3rd Day Candlestick Patterns /Engulfing Candlestick Pattern

                               Bullish Engulfing Pattern

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The bullish engulfing pattern is a two candlestick reversal pattern that occurs during a downtrend. The definition of a bullish engulfing pattern is as follows:

• The first day is a bearish candlestick, but can be a doji as well.
• The second day is a bullish candlestick that is larger in height than the first day’s candlestick.
• Lastly, the open and low of the second day should be lower in price than the first day’s close and the second day’s close and high should be higher in price than the first day’s open.
• The strictest description of a bullish engulfing candlestick pattern requires that the real body of the second day be larger than the first day’s candlestick which would include its upper and lower shadow.

Sometimes the bullish engulfing pattern is referred to as a three outside up pattern. The difference being the addition of a bullish candlestick on the third day that closes above the high of the second day’s bullish candlestick.

Traits That Improve the Bullish Engulfing Pattern's Effectiveness

According to Nison (1991, p. 39) the following traits increase the odds that a bullish engulfing pattern is an important reversal indicator:

• The first day has a very small real body and the second day has a very long real body.
  Reasoning: A small bearish candlestick after a downtrend shows the bears are unable to push prices as low as they have during the prior trend. A small bearish candlestick shows the bears have less power; whereas, a large bearish candlestick shows the bears having more power. Likewise, a large bullish candlestick that defies the previous downtrend shows that bulls came back into the market and the bears were unable to stop them. The longer the bullish candlestick the greater the show of force by the bulls.
• The bullish engulfing pattern occurs after a long downtrend or a very quick move lower.
  Reasoning: Sellers or traders who are shorting have probably already done so after an extended move downward and therefore there are fewer potential sellers or shorters. In the case of a sudden move downward, often these quick moves are overdone and are susceptible to reversals.
• Volume on the second day candlestick is very large.
  Reasoning: The fact that unusually high amounts of volume were transacted on a large bullish candlestick means that there was a large turnover of shares throughout the day and that traders had to bid up prices in order to buy shares, which is very bullish. Explaining this using supply and demand basics, if there are less traders willing to sell their shares (ie less supply) and there are more traders willing to buy shares (ie more demand), then prices should rise, hence creating a bullish candlestick where prices opened and climbed throughout the trading day to close higher.
• The second day’s real body is larger than several previous days’ candlestick heights.
  Reasoning: Many small candlesticks show indecision. A large bullish candlestick that is larger than the previous indecisive candlesticks shows that the market has finally made a decision and the decision is to move upward.
• The bullish engulfing pattern occurs in an area of support.
  Reasoning: Support is an area where historically bulls have come into a market to buy at a certain price level. If the bullish engulfing pattern occurs at this support price level, then a trader might feel more confident buying because the support acts as another bullish confirmation.

Trading Suggestions for the Bullish Engulfing Candlestick Pattern

For those traders that go long based on the bullish engulfing pattern, Nison (2003, p. 66) suggests placing a stop loss order under the lows of the bullish engulfing pattern, since the bullish engulfing pattern should act as an area of support.

Bullish Engulfing Pattern Blended Candle = Hammer

When the first day and the second day of the bullish engulfing pattern are combined, it often looks like a hammer candlestick, which is also a bullish candlestick pattern.

Bullish Engulfing Pattern Confirmation of Support

The chart above of the Nasdaq 100 ETF (QQQ) shows a blue support line and the low of the second day of the bullish engulfing pattern bouncing off of that support. From the first day’s bearish candlestick closing price, it can be inferred that the next day prices gapped down to the open of the second day’s candlestick. After the bears tested support, the bulls were able to push prices to close above the first day’s opening price. Therefore the second day’s bullish candlestick engulfed the real body of the first day.

Bullish Engulfing Pattern Creating New Support

Nison (1994, p. 78) suggests that bullish engulfing patterns can become an area of support. The chart above of Exxon Mobil illustrates this concept well. After a long downtrend a bullish engulfing pattern emerges with many solid traits: the first day candle is small; the second day candle is very large engulfing two candlesticks prior to it; and it occurs after a long, continual downtrend. After the bullish engulfing pattern prices rally upward; however prices begin to trend back down until they reach a low equal to the low of the bullish engulfing pattern’s second day candle low. An aggressive trader could attempt to buy at the price level established by the bullish engulfing pattern over 30 trading days prior. In this specific instance, the trader would have been rewarded favorably.

Bullish Engulfing Pattern 2nd Day High Volume Confirmation

Notice on the chart above of the Energy SPDR ETF (XLE) how the second candle of the bullish engulfing pattern had the highest volume of any of the day’s shown in the chart. It is important confirmation to see high volumes accompany large bullish candlesticks. This shows that bulls are serious about buying that day.