Reversal Signal – The Engulfing Pattern

INTRODUCTION

Reversal patterns in technical analysis signify that the prior trend is likely to change but not necessarily reverse. Compare an uptrend to a car travelling forward at 30 kmph; when the red traffic signal comes the car stops. This is a reversal signal because the car is not going forward which was the prior trend and the trend has now changed to stationary (sideways).Most of the candlesticks reversal signals are single candlestick pattern but Engulfing pattern is a multiple candlestick pattern. The engulfing pattern is a major reversal signal with two opposite colour real bodies composing this pattern.

The Engulfing pattern can be of two types.

BULLISH ENGULFING PATTERNIn this pattern the market is in a downtrend, and then a white bullish real body wraps around or engulfs the prior periods black real body. This shows buying pressure has overwhelmed selling pressure.

BEARISH ENGULFING PATTERN

In a bearish Engulfing pattern market is trending higher and the white real body is engulfed by a black body and it is the signal for a top reversal. These shows the bears have taken over from the bulls.

IMPORTANT CRITERIA FOR ENGULFING PATTERN

1) The market has to be in a clearly definable uptrend or downtrend, even if the trend is short term.

2) Two candlesticks comprise the Engulfing pattern. The second real body must engulf the prior real body (it need not engulf the shadows).

3) The second real body of the Engulfing pattern should be the opposite colour of the first real body. The exception to this rule is if the first real body the Engulfing pattern is so small it is almost a doge (very small real body). Thus after a downtrend a tiny white real body could be a bottom reversal.

Some factors that would increase the likelihood that an Engulfing pattern would be an important reversal indicator would be:-

• If the first day of the engulfing pattern has a very small real body and the second day has a very long real body. This would reflect a dissemination of the prior trends force and then increase in force behind the new move.

• If the Engulfing pattern appears after a protracted or very fast move. A protracted trend increases the chance that potential buyers are already long. In this instance, there may be less of a supply of new longs in order to keep the market moving up. A fast move makes the market overextended and vulnerable to profit taking.

• If there is heavy volume on the second real body of the Engulfing pattern.

• If the second day of the Engulfing pattern engulfs more than one real body.

CONCLUSION

The chart above shows the perfect example of Engulfing pattern. The rally began with bullish Engulfing pattern and got concluded with the bearish Engulfing pattern in July than again a bullish pattern occurred in September. Thus Engulfing pattern is an important reversal indicator but it should be used in conjunction with other indicators like volume to have accurate idea of the reversal.

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