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Candlesticks: The Power Of The Engulfing Pattern

Jul. 12, 2013 11:11 AM ET
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Seeking Alpha Analyst Since 2011

Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for www.TheStreet.com and the StockCharts.com Top Advisor Corner 

One of the most reliable candlestick formations is call the engulfing pattern. It is found often and is a stronger reversal indicator than most other signals.

It consists of two sessions. In the bear version, the first session is white and the second is black. The second opens higher and closer lower, "engulfing" the first session. The bull version is the opposite, a black session followed by a white. Again, the second session opens higher and closer lower, engulfing the previous black session. Both bear and bull varieties are shown in the illustration.

The two-session engulfing pattern is especially strong because it demonstrates that momentum is falling. So a bear engulfing appearing after an uptrend or a bull engulfing after a downtrend, each indicate that the price direction is about to turn and move in the opposite direction. The size of the two sessions also indicates the relative strength of what it foretells. For example, when the first session is relatively small and the second much longer on both sides, it is an especially strong reversal signal. If the first session is a very narrow day followed by a long candlestick, that is perhaps the strongest possible version of an engulfing pattern. In this case, the narrow-range day (NRD) represents uncertainly because price does not move much between the two sessions.

A problem with all technical indicators is that they may fail. For this reason, traders need to be cautious in the timing of entry and exit decisions. Confirmation is essential as it is with any indicators, including candlesticks. The engulfing may confirm other indicators, or may itself by confirmed. The engulfing pattern is strongest when it appears at the conclusion of a traditional chart pattern testing support or resistance - such as head and shoulders or double top/bottom formations. When the attempted breakthrough fails, or when the signal completes and an engulfing pattern then appears, confirmation is especially noteworthy.

An equally important but more subtle feature of the engulfing pattern is the price gap between the two sessions. In the bear version, the second session opens after an upside gap at the opening and then moves down to close lower than the previous session's opening price. In the bull version, the second session opens lower than the close of the first, creating a downside gap; price then moves upward to closer higher than the previous day's opening price.

The pattern itself consisting of the different candlestick colors, the price gap, and the confirmation of other signals, is one of the most reliable of all candlestick reversal signals. As traders monitor a current uptrend or downtrend looking for early signs predicting a coming reversal, the engulfing pattern should be taken seriously as one signal likely to point to the precise point for reversal. Confirm with traditional tests of the trading range or with momentum oscillators such as RSI or MACD.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

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