Exploring the Bearish Engulfing Pattern

13. Sept. 2023

Welcome to our Power Patterns series in which we teach you how to trade some of the most powerful price patterns which occur on any timeframe in every market.

When it comes to powerful price patterns, the bearish engulfing pattern is right at the top of the list. It provides traders with a clear and decisive signal that sellers have taken control of the market.

We'll teach you:asx

• What makes the perfect bearish engulfing candle
  
• The powerful psychology that underpins the pattern
  
• Trying to maximise the patterns risk-reward potential
  

I. Deconstructing the bearish engulfing pattern

The bearish engulfing pattern is formed when the market trades higher than the previous day’s high, only for prices to reverse and close below the previous day's low.

Here’s the pattern deconstructed into its key elements:

Higher High: The engulfing candle must establish a higher high than the preceding day's candle, suggesting bullish optimism initially.

Lower Low: The engulfing candle should form a lower low compared to the previous day, indicating a shift in market sentiment.

Lower Close: Importantly, the engulfing candle must close below the prior day's low, sealing the bearish sentiment.



II. Simple yet powerful psychology

This pattern's underlying psychology is robust. It resonates with day traders and active market participants who use the prior day's high and low as reference points for trading decisions.

When a bearish engulfing pattern forms, it reveals not only the market's inability to sustain prices above the prior day's highs but also its capacity to erase those gains completely. This leaves bullish traders who entered on the break above the prior day's highs in a precarious position.

At its core, the bearish engulfing pattern, though composed of only two candles, might signal that the bears have taken control of the market, offering invaluable insight to traders looking to manage long-term positions or take short-term trades.

III. Take the bearish engulfing pattern to the next level

There’s a common misconception surrounding the bearish engulfing pattern. It is often regarded as a counter trend pattern which signals the end of uptrends.

However, we believe the pattern is at its most effective when it occurs following pullbacks in long-term downtrends.

Every downtrend goes through prolonged pullbacks and periods of sideways consolidation. During these periods a resistance level is often formed. When a bearish engulfing pattern forms at one of these resistance levels it may provide a possible sell signal which aligns short-term momentum with the long-term trend.

Here’s an example of the bearish engulfing pattern working well in a long-term downtrend:



IV. Trading the bearish engulfing pattern: A hybrid approach for optimal risk-reward

Trading the bearish engulfing pattern can be a rewarding endeavour, but it also presents traders with a crucial decision: how to maximise precision in entry and stop-loss placement while achieving favourable risk-reward ratios. In this section, we will explore a hybrid approach that attempts to combine the best of both worlds and allow traders to benefit from the pattern's precision while optimising their risk-reward potential.

Entry: To initiate a trade using the bearish engulfing pattern, enter the market on a break below the low of the engulfing candle. This entry point capitalises on the bearish momentum confirmed by the pattern.

Stop placement: Instead of placing your stop-loss order directly above the high of the engulfing candle, which can sometimes be a considerable distance away and increase risk, opt for a more strategic approach. Consider placing your stop-loss order just above the resistance level that the engulfing candle has rejected. This not only helps protect your trade but can also maximise the risk-reward potential by reducing the distance between your entry and stop-loss levels.

Targets: Determine your initial profit targets based on the nearest key support zones visible on your chart. However, to further optimise your trade, consider the following:

• Partial profits: If you are trading the bearish engulfing pattern in line with a long-term downtrend, it may be beneficial to take partial profits at your initial targets. This locks in gains and reduces risk in case of a potential retracement.
  
  
• Trailing stops: To capture as much of the trend as possible, you could implement a trailing stop for the second half of your position after taking partial profits. Trailing stops allow you to ride the trend while protecting your profits. Adjust your trailing stop level as the price moves in your favour, allowing you to stay in the trade as long as the trend remains intact.
  

V. Managing risks and pitfalls:

Risk management: Implement proper risk management techniques, such as position sizing, checking the economic calendar, and diversifying your trading portfolio. This helps protect against unexpected market movements and potential losses.

Additional analysis: Don't rely solely on the bearish engulfing pattern for trading decisions. Supplement your analysis with fundamental factors and sentiment indicators to gain a comprehensive view of the market.

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Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance.