Engulfing patterns in the forex market offer traders a valuable opportunity to enter the market in anticipation of a potential trend reversal. This article covers the essentials of the engulfing candle pattern, the trading conditions that create this pattern, and how to effectively trade engulfing candlesticks in forex.
Keep reading to learn more about:
• What an engulfing candlestick is and how it signals a reversal of current market trends
• The two main types of engulfing patterns: bullish engulfing and bearish engulfing
• Strategies for trading with engulfing candles
What is an Engulfing Candlestick?
Engulfing candlesticks typically signal a reversal of the current market trend. This pattern consists of two candles, with the latter candle completely ‘engulfing’ the entire body of the preceding candle. The engulfing candle can be either bullish or bearish, depending on where it forms in relation to the existing trend. The image below illustrates a bullish engulfing candle.
Types of Forex Engulfing Patterns
There are two types of engulfing candle patterns: the bullish engulfing pattern and the bearish engulfing pattern.
1. Bullish Engulfing Pattern
The bullish engulfing candle provides the strongest signal when it appears at the bottom of a downtrend, indicating a surge in buying pressure. This pattern often triggers a reversal of the existing trend as more buyers enter the market, pushing prices higher. The pattern involves two candles, with the second candle completely engulfing the body of the previous red candle.
Interpretation: Price action should show a clear downtrend when the bullish pattern emerges. The large bullish candle indicates that buyers are entering the market aggressively, providing an initial bias for further upward momentum. Traders then look for confirmation that the trend is indeed reversing by using indicators, key levels of support and resistance, and observing subsequent price action following the engulfing pattern.
2. Bearish Engulfing Pattern
The bearish engulfing pattern is the opposite of the bullish pattern. It provides the strongest signal when it appears at the top of an uptrend, indicating a surge in selling pressure. This pattern often triggers a reversal of the existing trend as more sellers enter the market, driving prices lower. The pattern involves two candles, with the second candle completely engulfing the body of the previous green candle.
Interpretation: Price action should show a clear uptrend when the bearish pattern appears. The large bearish candle indicates that sellers are entering the market aggressively, providing an initial bias for further downward momentum. Traders then seek confirmation that the trend is reversing by using indicators, support and resistance levels, and analyzing subsequent price action after the engulfing pattern.
Why Are Engulfing Candles Important for Traders?
Engulfing candles play a crucial role for traders by helping them identify potential reversals, confirming a strengthening trend, and providing signals for exiting trades:
• Reversals: Spotting reversals is straightforward—it allows traders to enter a trade at an optimal level and follow the trend until it completes.
• Trend Continuation: Traders can use the engulfing pattern to confirm the continuation of an existing trend. For instance, identifying a bullish engulfing pattern during an uptrend provides stronger conviction that the trend will persist.
• Exit Strategy: The engulfing pattern can also serve as a signal to exit an existing trade. If a trader holds a position in a trend that is nearing its end, the pattern can indicate it’s time to close the trade.
However, one limitation of the engulfing candle is that it may sometimes represent a retracement rather than a definitive change in direction. To mitigate this risk, traders should look for additional price action to confirm the pattern’s validity.
Engulfing Candle Trading Strategies
Using the Engulfing Candle Reversal Strategy
When trading the bearish engulfing pattern, traders can wait for confirmation of the move by observing subsequent price action or by waiting for a pullback before initiating a trade.
Below is a guide on how to trade the engulfing candlestick pattern, as seen on the GBP/USD four-hour chart.
• Entry: Look for a confirmed close below the low of the bearish engulfing candle. Alternatively, traders can wait for a brief retracement (towards the dotted line) before entering a short trade.
• Stop: Place stop-loss orders above the swing high where the bearish engulfing pattern occurs.
• Target/Take Profit Level: Set the target at a previous level of support while ensuring a positive risk-to-reward ratio. The risk-to-reward ratio can be visualized by the green (reward) and red (risk) rectangles.
Using the Engulfing Candle When Trend Trading
Engulfing candles don’t necessarily have to appear at the end of a trend. When observed within a strong trend, these patterns can provide traders with insights that suggest continued momentum in the direction of the existing trend.
For instance, the chart below illustrates a strong uptrend in the S&P 500, where multiple bullish engulfing patterns (aligned with the trend) offer additional conviction for long trades. Traders can consider entering a long position after a close above the bullish engulfing candle.
Additionally, this example includes a bearish engulfing pattern (marked by the red rectangle) that appeared at the top of the trend, signaling a potential reversal. However, subsequent price action did not confirm this move, as the following candles failed to close below the low of the bearish engulfing candle, and the market continued higher. This highlights the importance of validating the pattern before acting on it.
