Trading The Engulfing Candlestick Pattern With Market Structure

If you have learnt how to trade candlesticks, you must know the engulfing candlestick pattern. Its striking name and visual makes it one of the most popular candlestick pattern.

Reference: Japanese Candlestick Charting Techniques

The engulfing candlestick pattern has two candlesticks. The body of the second bar completely engulfs the body of the first bar. It represents a total change of market sentiment.

An engulfing candlestick in the right context offers a high probability trading setup. Finding the best context with moving averages and oscillators are reliable trading methods.

Learn: Candlestick with RSI Trading Strategy

However, in this review, we will look at a simpler method that uses the concept of market structure to find point us in the right direction. Market structure refers to the relationship of swing highs and lows that lend structure to market trends.

Trading Rules – Engulfing Candlestick

Bullish Engulfing

1. Higher swing high and higher swing low
2. Buy with bullish engulfing candlestick pattern
3. High of pattern must stay below previous swing high

Bearish Engulfing

1. Lower swing high and lower swing low
2. Sell with bearish engulfing candlestick pattern
3. Low of pattern must stay above previous swing low

Engulfing Candlestick Trading Examples

Winning Trade – Bearish Engulfing

This is a daily chart of Allergan (AGN on NYSE). It shows a market plunge that erased months of gains.

1. The lower swing high and low confirmed the beginning of a downwards trend with the climatic bear bar.
2. Prices retraced up immediately after the drastic fall. The bull move stopped as a bearish engulfing candlestick emerged.
3. The bearish engulfing candlestick pattern formed on the mid-point (50% retracement) of the strong bear trend bar which provided resistance.

Losing Trade – Bearish Engulfing

This daily chart of Cardinal Health (CAH on NYSE) shows a bearish engulfing pattern that didn’t follow-through.

1. Technically, there was a set of lower swing high and low.
2. However, in this case, the swings did not push out of the sideways movement of CAH. Hence, the lower high and low structure was not a reliable indicator of a downwards trend.
3. The bearish engulfing candlestick pattern led to a losing short trade, as prices broke out above the trading range.

Review – Engulfing Candlestick with Market Structure

Many trading strategies use engulfing candlestick patterns as a signal for major trend reversals. That is a low probability strategy. However, as we use engulfing patterns for continuation trades here, we have better odds.

Many candlestick traders wait for one more candlestick after the engulfing pattern as confirmation. For this trading strategy, you should not wait for confirmation for most trading setups. Waiting for confirmation worsens our reward to risk ratio.

If you wait for confirmation, the trading setup is likely invalid due to trading rule 3. Basically, that rule keeps us away from taking trades that have poor reward to risk ratio.

Observing swing highs and lows is the simplest way to follow market trends. It builds on the market structure and does not need any trading indicator. While this approach gives some confusing signals during deeper pullbacks, its simplicity is still attractive. Regardless of your trading strategy, paying attention to the market structure will help you filter bad trades.

Read: Take Only The Best Trades

Congested markets might have many engulfing candlestick patterns with no follow-through. Be careful and avoid signals in sideways market. Look for clear swings to avoid congestion.

Hone your skills in reading the market structure. It is invaluable in any trading method.