ENGULFING PATTERN

ENGULFING PATTERN

The hammer and hanging man are individual candlestick lines. As previously discussed, they can send important signals about the market's health. Most candlestick signals, however, are based on combinations of individual candlestick lines. The engulfing pattern is the first of these multiple candlestick line patterns. The engulfing pattern is a major reversal signal with two opposite color real bodies composing this pattern.

Exhibit 4.18 shows a bullish engulfing pattern. The market is in a downtrend, then a white bullish real body wraps around, or engulfs, the prior period's black real body. This shows buying pressure has overwhelmed selling pressure. Exhibit 4.19 illustrates a bearish engulfing pattern. Here the market is trending higher. The white real body engulfed by a black body is the signal for a top reversal. This shows the bears have taken over from the bulls.

There are three criteria for an 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 color of the first real body. (The exception to this rule is if the first real body of the engulfing pattern is so small it is almost a doji (or is a doji). Thus, after an extended downtrend, a tiny white real body engulfed by a very large white real body could be a bottom reversal. In an uptrend, a minute black real body enveloped by a very large black real body could be a bearish reversal pattern).

The closest analogy to the Japanese candlestick engulfing pattern is the Western reversal day. A Western reversal day occurs when, during an uptrend (or downtrend), a new high (or low) is made with prices closing under (or above) the prior day's close. You will discover that the engulfing pattern may give reversal signals not available with the Western reversal day. This may allow you to get a jump on those who use traditional reversal days as a reversal signal. This is probed in Exhibits 4.21, 4.22, and 4.23.

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

1. 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 dissipation of the prior trend's force and then an increase in force behind the new move.
2. 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.
3. If there is heavy volume on the second real body of the engulfing pattern. This could be a blow off.
4. If the second day of the engulfing pattern engulfs more than one real body.

Exhibit 4.20 shows that the weeks of May 15 and May 22 formed a bullish engulfing pattern. During the last two weeks of July, a bearish engulfing pattern emerged. September's bullish engulfing pattern was the bottom of the selloff prior to the major rally.

In Exhibit 4.21 a monthly crude oil chart with both the bullish and bearish engulfing patterns can be seen. In late 1985, a precipitous $20 decline began. The third and fourth month of 1986 showed the two candlestick lines of the bullish engulfing pattern. It signaled an end to this downtrend. The rally that began with this bullish engulfing pattern concluded with the bearish engulfing pattern in mid-1987. The small bullish engulfing pattern in February and March of 1988 terminated the downtrend that started with the mid-1987 bearish engulfing pattern. After this bullish engulfing pattern, the trend went from down to sideways for five months.

The black candlestick of February 1990 came within 8 ticks of engulfing the January 1990 white candlestick. Consequently, this was not a perfect bearish engulfing pattern but, with candlesticks, as with other charting techniques, there should be some latitude allowed. It is safer to view this as a bearish engulfing pattern with all its inherently bearish implications than to ignore that possibility just because of 8 ticks. As with all charting techniques, there is always room for subjectivity.

The bearish engulfing patterns in 1987 and in 1990 convey an advantage provided by the engulfing pattern—it may give a reversal signal not available using the criteria for a reversal day in Western technicals. A rule for the Western top reversal day (or, in this case, reversal month) is that a new high has to be made for the move. New highs for the move were not made by the black real body periods in the bearish engulfing patterns. Thus, using the criteria for the Western reversal they would not be recognized as reversal patterns in the United States. Yet, they were reversals with the candlestick techniques.

Exhibit 4.23 is a series of bearish engulfing patterns. Pattern 1 dragged the market into a multi-month lateral band from its prior uptrend. Engulfing pattern 2 only called a temporary respite to the rally. Bearish engulfing patterns 3, 4, and 5 all gave reversal signals that were not available with Western technical techniques (that is, since no new highs were made for the move they were not considered reversal weeks).