The Engulfing Candle Day-Trading Strategy
Trading with the trend is one of the most advantageous things a trader learns to do. Using an engulfing candle day-trading strategy for stocks, currencies, or futures is one way to get into trending moves just as momentum is picking up.
In a candlestick price chart, the wide parts of candlesticks are called "real bodies." In a down or bearish candle, the top marks the opening price and the bottom marks the closing price for the period you're observing. The real body of a down candle is often black or red in color. In an up or bullish candle, the top marks the closing price and the bottom marks the opening price. The real body of an up candle is often white or green. The high and low prices for the period may be indicated by thin lines that look like wicks of the candle and that extend beyond the real body.
A bearish engulfing candle occurs when the real body of a down candle completely envelops the real body of the prior up candle. A bullish engulfing candle occurs when the real body of an up candle completely envelops the real body of the prior down candle.
These engulfing candles indicate a strong shift in direction, and when combined with observation of the price-trending direction that precedes it, this shift creates the opportunity for a trading strategy.
Isolate the Trend
The first step in applying the engulfing candle day-trading strategy is to determine the dominant trend direction, and thus the direction you will trade in.
An uptrend is defined by higher-swinging highs and higher-swinging lows in price. Prices move in waves, advancing, pulling back, and then advancing again. In an uptrend, the advancing waves are larger than the pullbacks lower, creating overall progress higher. During an uptrend, you should take only long positions: buying with the intention of selling later at a higher price.
A downtrend is defined by lower-swinging lows and lower-swinging highs in price. In a downtrend, the declining waves are larger than the pullbacks higher, creating overall progress lower. During a downtrend, you should take only short positions: selling a borrowed asset with the intention of buying and returning it later at a lower price.
Watch for an Upward or Downward Pullback
Once the trend is established, wait for a pullback. If there is no trend, or it is unclear, don't utilize this strategy.
Waiting for a pullback means you're getting advantageous pricing for the next wave of the trend when—and if—it unfolds.
If the trend is down, watch for an upward pullback. The pullback should not rally above the high of the prior pullback, as this violates the rules of a downtrend.
If the trend is up, watch for a downward pullback. The pullback should not drop below the low of the prior pullback, as this violates the rules of an uptrend.
A pullback should be composed of at least two price movements, indicating the price has actually corrected. Pullbacks may move in the opposite direction of the trend or may just move sideways.
Entering the Trade
With the trend isolated and a pullback occurring, wait for the engulfing candle strategy trade signal.
During a downtrend, wait until a down candle engulfs an up candle. Enter a short trade as soon as the down candle moves below the opening price (the bottom of the real body) of the up candle in real time. There is no need to wait for the candle to be completed.
For an engulfing candle strategy signal during an uptrend, wait until an up candle engulfs a down candle. Enter a long trade as soon as the up candle moves above the opening price (the top of the real body) of the down candle in real time.
Once a trade is initiated using the engulfing candle strategy, place a stop loss above the recent high for short positions, and below the recent low for long positions.
Exiting the Trade
The engulfing candle that occurs after a pullback in an overall trend is designed to get you into a trade as the next wave of the trend is likely to unfold. (It doesn't always.) Trends can persist for a long time or can fail quickly. Therefore, this method does not have a specific exit.
A rule of thumb is to make sure your winners are at least one-and-a-half times as big as your losers; two times bigger is even better. Therefore, measure the distance between your entry point and where you placed the stop loss. For example, if it is 30 cents, that is your risk. Your target price should be at least one-and-a-half times greater than that, or 45 cents. Therefore, hold the trade for at least a 45-cent gain to compensate yourself for the risk you've taken.
If the trend threatens to reverse—by making a higher high and higher low (not necessarily in that order) during a downtrend and short trade or by making a lower high and lower low during an uptrend and long trade—exit the trade.
If you're trading using a short time frame, such as a one-minute or, say, a 30-tick chart, be "quick on the draw." (A tick chart is based on the number of transactions rather than on time.) If an engulfing candle signal is potentially imminent, plan where you'll place your stop and then quickly calculate what your minimum target price for the trade is.
Engulfing patterns won't occur after every pullback, which means potentially missed opportunities. To help avoid this, consider allowing multiple candles to create an engulfing pattern. For example, if after a pullback in an uptrend, it takes two up candles to engulf the prior down candle, consider this a valid signal of a shift in momentum back in the trending direction.
An engulfing candle strategy signal doesn't mean the trend will always resume. That is why a stop loss is mandatory.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.