What qualifies as an engulfing candle is fairly simple: as long as the body of a candle "engulfs" the previous candle in terms of the body (some will say wicks as well), it would be considered an engulfing candle. As such, it can indicate that a move in the opposite direction of the candle that was “engulfed” may take place.
In other words, if a bullish candle is engulfed by bearish candle, the higher probability direction to trade the pair will be to short it. If a bearish candle is engulfed by a bullish candle, the higher probability direction to trade the pair will be to buy it.
Remember, just because a trader sees an engulfing candle does not mean that a move in the opposite direction is assured. As far as being certain goes, a trader can be certain that a candle is an engulfing candle, but we can never be certain of what may transpire on the chart going forward.
Below you will find a historical 4 hour chart of the EURGBP currency pair. Examples of engulfing candles are outlined...bullish engulfing in black and bearish engulfing in green. No two candles will be exactly alike although you will see that the criteria of an engulfing candle is met in each.
Keep in mind, as is the case when interpreting candlesticks, a trader cannot make a decision regarding what a candle might turn out to be until that candle is closed. For example, the last candle on the right of the chart at this point looks like a bullish engulfing. However, when the 4 hour period closes and that candle closes along with it, based on price action between now and then, that candle may turn out not to engulf the previous candle at all.
Always wait for a candle to close before making a trading decision based on it.
One strategy that can be used when an engulfing candle is identified is to only take a trade when the candle signals a potential change of direction when that change is in the direction of the trend. In other words, in a downtrend we would look for bearish engulfing candles and in an uptrend we would look for bullish engulfing candles.
Should the trade be taken, the stop would be placed below the bullish engulfing candle in an uptrend and above the bearish engulfing candle in a downtrend.
Lastly,be sure to note that there are several engulfing candles on the chart where a move in the opposite direction did not take place after the engulfing candle closed. As usual, nothing in trading is ever a certainty.
---Written by Richard Krivo
To contact Richard, please email firstname.lastname@example.org . You can follow Richard on Twitter@RKrivoFX.
To be added to Richard’s distribution list, please send an email with the subject line “Notification”, to email@example.com .
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
Learn forex trading with a free practice account and trading charts from FXCM.