Engulfing Candle Trading Strategy
Candlestick charts have become a staple for most traders, and nearly every trading platform offers this highly visual chart style. Whether it is better than other chart forms I leave up to you. I personally like to use them. It isn’t necessary to use candlesticks to trade the strategy, OHLC charts also work.
I use this strategy for day trading, although it can be applied to other time frames as well, such as daily or weekly charts. Forex examples are used below, but I also use this entry technique in stocks and futures as well.
Forex Engulfing CandlesCopy link to section
There are two types of engulfing candles, a bullish engulfing candle and a bearish engulfing candle.
For the purposes of this strategy, a bullish engulfing candle occurs when the “fat” part of an Up candle completely envelops a prior Down candle. The fat part of the candle marks the distance between the open and close of that bar, while the “wicks” mark the high and low. While there is no specific size requirement, typically both bars in the pattern should be substantial, with the up bar showing a strong short-term shift in momentum.
Figure 1 shows an example of a bullish engulfing pattern in the AUDUSD.
On my charts, up candles are green because the close was higher than the open. Down candles are red because the close of the candle was lower than the open of the candle.
A bearish engulfing candle occurs when the “fat” part of a Down candle completely envelopes a prior Up candle. Figure 2 shows an example of a bearish engulfing pattern in the EURUSD.
Engulfing candles occur quite often, which is why we need additional criteria to trade them. I opt to use the trend and enter during a pullback.
Forex Engulfing Candle Trading StrategyCopy link to section
An engulfing candle occurs often. While its appearance signifies a sharp short-term change in direction, many of these patterns aren’t of concern or interest. In a trend, there are impulse waves and corrective waves. Ideally, we want to enter trades during corrective waves/pullbacks, assuming that the trend will continue and the next impulse wave in the trending direction will give us a nice profit.
The engulfing candle provides us a signal that a pullback is over, and the trend is about to resume. In the case of an uptrend, the bullish engulfing pattern signals that the selling which occurs on a pullback is over, and the buying is resuming. The trend doesn’t always resume right away, we may simply get a small push in the trending direction before the pullback resumes. Losing trades occur, and that is okay, as all losing trades can’t be avoided. Experienced traders can actively manage trades when this occurs, taking a small profit or small loss. Alternatively, simply let the price hit the stop or target (discussed shortly) and let the odds of the trade, and having a larger potential profit than risk, work in your favor.
For a bullish engulfing candle in an uptrend, the stop-loss is placed one pip below the low of the engulfing candle if trading on a one-minute chart. If using a longer time frame, like hourly, 4-hour, daily or weekly chart, then place the stop loss at least several pips below the low (the longer the chart time frame, the more space I give).
In the case of a downtrend, the bearish engulfing pattern signals the buying which occurs on a pullback is over, and the selling is resuming.
For a bearish engulfing candle in a downtrend, the stop-loss is placed just above the high of the engulfing candle.
Engulfing candles are simply an entry technique, and therefore don’t provide a profit target. Profit targets can be established using Fibonacci Extensions or a reward:risk ratio. Apply the Fibonacci extension tool to the impulse wave and the pullback to get an idea of where the price will go on the next impulse wave (see Fibonacci Extension article).
Alternatively, use a 1.6:1 or 2:1 reward to risk ratio if day trading. For example, if you risk is 10 pips, your profit target is 16 or 20 pips respectively.
If swing trading, Setting Targets to Maximize Gains shows how to place profit targets effectively.
To help filter which trade signals you take, and isolate the trend, you may wish to employ other indicators such as trendlines or a moving average.
Forex Engulfing Candle Trading Strategy Entry PointCopy link to section
The traditional engulfing method is to let candles complete before entering. That means once the engulfing candle finishes and a new one begins we enter the trade. Yet price bars are arbitrary. There is no relevance to the close of a 1, 5 or 15-minute candle. Therefore, we are watching for these signals in real-time, and as soon as we see an engulfing pattern with the proper setup we trade it, without letting the bar complete.
In the stock market the daily open and close aren’t arbitrary, they are set and have an impact. Therefore, stock traders may opt to let daily bars complete. Intra-day bar timed bars, in all markets, are arbitrary. If day trading, I always trade a pattern as soon as I see it, and don’t wait for bars to complete.
Figure 5 shows how this works in a downtrend. The little horizontal red lines indicate the entry point.
There are a number of reasons for entering before the bar completes. Mainly, a timed price bar is arbitrary.
Also, it helps to reduce risk. Engulfing candles show a powerful change in direction. If we wait for a bar to complete it may have already run significantly, which means our entry is work, which means our stop loss is bigger and our profit potential is diminished. Look at Figure 5. The little red lines are at a better entry point, compared to waiting for the bar to complete.
Finally, we’re trading with the trend, so the probability is already on our side. Getting in before a bar closes doesn’t change our odds of success.
It is possible that when we look back at our trades, an engulfing pattern may not be present. By entering early we allow for the possibility that by the time the bar closes it is no longer a traditional engulfing pattern. Yet, in real-time, it exhibited the shift in momentum we were looking for, and that is all that matters.
The engulfing signal doesn’t necessarily have to come from one bar either. Assume we have a downtrend, and a pullback moving higher. Then a down (red) bar comes, but it isn’t quite an engulfing candle. A few seconds after another down (red) starts taking out the lows of prior up (green) candles. To me, this is a still a valid entry. Even though it was over a number of candles, it still shows the change direction. Once again, traders need to rid themselves of the notion that there is something magical about the close of a bar, especially in forex day trading. For examples of how to use multiple bars to enter a trend during a pullback, see the ABC Forex Trading Strategy Video. The video also provides some other information which will help in reading trends.
Forex Engulfing Candle Trading Strategy – Final WordCopy link to section
I don’t trade every engulfing candle I see. This strategy is subjective.
The goal of the strategy is to isolate a trend, and then use engulfing patterns to signal the pullback is ending and the trend is resuming. Not every pullback ends with an engulfing pattern though, sometimes we can use multiple bars to signal the end of a pullback. There is no need to wait for the engulfing candle to complete. Once it has engulfed the prior candle, take the trade. Engulfing patterns don’t have a specific profit target, therefore use a Fibonacci extension or a reward to risk ratio. Stops are placed above the high of a bearish engulfing pattern, or below the low of a bullish engulfing pattern.
If trading on a 1 or 5-minute chart, trying using an ECN forex broker with a small spread and low commissions.
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