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Bearish Engulfings - Trades On GDX, CAT, YUM

|Includes:Caterpillar Inc. (CAT), GDX, YUM

The Bearish engulfing is a candlestick pattern that occurs when a bullish candle is immediately followed by a bearish candle that completely "engulfs" it. These candle patterns are very nice for short term traders as they typically signal a 2-3 day pullback in a stock. This pullback can be taken advantage of with an easy stop to control risk.

The image to the right illustrates the look of a bearish engulfing. Note the bullish nature of the stock before the bearish engulfing candle. The bearish candle is then represented by a morning gap higher followed by selling throughout the day. The stock eventually closes below the previous day's low.

The bearish engulfing price action is typically followed by a pullback in the stock. The severity of the pullback varies from stock to stock but traders normally can capture 2-3 days worth of gains on short or put option position. In some cases driven by fundamental news events like earnings, a bearish engulfing can signal a much more significant top and the beginning of a new longer term downtrend.

Yesterday, the market opened a bit higher in the morning and closed slightly lower. This action helped to create bearish engulfings patterns in many stocks. In fact, 26 stocks in the S&P 500 exhibited these characteristics. While bears can use this action to establish downside positions, bulls can also use the price action to reevaluate their gains and look to take profits.

The trade on a bearish engulfing offers a very easy stopping point that can be used to control risk. If the stock closes above the engulfing day's high, the trade is compromised and it is time to exit the short or put option position. Typically this type of stop represents relatively small risk compared to the potential gains achieved on a 2-3 day pullback.

There are 3 engulfing plays that I find interesting in the market today. All 3 can be played with stops on the engulfing candle's day high. The gold miners etf (NYSEARCA:GDX) may be my favorite as it goes along with my bearish gold thesis. Caterpillar (NYSE:CAT) and Yum Brands (NYSE:YUM) represent stocks that have underperformed the market and are more likely to pullback severely if the market falls. Below are the 3 charts. Note that of the 3 stocks, there was only one bearish engulfing that did not work. CAT had an engulfing on the last day of June that was followed by a rally. One sign that the engulfing was suspect was the gap up 2 days prior. A strong gap especially in a stock on a downtrend can signal that the engulfing may just be a bullish trap. Currently, all three stocks show nice bearish engulfing patterns after a 1 month rally and can be played lower with a stop on the engulfing high.

Stocks: CAT, YUM, GDX