If you are tracking or trading in a bearish market, one of the most important signals you need to look out for is a reversal indicator. The bullish engulfing pattern is one such signal that may warn you of a possible trend reversal in the market —from a prevailing downtrend to a new uptrend.
Find out how you can identify the bullish engulfing candlestick pattern, what it indicates, how to trade in a market that has this pattern and what its limitations are.
What is the bullish engulfing pattern
The bullish engulfing candlestick pattern is a two-candle signal that occurs over two trading days or sessions. It typically occurs at the end of a downtrend and, when accompanied by the appropriate confirmation signals, could indicate a potential bullish reversal in the market.
Here is what the two candlesticks in this pattern look like:
- The first candle: The first candle in a bullish engulfing pattern is a red (or black) candle that represents a bearish trading session. Here, the closing price of the stock or security is lower than its opening price.
- The second candle: The second candle in the bullish engulfing pattern is a green (or white) candle. It represents a bullish session where the price of the stock or security closed well above its opening price. This bullish candle completely engulfs the first bearish candle, leading to the name of the pattern.
Decoding the bullish engulfing pattern
In the bullish engulfing candlestick indicator, the second candle covers the first entirely. Since the second candle represents a bullish session, here is what the pattern tells you about the price movement on day 2.
- The price opened lower on day 2 than the closing price on day 1.
- Then, by the end of the second day, the price shot up and closed well above the opening price on day 1.
This is why the real body of the second candle engulfs the body of the first one. It indicates that the sellers dominated the market on the first day, leading to a bearish candle. Then, when the markets opened on the second day, the sellers continued to push the market down, leading to a lower opening than the previous day’s close.
However, the buyers or the bulls gain control over the second trading session and drive the price steeply upward, so it closes much higher than the previous day’s opening. This price action indicates a switch in control from the sellers to the buyers. Hence, the bullish engulfing pattern is considered a possible indicator of a bullish reversal.
How do you trade a bullish engulfing pattern
Noticing a bullish engulfing candlestick on a chart is not enough to chart out a buying strategy. You need to confirm the potential reversal with other signals that typically accompany a switch to an uptrend. Here are the confirmation signals to look for when you want to trade a bullish engulfing candle.
- The candles before day 1: To confirm a reversal when a bullish engulfing candlestick appears, you need to check the candles that come before the first trading session in the pattern. Ideally, there must be at least four red/bearish candles before the pattern to establish a prevailing downtrend.
- The candle after day 2: Once the green candle appears in the bullish engulfing pattern, look for confirmation in the next session. A bullish candle could indicate that the buyers have taken control of the market and set the stage for a confirmed reversal from a downtrend to an uptrend.
- The trading volume: The trading volume may be moderate on day 1, but in the bullish trading session on day 2, you should ideally notice rising volume as the price goes up. This indicates growing interest among buyers along with fading interest among sellers — which is just the confirmation you need for a bullish reversal.
The limitations to trading a bullish engulfing pattern
A bullish engulfing candlestick pattern has a few limitations that you should be mindful of before you enter a trade. Firstly, if the pattern occurs after a vague or choppy downtrend, it may not be a powerful indicator of a reversal. Also, if the second candle in the pattern is significantly large, it indicates a huge price jump on day 2. This means you may have to set a huge stop-loss if you enter the market at this point — leading to a skewed risk-reward ratio.
Conclusion
The presence of a bullish engulfing candle could indicate a potential reversal from a downtrend to an uptrend. If you notice this pattern in the broad market or in a stock you are tracking, make sure you check for other confirmation signals like increased trading volume in the second session, subsequent bullish candles, and a breakout from a previous resistance level. This way, you can make a more informed decision.
