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The bullish engulfing pattern is one of my favorite reversal patterns in the Forex market. I have previously written about how to trade the bearish engulfing pattern, and as you might expect there are many similarities between the two.
As similar as they may be, I believe each deserves its own spotlight given the significance of the pattern.
Navigating the Forex market to find consistent profits is all about following the clues it leaves behind. Of course, when I say clues, I’m referring to the formations that price action leaves in its wake.
One such formation is that of the bullish engulfing bar. They don’t come around often, but when they do it’s important that you know how to take full advantage of the profit potential.
In this lesson, you will learn what a bullish engulfing pattern is and how you can trade it for huge profits. You will also learn the three characteristics that must be present to make it tradable. Knowing these three things will help you maximize your profit potential and minimize your risk.
First and foremost, know that the terms engulfing bar and engulfing candle are interchangeable. They are simply two different ways of saying the same thing.
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A bullish engulfing bar typically forms after an extended move down. It signals exhaustion in the market where sellers begin to book profits and buyers begin to take an interest, thus pushing prices higher.
As the name implies, an engulfing candle is one that completely engulfs the previous candle. Another way of saying it is that the previous candle is completely contained within the engulfing candle’s range (low to high).
The illustration below shows a bullish engulfing candle in action.
One thing I want to point out is that it’s okay if the body of the engulfing candle doesn’t engulf the previous candle. What’s more important is whether the range of the engulfing candle contains the previous one.
Here is an example:
The illustration above shows an engulfing candle where the range engulfs the previous candle but the body (open and close) are inline with the previous candle. This is okay because the range of the engulfing candle still completely covers the preceding candle.
In my experience, the most probable patterns are the ones where the body of the engulfing bar engulfs the previous candle. The reason this pattern works so well is because of conviction in the market. So the more conviction you have, the more probable the setup becomes.
That said, patterns where only the range engulfs the previous candle can also be extremely effective and should not be ignored.
Before we move on, I want to point out that the bullish engulfing pattern is most effective on the higher time frames. Therefore anything below the daily time frame should be ignored.
There are many different ways to trade this pattern, ranging from buying as soon as the candle closes to waiting for a pullback to support. The way I like the trade it is a bit different from what you are probably used to seeing.
The strategy I’m going to teach you today has three parts to it:
The first two points above are pretty obvious when trading this reversal pattern. However what may not be so obvious is the third requirement – a broken resistance level.
Remember my comment about conviction? The effectiveness of this pattern is all about the level of bullish conviction in the market. So when you combine the pattern with a broken resistance level, the conviction becomes that much stronger.
To further this point, you wouldn’t want to trade this pattern with a key resistance level just above it. You would run the risk of having your position come back on you within the first 24 hours of taking a position.
Now that we’ve covered the requirements, let’s get into an example.
The chart below shows a bullish engulfing pattern that formed on the NZDJPY daily time frame.
The chart above illustrates the first two requirements of the pattern. We have a bullish engulfing candle at a swing low.
Notice how the body of the engulfing candle doesn’t cover the previous one. However, the range certainly does. This represents a valid bullish engulfing bar. But to make it a tradable pattern we need a key level.
Before we get to that, let’s get some perspective on this setup. The chart below shows the daily time frame again, only this time we’ve zoomed out to get a feel for where the setup formed relative to previous price action.
The NZDJPY daily chart above shows more than a year’s worth of price action. A few things to note here before we move on:
Now that we have a good feel for the context of the setup, let’s dig into the details.
Keeping the same levels on the chart, we’ve now moved in for a closer look at the setup. The first thing to notice is how the bullish engulfing candle closed above our key level.
As we all know, old resistance becomes new support. So as soon as NZDJPY closed the day back above this key level, it began acting as new support.
Also take note of the distance between this key level that was broken and the next resistance level. This was a 400 pip range, giving us plenty of room to profit from this setup.
The next chart shows the setup from start to finish.
Now things are really starting to take shape. Notice that we entered on a retest of the key level that was broken, which now becomes support. Also take note where we placed our take profit – just below the next key resistance level.
One thing that may be unclear is the stop loss placement. Why wouldn’t we place it under the bullish engulfing bar?
You certainly could have done that and still maintained a favorable risk to reward ratio. However, I like to place my stops in positions where, if the market travels there, it’s going to make me a bit uncomfortable.
If the market is indeed going to respect the key level as new support, it should do so within a 20 to 50 pip window. Any more than that and there’s a good chance this market would see a larger correction. Therefore a 140 pip stop was more than acceptable if the market is indeed going to respect old resistance as new support.
By using a tighter stop loss, I was also able to achieve a better risk to reward ratio. Here is a breakdown of the numbers for this setup:
Our stop loss was 140 pips with a 400 pip profit target. This equals a potential 2.8R, or 5.6% profit if risking 2%.
For those who have been following me for a while, you know that I like to use the 50% entry method. Many traders believe that this method of entry only works with pin bars. However, it can also be used when trading engulfing patterns.
Here is a look at the same NZDJPY setup, only this time I have used the Fibonacci retracement tool to identify the 50% retracement level.
The chart above shows the 50% retracement level, which was found by dragging the Fibonacci tool from the engulfing bar’s low to the bar’s high.
Notice how the second candle following the engulfing pattern didn’t quite touch the 50% level, although it did come within 15 pips of it. This goes to show that using a 50% entry is not an exact science, nor is any other strategy or technique used in trading the Forex market.
Still, a 15 pip difference isn’t much. If you can identify a 15 pip area as a favorable entry, you are far ahead of the majority of retail traders.
Last but not least, I want to point out that although I like to use the Fibonacci tool in this manner, it is never used as a replacement for key support and resistance levels. These levels should always be first and foremost when identifying entries and exits alike.
Bullish engulfing patterns can be a great way to identify potential reversals in the market. They provide you with yet another clue you can use to determine a probable outcome, thus putting you one step closer to becoming a successful Forex trader.
We have covered a lot of material in this lesson, so let’s finish up with some of the more important points to keep in mind when trading this pattern.
Above all, remember that you need three characteristics for a bullish engulfing pattern to be considered tradable. 1) bullish engulfing bar, 2) swing low, 3) broken resistance level. Once you have those three things, you can move to the next stage of your analysis to determine if it’s a setup worth taking.
Are you currently trading bullish engulfing patterns? Having read this lesson, do you feel your view of the pattern has changed?
Leave your questions or comments below. I look forward to hearing from you.
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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