements of 50%-61.8%, investors look for a retracement of 38.2% with a stop loss at the highest point in a bearish engulfing pattern or the lowest point in a bullish pattern. This results in a more significant risk for the trade, but the reward typically exceeds the 1:3 risk-reward ratio suitable for trading the currency market.
As a rule of thumb, when looking for the entry point search for the 38.2% retracement level by measuring the distance between the lowest and the highest points of the bullish or bearish engulfing pattern.
- Bullish and bearish engulfing patterns are two-candle patterns.
- The second candle must not engulf the previous candle’s shadow.
- A retracement of 38.2% is considered sufficient for a good entry.
- A 1:3 risk-reward ratio is a common target.