The engulfing bar price action setup is one of the most popular and reliable candlestick patterns.
Just like the pin bar pattern, the engulfing bar may indicate a potential price reversal, depending on where it forms on the chart.
Interestingly, this price action setup is quite easy to identify on your candlestick chart.
An engulfing candlestick is one that consumes, at least, the immediate preceding candlestick, but the more preceding candlesticks it engulfs, the more powerful the pattern is.
The engulfing pattern occurs quite commonly on the price chart, and it’s one of the favorite patterns among price action traders.
Read on to find out the best way to trade the engulfing bar price action setup.
But, first, let’s see how the engulfing pattern looks and the psychology behind its formation.
Anatomy of the engulfing bar
Basically, the engulfing pattern is a 2-candlestick pattern in which the body of the second candlestick completely engulfs the body of the first candlestick, and the range (body plus upper and lower wicks) of the second candle may also consume that of the first bar.
A more powerful variant of the engulfing pattern is called the outside bar — where the body of the second candlestick completely engulfs the entire range of the first candlestick.
In the daily chart, the outside bar pattern is called a reversal day.
The significance of the engulfing pattern depends on where it occurs in the context of price movements — after a rally or a decline — and the combination of candlesticks in the pattern.
Based on those characteristics, the pattern is classified into:
Bullish engulfing pattern
The bullish engulfing pattern occurs after a price decline and indicates that the price may be about to reverse to the upside.
The first candlestick in the pattern has a bearish body (in keeping with the price decline), while the second candlestick has a tall bullish body that completely engulfs the first one.
Looking at the pattern closely, you will see that it’s closely related to the bullish pin bar.
In fact, in a higher timeframe that merges the two trading sessions into one, the bullish engulfing pattern becomes a bullish pin bar with a bullish color.
Bearish engulfing pattern
In the bearish engulfing pattern, the first candlestick has a bullish body (in keeping with the ascending price), while the second candlestick has a tall bearish body that completely engulfs the first one.
The pattern is seen after a price rally and indicates that the price may be about to reverse to the downside
When you look at the bearish engulfing pattern closely, you will realize how closely it’s related to the bearish pin bar.
In fact, in a higher timeframe that coverts the two trading sessions into one session, the pattern becomes a bearish pin bar with a bearish body.
The psychology behind engulfing formation
The engulfing bar price action setup says a lot about what is going on in the market.
Just like the pin bar pattern, this pattern also shows how the buyers and sellers wrestle to control the price direction, except that, in this case, it happens in two trading sessions.
The bullish engulfing pattern shows that the sellers were still in control of the market, pushing the price low — as they had been all through the price decline preceding the pattern formation.
Those bears even extended their pressure to the next session, where the price opened with a gap below the first session’s close.
However, at a point in that second trading session, the bulls stepped up their game and took control of the session, pushing the price above the previous session’s open price.
The strong momentum in the engulfing candlestick is a statement of intent from the bulls.
In some cases, the second candlestick engulfs more than just the immediate preceding candle, which implies a stronger bullish momentum.
In the bearish engulfing pattern, bulls were still in control of the market in the first trading session, pushing the price up like they had been doing throughout the price rally before the pattern occurred.
At the opening of the next trading session, the bulls were still in control because the session opened with a gap above the preceding session’s close.
But, at some point in this session, the bears furiously came in and took control of the session, pushing the price below the previous session’s open price.
The bears just made a strong statement of intent and might remain in control for a while.
In some cases, the second candlestick engulfs more than just the immediate preceding candle, which implies a stronger bearish momentum.
Trading engulfing bars with the trend
The engulfing bar price action setup can form a profitable trading strategy if
you know how to spot the setups that work.
Not every engulfing bar pattern that you see on the chart is a high probability
For example, a setup that occurs against the direction of the main trend is unlikely to result in a successful outcome.
“The trend is your friend”, they say. If you trade only in the direction of the trend, there is a better chance that the trade would work out fine.
To further improve the odds of your trade, you need to look for other factors that support the trade.
Examples of those confluence factors include:
- Support and resistance levels
- Fibonacci retracement levels
- Moving averages
- Trend lines
Support and resistance levels
When the market is in a trend, it moves in swings/waves — impulse wave (same direction as the trend) and corrective waves or pullbacks (opposite to the trend direction).
The highs and lows of these price swings create a series of support and resistance levels on the price chart.
These are levels at which a new price wave can potentially reverse.The support levels lie below the current price, while the resistance
levels are above the current price.
So, in an uptrend, the impulse waves end at a known or new resistance level, while pullbacks (downswings) tend to reverse at a support level.
Conversely, in a downtrend, pullbacks (rallies) tend to reverse
at resistance levels, and impulse waves end at support levels.
To trade the engulfing bar price action setup in the direction of the trend, your aim will be to look for the candlestick pattern at the end of a pullback so that you can ride the next impulse wave in the direction of the trend.
In other words, if the market is in an uptrend, look for the engulfing pattern at a support level, and if the market is in a downtrend, look for the pattern at a resistance level.
In the GBP USD chart below, the market was in an uptrend but kept making a pullback to a particular support level.
The pullback ended with a powerful bullish engulfing candlestick that consumed the previous candlestick before it, and the market started climbing again.
The EURUSD chart below shows a downtrend. Notice that the price broke below a support level, which then turned to a resistance level.
When the price pulled back to it, a bearish engulfing pattern formed and the price dropped again.
Fibonacci retracement levels
The Fibonacci retracement levels help you to know, in advance, where a pullback might stop and reverse to the trend direction.
So, they act as potential support and resistance levels. The levels are derived from various ratios of the Fibonacci sequence of numbers.
Technically, the Fibonacci retracement levels estimate the percentage of the preceding impulse wave at which the price may retrace before turning back to the trend direction.
Hence, you attach the tool to your chart, from the low to the high of the preceding impulse wave, when the pullback starts.
The most important Fib retracement levels are 38.2%, 50%, and 61.8%, so in a trending market, it’s best to look for engulfing bar price action setups around these levels.
For example, in the USDCAD chart below, the price is trending upwards.
A bullish engulfing pattern occurred when the correction wave got to around the 50% retracement level.
Thereafter, the price turned upwards. So, that level acted as a support level.
In the AUD USD chart below, the market was in a downtrend.
A bearish engulfing pattern occurred around the 50% retracement level, which was acting as a resistance level, and the market gradually started dropping again.
Trend lines can be very useful when trading the engulfing bar price action setup with the trend.
The trend lines are not only helpful in identifying the direction of the trend but can also act as dynamic support or resistance levels.
If the price is trending up, you attach the trend line to the low of downward price swings (pullbacks) so it acts as a rising support level for future downswings.
Take a look at the EURUSD chart below. The price was trending up and made pullbacks to the trend line.
The bullish engulfing pattern formed on two occasions — the second one slightly at the trend line.
When the market is in a downtrend, you attach the trend line at the highs of the price rallies, making it a sloping resistance line.
In the AUD JPY chart below, the price was trending down and made a pullback to the trend line.
A bearish engulfing pattern occurred and the price dropped again.
The moving average indicator is another helpful tool when trading the engulfing bar price action setup with the trend.
You can use it to identify the direction of the trend, but it can also act as a shifting support and resistance level from where the price can bounce off.
While there are different styles of the moving average indicator, which can be set to any period, we prefer the 8-period or 21-period simple moving average at the session close.
In a market that is trending up, the moving average can act as a rising support level where the price can pull back to and reverse.
So, look for a bullish engulfing pattern at the indicator line when there’s a pullback.
The USDCAD chart below shows an uptrend.
Notice the bullish engulfing pattern that formed on the indicator and how the price climbed up afterward.
For a down-trending market, the moving average can act as a dynamic resistance level.
In the GBP CHF chart below, the price frequently pulled back to the moving average line.
Notice the bearish engulfing pattern that formed around the indicator ,as a result, the price fell sharply afterward.
Engulfing pattern order entry and exit strategies in a trending
Here are a few ways you can place your order when trading the engulfing pattern with the trend:
- A buy stop order a few pips above the high of the engulfing candlestick (for a long position) or a sell stop order a few pips below the low of engulfing candlestick (for a short position)
- A market order immediately after the engulfing candlestick has closed
If you are long, place your stop loss a few pips below the preceding swing low.
You can also place it some pips below the low of the current pullback, but it carries a higher risk of being stopped out before the impulse wave begins.
In the case of a short position, place your stop loss order above the high of the preceding swing or above the high of the pullback you’re trading — but this carries a higher risk of being stopped out.
For your profit target, you can use any of these methods:
- Fibonacci extension or expansion levels
- The average size of impulse waves in the trend, measured from the low/high of the pullback you’re trading
- A risk/reward ratio of 2:1 or 3:1
- The next support or resistance level
Trading engulfing bars in ranging markets
We know that the market is not always in a trend, and on many occasions, it simply moves sideways — what is otherwise known as a ranging market.
In such market situations, you can still trade the engulfing bar price action setup profitably if you know what to look for and are ready to protect your account in case of a breakout.
There are tools that can help you spot high probability setups in a ranging market, and these are some of them:
- Support and resistance zones
- Oscillator indicators
Support and resistance zones
If you want to trade a ranging market, the first thing you need to do is identify the boundaries of the range by connecting two consecutive swing highs as the upper boundary and two consecutive swing lows as the lower boundary.
The upper boundary becomes the resistance zone, while the lower boundary becomes the support zone.
These are the levels where you expect the price to reverse, so you have to watch out the engulfing bar setups.
Look for the bullish engulfing pattern around the support zone and the bearish engulfing pattern around the resistance zone.
Those patterns indicate that the market is about to turn.
In the USD CAD chart below, you can see a market that was in a range for a long period of time .
There was one occasion when the bullish engulfing pattern formed at the lower boundary, and the market reversed upward.
At the upper boundary, an abnormally tall bearish engulfing pattern occurred initially, and the market dropped to the support zone.
One of the best indicators for trading a ranging market is an oscillator, which can be the stochastic, RSI, CCI, OsMA, Williams %R, MACD, or the momentum indicator.
Any of these indicators can be used to confirm the engulfing setup since they show when a price move is stalling and likely to reverse.
The oscillators are fashioned in such a way that, as the price moves up and down within a range, they move between overbought and oversold regions or oscillate about a midline.
Their trade signal can be in the form of any of these:
- The indicator climbing up from the oversold region (a buy signal) or descending from the overbought region (a sell signal)
- The indicator bars (MACD, OsMA) rising from below the midline (buy signal) or descending from above the midline (sell signal)
- A divergence between the oscillator indicator and the price swing high or low
When a stochastic was added to the USD CAD chart, you will notice that the first bullish engulfing setup coincided with an oversold signal and a classical bullish divergence in the stochastic.
The second bullish engulfing pattern occurred with an oversold signal in the stochastic, while the bearish engulfing pattern occurred with an overbought signal in the indicator.
Engulfing pattern order entry and exit strategies in a ranging
When trading the engulfing bar price action setup in a ranging market, this is how you can enter and exit your trades:
- Place a market order once the engulfing pattern has completed, especially if an oscillator signal is confirming it.
- Place a stop order a few pips above the pattern’s high (for a long position) or below the pattern’s low (for a short position)
For your stop loss, place it some pips below the lowest swing low in the support zone if you are long.
If you are short, place your stop loss a few pips above the highest swing high in the resistance zone.
Your aim should be to get out quickly if the price breaks out of the range.
Place your take profit a few pips before the opposite boundary.
Mistakes to avoid when trading engulfing bars
Although the engulfing bar price action setup can be a profitable trading strategy, traders make some mistakes when trying to follow price action strategies.
Here are some of the common ones:
Going against the trend is one common mistake traders make, and it can be dangerous.
Such setups offer low probability trades, and any mistake with your stop loss can blow your trading account.
The best way to trade the engulfing pattern in a trending market is to find the pattern in a pullback so that you can ride the impulse wave.
The USDCAD chart below shows a bearish engulfing pattern that occurred against the impulse wave.
Trading that setup would have led to a loss because the market continued rising.
Not using other supporting factors
Trading the engulfing pattern on its own does not offer enough odds of success, even when trading in the direction of the trend.
You need to have a confluence of other factors that support the direction you want to trade.
Examples of those factors are support or resistance levels, Fibonacci retracement levels, trend lines, and the moving average indicator.
Not considering what the chart is showing
Some traders just memorize the candlestick patterns and try to spot them on the chart. That is not the right way to trade price action strategies.
To successfully trade a price action setup, you need to master the art of reading the chart to understand the general picture of the market.
An engulfing pattern occurring with a head and shoulder chart pattern is not the same as a stand-alone engulfing pattern.
Putting stop loss too close to the entry
Placing your stop loss close to your entry can be really dangerous.
While risking fewer pips may feel like the right thing to do, it comes at a price — you will get knocked out before the journey even begins. Several small losses can amount to a lot.
Yes, you can build a profitable trading strategy using the engulfing bar price action setup.
However, you need to master the art of reading price action both in trending and ranging markets.
You also need to bring in other supporting tools, like the support and resistance levels, Fibonacci retracement levels, trend lines, and moving averages. Remember, don’t trade against the trend.