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).

> HAMMER AND HANGING-MAN LINES

In Exhibit 4.14 we see that the rally, which began in early February, terminated with the arrival of two consecutive hanging-man lines. The importance of bearish confirmation after the hanging-man line is reflected in this chart. One method of bearish confirmation would be for the next day's open to be under the hanging man's real body. Note that after the appearance of the first hanging man, the market opened higher. However, after the second hanging man, when the market opened under the hanging man's real body, the market backed off.

Exhibit 4.15 illustrates that a black real body day, with a lower close after a hanging-man day, can be another method of bearish confirmation. Lines 1, 2, and 3 were a series of hanging-man lines. Lack of bearish confirmation after lines 1 and 2 meant the uptrend was still in force.

Observe hanging man 3. The black candlestick which followed provided the bearish confirmation of this hanging man line. Although the market opened about unchanged after hanging man 3, by the time of its close, just about anyone who bought on the opening or closing of hanging man 3 was "hanging" in a losing trade. (In this case, the selloff on the long black candlestick session was so severe that anyone who bought on the hanging-man day—not just those who bought on the open and close—were left stranded in a losing position.)

Exhibit 4.16 shows an extraordinary advance in the orange juice market from late 1989 into early 1990. Observe where this rally stopped. It stopped at the hanging man made in the third week of 1990. This chart illustrates the point that a reversal pattern does not mean that prices will reverse, as we discussed in Chapter 3. A reversal indicator implies that the prior trend should end. That is exactly what happened here. After the appearance of the hanging-man reversal pattern, the prior uptrend ended with the new trend moving sideways.

Another hanging man appeared in July. This time prices quickly reversed from up to down. But, as we have discussed previously, this cenario should not always be expected with a top trend reversal.

Exhibit 4.17 illustrates a classic hanging-man pattern in May. It shows a very small real body, no upper shadow, and a long lower shadow. The next day's black real body confirmed this hanging man and indicated a time to vacate longs. (Note the bullish hammer in early April.)

> HAMMER AND HANGING-MAN LINES

Drawing the intra-day chart using candlesticks shows the high, low, open, and close of the session (see Exhibit 4.11). For example, an hourly session would have a candlestick line that uses the opening and close for that hour in order to determine the real body. The high and low for that hour would be used for the upper and lower shadows. By looking closely at this chart, one can see that a hammer formed during the first hour on April 11. Like hammer 4 in Exhibit 4.10, prices gapped lower but the white candlestick which followed closed higher. This helped to confirm a bottom.

 

The second hourly line on April 12, although in the shape of a hammer, was not a true hammer. A hammer is a bottom reversal pattern. One of the criterion for a hammer is that there should be a downtrend (even a minor one) in order for the hammer to reverse that trend. This line is not a hanging man either since a hanging man should appear after an uptrend. In this case, if this line arose near the highs of the prior black candlestick session, it would have been considered a hanging man.

Exhibit 4.12 shows a hammer in early April that successfully called the end of the major decline which had began months earlier. The long lower shadow, (many times the height of the real body) a small real body, and no upper shadow made this a classic hammer.

 

Exhibit 4.13 shows a classic hanging-man pattern. New highs were made for the move via an opening gap on the hanging-man day. The market then gaps lower leaving all those new longs, who bought on the hanging man's open or close, left "hanging" with a losing position.

> HAMMER AND HANGING-MAN LINES

Exhibit 4.9 shows a series of bullish hammers numbered 1 to 4 (hammer 2 is considered a hammer in spite of its minute upper shadow). The interesting feature of this chart is the buy signal given early in 1990. New lows appeared at hammers 3 and 4 as prices moved under the July lows at hammer 2. Yet, there was no continuation to the downside. The bears had their chance to run with the ball. They fumbled. The two bullish hammers (3 and 4) show the bulls regained control. Hammer 3 was not an ideal hammer since the lower shadow was not twice the height of the real body. This line did reflect, however, the failure of the bears to maintain new lows. The following week's hammer reinforced the conclusion that a bottom reversal was likely to occur.

In Exhibit 4.10 hammers 1 and 3 are bottoms. Hammer 2 signaled the end of the prior downtrend as the trend shifted from down to neutral. Hammer 4 did not work. This hammer line brings out an important point about hammers (or any of the other patterns I discuss). They should be viewed in the context of the prior price action. In this context, look at hammer 4. The day before this hammer, the market formed an extremely bearish candlestick line. It was a long, black day with a shaven head and a shaven bottom (that is, it opened on its high and closed on its low). This manifested strong downside momentum. Hammer 4 also punctured the old support level of January 24. Considering the aforementioned bearish factors, it would be prudent to wait for confirmation that the bulls were in charge again before acting on hammer 4. For example, a white candlestick which closed higher than the close of hammer 4 might have been viewed as a confirmation. (contd.)

> HAMMER AND HANGING-MAN LINES

It is especially important that you wait for bearish confirmation with the hanging man. The logic for this has to do with how the hanging-man line is generated. Usually in this kind of scenario the market is full of bullish energy. Then the hanging man appears. On the hanging-man day, the market opens at or near the highs, then sharply sells off, and then rallies to close at or near the highs. This type of price action now shows once the market starts to sell off, it has become vulnerable to a fast break. However, it might not be the type of price action that would let you think the hanging man could be a top reversal.

Yet, if the market opens lower the next day, those who bought on the open or close of the hanging-man day are now left "hanging" with a losing position. Thus, the general principle for the hanging man; the greater the down gap between the real body of the hanging-man day and the opening the next day, the more likely the hanging man will be a top. Another bearish verification could be a black real body session with a lower close than the hanging-man sessions close.

Exhibit 4.7 is an excellent example of how the same line can be bearish (as in the hanging-man line on July 3) or bullish (the hammer on July 23). Although both the hanging man and hammer in this example have black bodies, the color of the real body is not of major importance.

Exhibit 4.8 shows another case of the dual nature of these lines. There is a bearish hanging man in mid-April that signaled the end of the rally which had started with the bullish hammer on April 2. A variation of a hanging man emerged in mid-March. Its lower shadow was long, but not twice the height of the real body. Yet the other criteria (a real body at the upper end of the daily range and almost no upper shadow) were met. It was also confirmed by a lower close the next day. This line, although not an ideal hanging man, did signal the end of the upturn which started a month earlier. Candlestick charting techniques, like other charting or pattern recognition techniques, have guidelines. But, they are not rigid rules.

As discussed above, there are certain aspects that increase the importance of hanging-man and hammer lines. But, as shown in the hanging man of mid-March, a long lower shadow may not have to be twice the height of the real body in order to give a reversal signal. The longer the lower shadow, the more perfect the pattern.

HAMMER AND HANGING-MAN LINES

HAMMER AND HANGING-MAN LINES

Exhibit 4.4 shows candlesticks with long lower shadows and small real bodies. The real bodies are near the top of the daily range. The variety of candlestick lines shown in the exhibit are fascinating in that either line can be bullish or bearish depending on where they appear in a trend. If either of these lines emerges during a downtrend it is a signal that the downtrend should end. In such a scenario, this line is labeled a hammer, as in "the market is hammering out" a base. See Exhibit 4.5. Interestingly, the actual Japanese word for this line is takuri. This word means something to the affect of "trying to gauge the depth of the water by feeling for its bottom."

If either of the lines in Exhibit 4.4 emerge after a rally it tells you that the prior move may be ending. Such a line is ominously called a hanging man (see Exhibit 4.6). The name hanging man is derived from the fact that it looks like a hanging man with dangling legs.

It may seem unusual that the same candlestick line can be both bullish and bearish. Yet, for those familiar with Western island tops and island bottoms you will recognize that the identical idea applies here. The island formation is either bullish or bearish depending on where it is in a trend. An island after a prolonged uptrend is bearish, while the same island pattern after a downtrend is bullish.

The hammer and hanging man can be recognized by three criteria:

1. The real body is at the upper end of the trading range. The color of the real body is not important.

2. A long lower shadow should be twice the height of the real body.

3. It should have no, or a very short, upper shadow.

The longer the lower shadow, the shorter the upper shadow and the' smaller the real body the more meaningful the bullish hammer or bearish hanging man. Although the real body of the hammer or hanging man can be white or black, it is slightly more bullish if the real body of the hammer is white, and slightly more bearish if the real body of the hanging man is black. If a hammer has a white real body it means the market sold off sharply during the session and then bounced back to close at, or near, the session's high. This could have bullish ramifications. If a hanging man has a black real body, it shows that the close could not get back to the opening price level. This could have potentially bearish implications. (contd.)

REVERSAL PATTERNS IN SHARE PRICE

REVERSAL PATTERNS IN SHARE PRICE

Technicians watch for price clues that can alert them to a shift in market psychology and trend. Reversal patterns are these technical clues. Western reversal indicators include double tops and bottoms, reversal days, head and shoulders, and island tops and bottoms.

Yet the term "reversal pattern" is somewhat of a misnomer. Hearing that term may lead you to think of an old trend ending abruptly and then reversing to a new trend. This rarely happens. Trend reversals usually occur slowly, in stages, as the underlying psychology shifts gears.

A trend reversal signal implies that the prior trend is likely to change, but not necessarily reverse. This is very important to understand. Compare an uptrend to a car traveling forward at 30 m.p.h. The car's red brake lights go on and the car stops. The brake light was the reversal indicator showing that the prior trend (that is, the car moving forward) was about to end. But now that the car is stationary will the driver then decide to put the car in reverse? Will he remained stopped? Will he decide to go forward again? Without more clues we do not know.

Exhibits 4.1 through 4.3 are some examples of what can happen after a top reversal signal appears. The prior uptrend, for instance, could convert into a period of sideways price action. Then a new and opposite trend lower could start. (See Exhibit 4.1.) Exhibit 4.2 shows how an old uptrend can resume. Exhibit 4.3 illustrates how an uptrend can abruptly reverse into a downtrend. 

It is prudent to think of reversal patterns as trend change patterns. I was tempted to use the term "trend change patterns" instead of "reversal patterns" in this blog. However, to keep consistent with other technical analysis literature, I decided to use the term reversal patterns. Remember that when I say "reversal pattern" it means only that the prior trend should change but not necessarily reverse.

Recognizing the emergence of reversal patterns can be a valuable skill. Successful trading entails having both the trend and probability on your side. The reversal indicators are the market's way of providing a road sign, such as "Caution—Trend in Process of Change." In other words, the market's psychology is in transformation. You should adjust your trading style to reflect the new market environment. There are many ways to trade in and out of positions with reversal indicators. We shall discuss them throughout the blog.

An important principle is to place a new position (based on a rever sal signal) only if that signal is in the direction of the major trend. Let us say, for example, that in a bull market, a top reversal pattern appears. This bearish signal would not warrant a short sale. This is because the major trend is still up. It would, however, signal a liquidation of longs. If there was a prevailing downtrend, this same top reversal formation could be used to place short sales. I have gone into detail about the subject of reversal patterns because most of the candlestick indicators are reversals. Now, let us turn our attention to the first group of these candlestick reversal indicators, the hammer and hanging-man lines. (continue.)