Reversal Engulfing Patterns

What is an engulfing pattern? Here is a example chart of a bearish engulfing pattern

which is similar to what we saw in the OTC issues this past week (look at the NDX and the SMH for clear cut examples on 05/07/2009).

What are the rules regarding engulfing patterns and what are the implications?

Engulfing patterns can be either bullish or bearish. There are certain rules that apply to them and interpreting candles, I turn to the most comprehensive source on candlestick charting - Steve Nison to supply the rules and implications

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Identification Rules
From Steve Nissan's, Japanese Candlestick Charting Techniques, Second Edition, New York Institute of Finance, 2001.

  • The market has to be in a clearly definable uptrend (for a bearish engulfing pattern) or downtrend (for a bullish engulfing pattern), even if the trend is short
  • Two candles comprise the engulfing pattern. The second real body must engulf the prior real body (it need not engulf the shadows).
  • The second real body of the engulfing pattern should be the opposite color of the first real body. (The exception to this rule is if the first real body of the engulfing pattern is a doji. Thus, after an extended fall, a doji engulfed by a very large white real body could be a bottom reversal. In an uptrend, a doji enveloped by a very large black real body could be a bearish reversal pattern).
  • Factors Increasing Probabilities
    Some factors increasing the likelihood that an engulfing pattern could be an important turning signal are:

  • If the first day of the engulfing pattern has a very small real body (i.e. a spinning top) and the second day has a very long real body. The small first real body candle reflects a dissipation of the prior trend's force and the large second real body proves an increase in force behind the new move.
  • If the engulfing pattern appears after a protracted or very fast move. A fast or extended move creates an overextended market (either overbought or oversold) and makes it vulnerable to profit taking.
  • If there is heavy volume on the second real body of the engulfing pattern.
  • What Signals a Failure?
    So now that we know what an engulfing pattern is and what increases the probablities of a success in the pattern, what indicates the pattern has failed?

  • The highs (in a bearish engulfing pattern) becomes resistance for any further advance (based on a close in price). In other words, the prices should not trade over and above the high of the engulfing day bar and close there. If they do, the pattern is violated. The opposite is true for a bullish engulfing pattern.
  • Author's Bio: 

    L.A. Little – Author, professional trader and money manager writes daily on TA Today . His new book, Trade Like the Little Guy (available on Amazon.com), shows small traders how they can consistently profit in the markets. These methods allowed L.A.’s investors to sidestep the huge losses of the past year and actually turn profits once again.