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Your success as a Forex trader depends on your ability to identify reversals in the market. The better you become at doing this, the closer you are to experiencing consistent profits. One pattern that can greatly assist you in doing just that is the bearish engulfing pattern.
I’ve written before that, as price action traders, our job is to find clues the market leaves behind. Those clues often come in the form of candlestick patterns such as pin bars or inside bars. The bearish engulfing candle is one more clue we can use to identify a potential top in a market.
By the end of this lesson you will know the three things that are required to make these patterns “tradable”. This will allow you to trade bearish engulfing patterns in a way that will maximize your profit and reduce your risk.
Let’s get to it…
A bearish engulfing pattern typically forms after an extended move up. It’s a sign of exhaustion and a signal that a market may be in the early stages of reversing.
Just as the name implies, an engulfing candle is one that completely engulfs the previous candle. In other words, the previous candle is completely contained within the engulfing candle’s range.
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The following video illustrates the characteristics. I also share with you two critical rules that should be followed when trading this candlestick pattern.
The illustration below shows a bearish engulfing pattern that formed at a swing high.
Notice in the illustration above, the engulfing candle’s range (high to low) completely engulfs the previous candle.
It’s okay if the body of the engulfing candle doesn’t engulf the previous candle. Only the range of the engulfing candle needs to engulf the previous candle to be considered a valid pattern.
For example, the following would also be considered a valid engulfing pattern.
Notice how in this example, the engulfing candle’s range covers the previous candle, however, the body does not. This is still a valid bearish engulfing pattern.
Although the second illustration is a valid pattern, it’s far better to trade a candle where the entire body engulfs the previous and also closes below the previous candle’s low.
One last thing. These engulfing patterns are most favorable when traded on the higher time frames. Anything below the daily time frame should be ignored.
There are many different ways to trade a bearish engulfing pattern. However, the way I like to trade them is probably a bit different from what you’re used to seeing.
The strategy you’re about to learn has three requirements to be considered a valid setup.
The best way (by far) that I have found to trade these patterns is to use them in combination with a break of a key level at a swing high. If you can also identify bearish price action on a retest of the broken level as new resistance, even better.
Let’s walk through an example. Below is a bearish engulfing pattern that formed at a swing high on the NZDUSD daily time frame.
In the chart above, we have the first two requirements at work. We have a bearish engulfing candle at a swing high.
Now let’s add the key level so you can see how influential these patterns can be with the proper amount of confluence.
Now we’re starting to put this bearish engulfing pattern into context. We have two key levels at work in the chart above. Both levels are represented by highs and lows as well as several gaps. As I’ve mentioned in other lessons, these gaps often act as support and resistance.
Notice in the chart above how the bearish engulfing candle broke below one of the key levels. This gives us our third requirement, moving the pattern from a potential setup to a tradable setup.
So now that we have our three requirements, let’s move down to the 4-hour chart and see if we can find a more precise entry point.
A look at the NZDUSD 4-hour chart shows a bearish pin bar rejecting the broken level.
We now have several confluence factors at work. We have a bearish engulfing pattern on the daily time frame at a swing high which broke a key level. We also have a bearish pin bar on the 4 hour chart at new resistance.
This is now a high probability trade, meaning the success rate is well above 50%. Furthermore, the setup above gave us a chance at a 3R trade (23 pip stop loss and a 68 pip profit target). That’s a 6% profit if risking 2%. Moreover, the trade took just 12 hours from start to finish.
Just as we can sell a pin bar at a 50% retracement, we can also sell a bearish engulfing pattern in the same manner. The Forex market has a habit of retracing 50% of these patterns, so why not take advantage of it?
Here is the same NZDUSD setup, only this time we’re taking a blind entry (one that does not require a price action signal) on a 50% retracement measured from the high to the low of the engulfing candle.
Note that in the NZDUSD 4-hour chart above, we’re taking a blind entry on a 50% retrace of the bearish engulfing candle that formed on the daily time frame. The high and low you see in the chart above represent the daily range of the engulfing candle.
One thing to keep in mind about blind entries is that while they can be extremely profitable, they aren’t nearly as probable as setups with price action as confirmation. This is because a blind entry has one less confluence factor at work versus a setup with confirming price action.
I don’t advocate the use of blind entries if you are just starting out. You’re far better off trading only the setups that are confirmed by price action and working your way up to trading blind entries, if you so choose.
Bearish engulfing patterns are a great way to identify a potential top in a market. It’s one more clue you can use to determine a probable outcome. The more clues you can gather about a market’s probable future direction, the closer you will be to becoming a successful Forex trader.
Here are a few things to keep in mind when trading bearish engulfing patterns:
In closing, just remember to look for the three requirements that form a viable setup – 1) bearish engulfing pattern, 2) swing high and 3) broken key support level. If you have those three things, you have a valid bearish engulfing setup.
Do you currently trade bearish engulfing patterns? If so, do you think you will change the way you trade them based on what you just read?
Leave your comments or questions below.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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