One of the goals of a technical trader in the Forex market is to identify changes in the direction of price action. Candlesticks are a natural tool for this task as they give visual insight into market psychology and can suggest changes in sentiment. With this in mind, today we will focus on spotting and trading one of the markets most clear cut reversal signals using the bearish engulfing candle pattern.
What is a bearish engulfing pattern?
A bearish engulfing pattern is a candle pattern established at the end of an uptrend. Pictured above the pattern is created by interpreting the data of two completed candles. The first candle will depict the end of the established trend strength. It should be noted the size of this primary candle can vary and is not pertinent to the pattern itself. Dojis and other small candles are preferable though in this position, as they can reflect market indecision in the current trend.
The second candle in the pattern is the reversal signal. This candle is comprised of a long red candle creating fresh downward price momentum. Ideally the high of this candle should extend above the high of the previous candle followed by the creation of a new low. This strong downward movement reflects sellers overtaking buying strength, and often precedes a continued fall in price. The further this secondary candle declines, the stronger our signal is considered.
(Created using FXCM’s Marketscope 2.0 charts)
Bearish Engulfing in Trading
Once you are familiarized with identifying the bearish engulfing candle pattern it can then readily be applied to your trading. Above is an excellent example of the pattern in action on a daily EURUSD chart. From the January the 13th through February 24th the EURUSD rallied as much as 863 pips. This rally was concluded with the formation of a bearish engulfing pattern and this was our first opportunity to consider new selling opportunities prior to the subsequent 1444 pip price decline.
Traders had the option of considering a variety of entry mechanisms once this two candle pattern was concluded. While it is not uncommon to see traders execute on the pattern alone, it can also be used with an oscillator or breakout strategy to give further confirmation of the reversal. Most often the high of the bearish engulfing pattern can be used as an area of resistance. Regardless of the method chosen, traders using fresh entries may choose to place stop orders above this level in the event that a reversal fails and a higher high is made.
---Written by Walker England, Trading Instructor
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