For centuries, traders have been relying on numerous analytical tools to predict the future price of a particular trading instrument. Long before the first computer was even invented, traders were using paper charts to track and predict how the price of commodities might change in the future.
You might think that a lot has changed since the 1700s when Japanese rice traders allegedly conceived the candlestick chart, aka, the Japanese-candlestick chart. However, many of the tools we use for analyzing financial markets are decades, or even centuries, old. Only the processing power we have to apply those analytics has improved.
Traders build strategies around different patterns which emerge on candlestick charts. In this article, we’ll be focusing on an engulfing pattern trading strategy for forex traders.
What are Japanese candlesticks?
If you’ve ever opened a trading platform, you’ll have most likely seen candlesticks. They are usually the default chart type used by forex traders, and they look like this:
The name originates from the appearance. The visual representation of the data on the chart looks like a candle. Each candle represents a period of time and shows how the price behaved during that period.
The candle shows the opening and closing price (the top and bottom of the main part of the candle) and the high & low price (the ends of the wick).
What are candlestick patterns?
Numerous candlestick patterns have been defined. Some of these names might already sound familiar; Doji, Hammer, Shooting Star, Handing Man and Engulfing. When these patterns emerge, they indicate how the price might develop in the following periods.
What many new traders misunderstand about financial markets is that the price of an asset is not determined by some enigmatic or mythical beast. In a lot of cases, it’s quite predictable.
When buyers go long, it pushes the price up, and when sellers go short, it pushes the price down. If there are more buyers, the price moves up, when there are more sellers, it draws the price down. The marketplace determines the value of an asset.
Based on the understanding of how price behaves, traders who use candlestick patterns can observe the sentiment in the market and use it to their advantage. One of the most common patterns in forex trading strategies is the engulfing trading strategy.
Introduction to engulfing pattern trading strategy
An engulfing candlestick pattern is defined as the body (open & close) of a newer candle engulfing the body of the previous candle. If one candle engulfs another, one must be a bullish candle, and the other must be a bearish candle.
Depending on the circumstances when an engulfing candlestick emerges, it can be either a bullish or bearish signal. Take a look at the difference between a bullish and bearish candlestick:
A shorter bearish candlestick that is engulfed by a longer bullish candle typically signals a potential bullish movement. In contrast, a shorter bullish candle which is engulfed by a longer bearish candle would signal bearish sentiment. The longer the engulfing candle is, the stronger the indication.
How to apply engulfing pattern to your trading strategy
If you’re looking to develop an engulfing pattern trading strategy, or simply incorporate an additional signal to your existing forex strategy, pay close attention to this section.
The significance of an engulfing pattern depends on the context; specifically, where it emerges and how big the candles are.
In ranging markets where no clear trend is established, many engulfing candles can appear side by side where the engulfing candle is only marginally longer than the previous candle. Unfortunately, this is a natural characteristic of a sideways market.
What you want to watch out for is a prominent engulfing candle which presents itself at the end of an established trend.
The size of the candles involved in the formation of the pattern is important in determining the significance of a pattern. What an engulfing candle tells us when it presents at the end of a trend is that sentiment has changed.
The difference between bullish & bearish engulfing
Following a downtrend, a bullish engulfing candle tells us that selling pressure has dropped and buying pressure has increased. Essentially, it means fewer people are selling, and more people are buying, therefore indicating that the market no longer expects the price to fall. Instead, the price is now expected to increase.
Conversely, a bearish engulfing candle which should be given attention will form at the end of a strong uptrend.
When the pattern presents under those conditions, it shows that buying pressure is no longer the prominent force and sellers have begun pushing the price down.
Therefore, sentiment has shifted and implies the market no longer expects the price to progress and now is an appropriate time to sell.
How to begin using the engulfing pattern trading strategy
Before you put theory into practice, take some time to familiarize yourself with some examples on historical price data for the currency pairs you trade most often.
How candlestick patterns develop and what they predict can vary depending on the asset class, instrument and timeframe.
An engulfing candlestick pattern does not by any means guarantee movement in a particular direction, but it can be a useful signal when used alongside other indicators and is one of the more simple visual means traders can use to judge sentiment.
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