Introduction to Candlesticks
Before we can discuss candlestick technical analysis, it is imperative for a trader to understand how to read a candlestick chart. Unlike traditional line charts, candlesticks provide more insight. Developed centuries ago in Japan to help traders navigate the rice market, candlesticks are comprised of five parts: the open, the close, the high, the low, and the body which indicates direction by virtue of its color. If the open is lower than the close, the candle body will be green or clear, indicating the asset was bullish for that particular time frame. If the open was higher than the close, the body would be red or black, indicating a bearish time frame. Above and below the candle’s body will be what looks like a wick. The top of the top wick indicates the high of that time period. The bottom of the bottom wick indicates the low.
The Bullish Engulfing Pattern
A bullish engulfing pattern is a candlestick chart formation used for technical analytical purposes. The pattern occurs when a small black or red candlestick is followed by a larger white or clear candlestick. The bullish candlestick must completely engulf the previous, bearish, candlestick, hence the pattern’s name.
This pattern hints to traders and investors that the bulls have taken control of the market from the bears. The bullish engulfing pattern is, in many cases, a trend reversal pattern. What that means is, you would find it at the end of a bearish trend downward. The pattern infers that the downward trend may be over, and a reversal of trend in favor of the bulls is likely.
With all candlestick analysis, however, context plays a key role. Examine the candlesticks before and after the pattern emerges for confirmation before entering a trade based solely on the pattern’s occurrence. Also, take into account the time frame of the chart being analyzed. Longer time frames have more credibility than shorter ones. The longer the time frame, the more relevant the pattern becomes.
Bullish engulfing patterns visually represent a surge in buyer interest at a particular price point. The body of the engulfing candlestick should swallow not just the body of the bearish previous candle, it should engulf the shadows of its highs and lows as well. That is a proper bullish engulfing pattern. The closer it resembles this, the more value it lends as a useful indicator of potential directional change. The top wick of the engulfing candle is normally short as the candle will close near to its high. As confirmation, the proceeding candle should be bullish as well with its body higher than the bullish engulfing candle.
When the pattern is seen at the end of a downtrend, the reversal is much more likely. In this way, the bullish engulfing pattern is a powerful tool traders have been using to enhance their profitability. As a reversal pattern, the lows of the engulfing candles should indicate the lows of the downward trend. The previous several candles should be bearish. Each one lower than its predecessor. When the second candle after the pattern closes higher than the first, a market structure low is triggered. If the next candle successfully breaches that high, an official trend reversal starts to form.
Example
If you looking at the daily candlestick chart for Stock A, you happen to see the stock is in a downtrend with five consecutive low candles. Each one lower than the one previous. Then, on the sixth candle, you have a bullish engulfing pattern with the body of this sixth candle completely engulfing the highs and lows of the candle immediately on its left. The seventh candle closes higher than the bullish engulfing candle. The eighth candle breaks the high of the seventh, and a reversal is triggered. This scenario generally results in a surge that propels the stock even higher. An uptrend is now in play with the buyers holding the market.
This pattern is a more powerful trend reversal indicator than a typical hammer type reversal because of the engulfing formation which indicates strong buyer sentiment. The pattern is seen on frequent occasions and, more often than not, confirmed by subsequent candles. It is best used to infer pullbacks in a downward trend and should be used more generally to locate short term trend reversals.
The bullish engulfing pattern is an important tool in any trader’s tool chest. Like all investing, however, trading involves significant risk. Never trade more than you can afford to lose and always make sure to implement protective stops no matter how certain you may be of the pattern you are trading, bullish engulfing or otherwise. The only thing that is certain when trading the markets is, nothing is for certain. Do your homework and trade wisely.