Engulfing Candle Day Trading Strategy

Using Engulfing Candles to Find High Probability Trend Entry Points

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Figure 1. Bearish and bullish engulfing patterns in S&P 500 SPDR (SPY), 1-minute chart. ©FreeStockCharts.com

Trading with the trend is one of the most advantageous things a trader learns to do. Using an engulfing candle day trading strategy is one way to get into trending moves just as momentum is picking up (for another entry method, see How to Day Trade the Forex Market).

A bearish engulfing candle is when the wide part (marks the open and close of the period) of a down candle completely envelops the wide part of the prior up candle.

The wide part of candlesticks are called "real bodies."

Unfamiliar with candlestick charts? Read: Learn to Read and Use Candlestick Charts.

A bullish engulfing candle is when the real body of an up candle completely envelops the real body of the prior down candle. 

An up candle followed by an even larger down candle (or vice versa) shows a strong shift in direction. When combined with trading in the trending direction this shift creates a power strategy. Figure 1 shows examples of bearish and engulfing candlestick patterns

Isolate the Trend

The engulfing candle day trading strategy works best when used in conjunction with a trend. The first step in applying the strategy is to determine the dominant trend direction, and thus the direction we will trade in.

An uptrend is defined as higher swing highs and higher swing 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, creating overall progress higher (see: Analyzing Price Action - Velocity and Magnitude). During an uptrend, only take long positions (buy).

A downtrend is defined as lower swing lows and lower swing highs in price. During a downtrend the declining price waves are larger than the pullbacks higher, creating overall progress lower.

During a downtrend, only take short positions.

Figure 1 (click to see larger version) shows an uptrend on the left of the chart, and a downtrend on the right half of the chart.

Wait for a 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 your getting advantageous pricing for the next wave of the trend, when-- and if--it unfolds.

If the trend is down, watch for a pullback to the upside.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 pullback lower. 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 bars, showing the price has actually corrected. Pullbacks may move in the opposite direction of the trend or may move sideways. In either case, once the pullback occurs, watch for a bullish engulfing candle pattern if the overall trend is up and watch for a bearish engulfing candle pattern if the overall trend is down.

Engulfing Candle Day Trading Strategy

With the trend isolated and a pullback occurring, wait for an engulfing candle strategy trade signal.

For an engulfing candle strategy signal during a downtrend, wait for the price to pull back. Continue to wait until a down candle engulfs an up candle. Enter short as soon as the down candle moves below the open of the up candle (bottom of the real body of the up candle) in real-time. There is no need to wait for the candle to complete.

For an engulfing candle strategy signal during an uptrend, wait for the price to pull back. Continue to wait until an up candle engulfs a down candle. Enter long as soon as the up candle moves above the open of the down candle (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. This assures risk is controlled on the trade.

Figure 2 (click to see larger version) shows trade examples, as well as where to place stop loss orders.

Exiting Engulfing Candle Strategy Trades

The engulfing candle which occurs during 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 though is to make sure your winners are at least one-and-a-half times as big as your losers, two times bigger (or slightly more) is even better.

Therefore, measure the distance between your entry point and where you placed the stop loss. For example, if it is $0.30 in a stock, that is your risk. Your target price should be at least one-and-a-half times greater than that, or $0.45. Therefore, hold the trade for at least a $0.45 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.

Cautionary Notes and Final Word 

If trading on a short time frame, such as 1-minute or tick charts, be "quick on the draw." If an engulfing candle signal is potentially imminent, plan where you'll place your stop and then quickly calculate what your minimum target for the trade is (see Know These 4 Things About Every Trade).

Engulfing patterns won't occur during every pullback which means potentially missed opportunities. To help avoid this, consider using multiple bars to create an engulfing pattern. For example, if during a pullback in an uptrend it takes two up candles to engulf the prior down candle, consider this a valid signal. Even though it took two up candles to engulf the prior down candle, it still shows 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.