The Magic Of The Engulfing Pattern – And Trading It!
Before jumping in the Engulfing Pattern, here's what you NEED to understand…
The major goal of trading is determining who is “likely” to be in control of the price, and then trading in that direction. I say “likely” because we can never be certain that the buyers/sellers who were aggressive in the past will keep the momentum over the future periods.
As an example, as price reaches an area of support, a trader may believe that the buyers are most likely to take control of the market, thus driving the price all the way to the resistance level. This trader would then enter a LONG (buy) trade.
A trend trader could do a similar thing following a certain pullback. He would then buy a certain currency pair thinking that the buyers, who had control in the past, will step back in the market aggressively.
The tricky part comes down to this: “How am I supposed to know that the buyers/sellers are now in control?”
The answer to this is fairly simple: Look at the price movements.
Traders often overlook the fact that price movements are the only indication of who has more power in the market. Indicators like the Bollinger Bands or the ADX won't necessarily tell you this. However, looking at candlesticks is the first sign of aggressiveness and pressure from the buyers or the sellers.
Don't get me wrong here…
Indicators such as the RSI, Bollinger Bands, and the ADX still have their place in trading. However they must not be solely relied upon. Professional traders always look at the price before anything else.
The Engulfing Pattern
Alright, I recommend you download the checklist I prepared for this article. It's called the Perfect Engulfing Cheat Sheet.
One way of determining who has the control of a certain currency pair is to look at price action. Price action simply refers to all the movements in price. Traders may look at the trend, structure, or candlestick patterns to determine who has been more aggressive.
A powerful candlestick pattern (the one we'll explore) is called the Engulfing Pattern.
Before going further though, I want to address a false belief many new traders have:
Price action doesn't work, it's based on past data.
Indeed, price action represents the past but by knowing who was in control in the past, we can determine with good accuracy who will be in control of the market direction in the future.
Now that this is addressed, make sure you understand how candlesticks are formed. They contain the open, close, low, and the high of a specific period. I'll assume you know that stuff.
We can then move on to what's an Engulfing Pattern…
|Bullish Engulfing Pattern||Bearish Engulfing Pattern|
The Engulfing Pattern is a candlestick pattern in which the second candle's body covers the whole body of the previous candlestick. According to Investopedia, both the body and wick of the previous candlestick must be covered by the Engulfing candle. That will give you a better accuracy when trading those patterns.
The powerful aspect of the Engulfing Pattern is that it signifies a strong likelihood of reversal in the market. The buyers or sellers have been been aggressive enough to bring back the price to a level beyond the extreme level of the previous day.
The key however, is that not all Engulfing Patterns are considered significant. For a bullish Engulfing Pattern to be significant, it must appear after a significant drop in the price. For a bearish Engulfing Pattern to be considered valid, it must appear after a good increase in the price.
How To Trade The Engulfing Pattern
By looking at any currency pair, you will be able to notice several Engulfing Patterns. The key, however, is to combine those price action signals with other factors to create confluence.
My first real profitable trading strategy consisted of trading Engulfing candles with major structure points. Below are the steps I took to locate and enter a good trade.
1) Draw support and resistance levels
I would first start by identifying the major support and resistance zones. In order to get the major zones, I recommend looking at all time frames higher than the time frame you are planning to trade. For instance, if you were to trade the 1 hour chart, you would look at support and resistance levels on the 4hr, Daily, and Weekly charts. No need to go higher than the weekly chart. If you were to trade the Daily chart, you would look at support and resistance levels only on the Weekly chart. That will give you the main (significant) zones.
2) Identify Perfect Engulfing Patterns near support and resistance zones
Once price gets to a zone, your goal is to determine whether price is likely to reverse. While there are many ways to do this, an Engulfing Pattern will give you a good indication that the buyers or the sellers took control of the market. The thing is, you want to make sure that your Engulfing Pattern is a great one. The Perfect Engulfing Cheat Sheet I created will help you do just that.
3) Place your entry, stop loss, and take profit
While new traders think of this as the hardest part, it's actually quite simple.
For a buy trade:
- Your Stop Loss will be placed slightly below the most recent low (5 previous candlesticks).
- Your Entry will be above the high of the Engulfing Pattern.
- Your Take Profit will be slightly lower than the next possible resistance level.
For a a sell trade:
- Your Stop Loss will be placed slightly above the most recent high (5 previous candlesticks).
- Your Entry will be below the low of the Engulfing Pattern.
- Your Take Profit will be slightly higher than the next possible support.
This strategy is very simple, yet very powerful due to the fact that it uses a strong candlestick pattern.
Important Thing To Note!
I would be lying to you if I were to say that following this strategy will give you winning trades only. Based on the pair you decide to trade, your win ratio will vary. From the trades I have taken, you can expect a 50-70% win rate. In other words, for every trade you win, you can expect to lose one. Your success will depend on the other rules you put in place. Proper risk and money management is always a must.
There are several factors affecting the success of this strategy and I will be discussing those in an upcoming webinar. You can register to my free live training using this link.
The Engulfing Pattern is simple, yet highly powerful. Knowing how to identifying the strong patterns will help you determine who's in control of the market. That alone can give you an edge on other traders.
I want to know…have you ever used Engulfing Patterns in your trading? If so, what were the results? Leave a comment below!