Bullish Engulfing Pattern: Meaning, Example & Limitations

Introduction:

The stock market offers opportunities to build wealth through investing and trading. Though there are multiple instances where you can dive in to scoop your share of profits, tools like technical analysis can help you increase your chances of gains with a precise statistical approach to investing. Understanding technical analysis requires a basic understanding of how to read candlestick charts and interpret stock chart patterns. Out of the numerous available concepts, let’s discuss the engulfing patterns, primarily focusing on the bullish engulfing pattern. 

What is an engulfing pattern?

The engulfing candlestick pattern is a typical Japanese candlestick pattern of two candlesticks: bullish and bearish. The second candlestick is larger and fully engulfs the first one, signaling a potential price reversal. A perfect engulfing pattern happens when the second candle completely covers the first, including the high and low points. Still, the focus is mainly on the body of the candle. 

Engulfing candles are a popular tool for assessing market pressure but are a lagging indicator. They only appear after two candlesticks’ worth of data has been formed, making them a signal that follows price movement. This pattern is widely used in markets like Forex, stocks, cryptocurrencies, and commodities. 

There are two types of engulfing patterns: the bearish engulfing pattern and the bullish engulfing pattern. 

What is the Bullish Engulfing Pattern?

A bullish, engulfing candlestick signals a potential reversal in price trends for a stock or currency. In trading, a candlestick chart shows four key prices: opening, closing, the day’s high, and the day’s low. When security closes higher than it opened, the candlestick is usually green or hollow, indicating upward movement. The candlestick turns red or black if it closes lower, signaling a bearish phase.

In some cases, a red candlestick is followed by a green one. If the second day’s opening price is lower than the first day’s close and the close on the second day is higher, the green candlestick appears to “engulf” the red one, forming a bullish engulfing pattern.

It is alright if the body of the green candlestick doesn’t completely cover the red one as long as the range (high and low prices) of the green candle engulfs the previous day’s range. This pattern still indicates strength and potential for a trend reversal. Even when only the range engulfs the last candle, the pattern can still be very effective, making it an important signal to watch for in trading.

How do we identify the bullish engulfing pattern?

To identify the bullish engulfing pattern for a bullish reversal, look for these:

• Prior Trend: This pattern signals a bullish reversal, so it’s ideal when it appears after a downtrend. 
• First Candle: The first candle is bearish (red), showing selling pressure in the market.
• Second Candle: The second candle is bullish (green). It opens lower than the first candle’s close but closes higher than its opening price, signaling a buying momentum.
• Wicks: The wicks, the lines above and below the body of the candle, aren’t as important. What matters is that the body of the green candle fully covers the red candle’s body.
• Confirmation: A higher close on the next candle after the bullish engulfing pattern strengthens the chances of a trend reversal. 
• Technical indicators: To confirm the pattern further, make sure other indicators like the Relative Strength Index (RSI), Stochastic Oscillator, and Moving Average Convergence Divergence (MACD) also show an upward trend.

How to trade using the Bullish Engulfing pattern:

When you spot a bullish, engulfing candlestick pattern, your next move depends on your position in the asset. This pattern usually appears after a downward trend, which means many traders may already hold short positions. However, with a potential trend reversal, it’s time to rethink the strategy.

A bullish engulfing pattern signals that it might be a good time to take a long position. This simply means buying and holding onto the asset until its price rises. For maximum gains, you should aim to buy at the lowest intraday price on the pattern’s second day.

There are three common approaches to trading this pattern. 

• First, you can buy the asset when its price jumps on the second day, especially if the volume increases, signaling a reversal. 
• Second, wait an extra day to confirm the bullish reversal before buying. 
• Finally, some traders prefer to wait for a break above the downward resistance line as additional confirmation.

For a clearer understanding, let’s look at this chart of Mafatlal Industries. 

On December 26, 2022, a bullish engulfing pattern appeared, with a green candle completely engulfing the prior red one. This is a strong signal, especially at the end of a downtrend. It’s wise to wait for another bullish candle the next day and confirm with volume to strengthen the signal. However, combining this pattern with other indicators can provide better confirmation. 

Limitations to using the bull engulfing pattern:

A bullish engulfing pattern signals a potential trend reversal, highlighting strong buyer momentum. Spotting this pattern allows you to time your market entry for better profits. Incorporating it into your strategy can help minimize losses and enhance overall equity picks. However, there are certain limitations to using the engulf bullish pattern:

• Lack of Price Targets: Engulfing patterns, especially bullish ones, don’t provide clear price targets, making it hard for traders to estimate potential profits accurately.
• Effectiveness in Volatile Markets: In highly volatile markets, engulfing patterns can become unreliable due to sudden price swings. In such situations, it’s important to use other indicators to confirm signals.
• Risk-Reward Ratio: When an engulfing pattern forms, especially with a large engulfing candle, the risk-reward ratio may not be favorable. Traders might need to use larger stop-loss settings, as the size of the candle could outweigh potential profits.
• Need for Confirmation: Engulfing patterns should always be confirmed with other technical indicators. Relying solely on them without additional confirmation can increase the risk of false signals and losses.

Conclusion:

A bullish engulfing pattern suggests a possible reversal from a downtrend to an uptrend. For successful trades, confirming this pattern with other indicators and candlestick formations is crucial. However, remember that no technical indicator is perfect, so it’s important to thoroughly analyze and apply proper risk management before making trading decisions. Gaining expertise using patterns like the bullish engulfing pattern or the rounding bottom pattern can help you make precise investment decisions. But if interpreting the chart patterns still proves challenging, you can consult a registered stock market advisor and make the most of the different chart patterns. 

*Disclaimer Note: The securities quoted, if any, are for illustration only and are not recommendatory. This article is for education purposes only and shall not be considered as recommendation or investment advice by Research & Ranking. We will not be liable for any losses that may occur. Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors.

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