Importance of Bearish Engulfing Pattern
The chart pattern may serve as an early indicator of a possible shift from a bullish to a bearish trend. A bearish engulfing formation reflects a sharp change in sentiment, suggesting sellers have gained control over the market, overpowering previous buying momentum. Both patterns typically occur at the end of a trend. A bullish engulfing pattern, for instance, indicates a potential uptrend, as the second candle's low is lower than the first's, demonstrating a stronger buying pressure.
How to trade with Bearish Engulfing Patterns
This candlestick formation often acts as a sell signal, prompting traders to take short positions once confirmed. On a daily chart, each candlestick reflects a full day’s price activity. A significant volume increase during the engulfing candle’s formation can reinforce the potential for a strong downward move. Aggressive traders tend to act swiftly, entering trades by day’s end. Additional confirmation, such as price breaking a rising trendline, lends further weight to the signal. Some traders prefer to wait a day for confirmation, particularly when the pattern lacks conviction. Combining this setup with other indicators enhances its overall reliability.
How to identify a Bearish Engulfing Pattern
Merely noticing a bearish candle engulfing a bullish candle is not enough to assume that it is a bearish engulfing candle, signalling a trend reversal. To identify a strong bearish engulfing indicator, you need to look for other accompanying confirmation signals like the following:
- Prevailing trend: Before a potential bearish engulfing appears, the prices must have been moving upward, signalling a prevailing uptrend.
- Trading volume: The trading volume on day 1 of the bearish engulfing formation may be moderate to high, especially among the sellers in the market. However, on day 2, the higher the selling volume, the stronger the reversal indicated by the Bearish Engulfing Pattern may be.
- Support level breakouts: You can also confirm a reversal by checking if the price breaks out below the prevailing support line. This means that the selling pressure dominates over the buying pressure.
- Next-day confirmation: If you are a conservative trader, you can wait for a day to confirm the reversal. If the candle following the Bearish Engulfing Pattern is bearish, it means that sellers have continued to dominate the market, indicating a persistent downtrend.
How to use a bearish engulfing pattern
Traders often interpret the bearish engulfing pattern as a cue to initiate short positions. Typically, a stop-loss is placed just above the high of the engulfed bullish candle. Profit targets are set near major support zones or based on the individual’s preferred risk-reward ratio.
Consider a daily candlestick chart, where each candle represents a day's price movement. If the volume increases significantly during the formation of the engulfing candle, it could indicate a stronger downward trend. In such cases, aggressive traders might sell their positions at the end of the day when the engulfing candle forms.
Example of how to trade a Bearish Engulfing?
The GBP/USD chart below displays a bullish engulfing pattern, where a green candle fully engulfs the prior red candle. Although the red candle has a longer wick, the green candle’s body is nearly double in size, signifying strong buying pressure. This pattern marks the beginning of a short-term uptrend. Over the next seven days, the price continues to rise steadily, confirming the bullish sentiment. However, this upward movement is eventually halted, and a reversal sets in, signalling the onset of a bearish phase. This example demonstrates how engulfing patterns can provide early insight into potential trend shifts.
Trading a Bearish Engulfing Pattern
If you notice and confirm a Bearish Engulfing Pattern, you may want to capitalise on the potential downtrend it indicates. This is an ideal time to initiate a short position in the stock or security.
The stop-loss for your trade must be the highest price in the session, as represented by the engulfing candle. This way, even if the price rises upward when you have entered a short position, you can limit your losses.
Additional read: Fear and greed index
The limitations of a Bearish Engulfing Pattern
The Bearish Engulfing Pattern is generally quite reliable, especially if it is accompanied by adequate confirmation signals. However, it does have a few limitations that you must be mindful of.
- The reversal may not be strong enough if the bearish engulfing candle is not backed by strong trading volume.
- A Bearish Engulfing Pattern also does not guarantee a reversal.
- The effectiveness of the pattern also depends on the timeframe and other macroeconomic factors.
Sometimes, despite strong confirmation, the reversal following a Bearish Engulfing Pattern may not be persistent enough. In that case, you can exit your trade and reevaluate the market trend before entering a new position.
Conclusion
The appearance of a Bearish Engulfing Candlestick Pattern in the market is a sign that you may need to develop a strategy for a potential downward market. If you are a trader, this may be a suitable time to enter short positions. However, if you have already purchased the stock or security, a bearish engulfing candle may cause you to panic. Remember to avoid impulsive decisions and watch the markets to better plan your strategy — whether it is to hold or to sell.
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