Multiple candlestick patterns (Part 1)

The Engulfing Pattern

In a single candlestick pattern, only a single candlestick is required to identify a trading opportunity. In contrast, while evaluating several candlestick patterns, the trader need two or three candlesticks to find a trading opportunity. This indicates that the trading opportunity develops across at least two trading sessions.

The first multiple candlestick pattern we must examine is the engulfing pattern. The engulfing pattern requires two trading days to develop. In a typical engulfing pattern, the first day's candle will be small, while the second day's candle will be rather long and appear to engulf the first day's candle. When the engulfing pattern appears towards the bottom of the trend, it is referred to as "Bullish Engulfing." If the engulfing pattern comes during the peak of the trend, it is referred to as "Bearish Engulfing."

The Bullish Engulfing Pattern

The bullish engulfing pattern is a two candlestick pattern which appears at the bottom of the down trend. As the name suggests, this is a bullish pattern which prompts the trader to go long. The two day bullish engulfing pattern is encircled in the chart below. The prerequisites for the pattern are as follows:

  1. The prior trend should be a downtrend
  2. The first day of the pattern (P1) should be a red candle reconfirming the bearishness in the market
  3. The candle on the 2nd day of pattern (P2) should be a blue candle, long enough to engulf the red candle

The thought process behind the bullish engulfing pattern is as follows:

  1. The market is in down trend with prices steadily moving down
  2. On the first day of the pattern (P1), the market opens low and makes a new low. This forms a red candle in the process
  3. On the second day of the pattern (P2), the stock opens near the closing prices of the previous day (P1) and strives to create a new bottom. However, at this low point in the trading day, there is a sudden surge of purchasing activity, which causes the prices to close higher than they did at the beginning of the trading day. The current price action makes a blue candle.
  4. The price action on P2 also suggests that bulls made a very sudden and strong attempt to break the bearish trend and they did so quite successfully. This is evident by the long blue candle on P2
  5. The bears would not have expected the bull’s sudden action on P2 and hence the bull’s action kind of rattles the bears causing them some amount of nervousness
  6. The bullishness is expected to continue over the next few successive trading sessions, driving the prices higher and hence the trader should look for buying opportunities

The trade set up for the bullish engulfing pattern is as follows:

  1. The bullish engulfing pattern evolves over two days
  2. The suggested buy price is around the close price of blue candle i.e on P2
  • Risk taker initiates the trade on P2 itself after ensuring P2 is engulfing P1
  • The risk averse initiates the trade on the next day i.e the day after P2 around the closing price, after confirming the day is forming a blue candle
  • If the day after P2 is a red candle day, the risk averse trader will ignore the trade, owing to rule 1 of candlesticks (Buy strength and Sell weakness)

In multiple candlestick patterns where the trade evolves over 2 or more days it is worth to be a risk taker as opposed to a risk averse trader

3. The stop loss for the trade would be at the lowest low between P1, and P2

Needless to say, once the trade has been initiated you will have to wait until the target has been hit or the stoploss has been breached. Of course, one can always trail the stop loss to lock in profits.

 The bearish engulfing pattern

The bearish engulfing pattern is a two candlestick pattern which appears at the top end of the trend, thus making it a bearish pattern. The mental process is extremely similar to the bullish engulfing pattern, with the exception that one must consider it from a shorting standpoint.

In the previous chart, the two candles that comprise the bearish engulfing pattern are circled. You will observe: 

  1. To begin with the bulls are in absolute control pushing the prices higher
  2. On P1, as expected the market moves up and makes a new high, reconfirming a bullish trend in the market
  3. On P2, as expected the market opens higher and attempts to make a new high. However at this high point selling pressure starts. This selling comes unexpected and hence tends to displace the bulls
  4. The sellers push the prices lower, so much so that the stock closes below the previous day’s (P1) open. This creates nervousness amongst the bulls
  5. The strong sell on P2 indicates that the bears may have successfully broken down the bull’s stronghold and the market may continue to witness selling pressure over the next few days
  6. The idea is to short the index or the stock in order to capitalize on the expected downward slide in prices

The trade set up would be as follows:

  1. The bearish engulfing pattern suggests a short trade
  2. The risk taker initiates the trade on the same day after validating two conditions
  • The open on P2 is higher than P1’s close
  • The current market price at 4:10 PM on P2 is lower than P1’s open price. If the two conditions are satisfied, then it would be logical to conclude that it is a bearish engulfing pattern
  1. The risk averse will initiate the trade on the day after P2 only after ensuring that the day is a red candle day
  2. Since the bearish engulfing pattern is a 2 day pattern, it makes sense to be a risk taker. However this purely depends on the individual’s risk appetite