Trading Engulfing bars or Outside barsDefinition: An engulfing bar is a bar whose trading range totally encompasses or engulfs that of its predecessor such that it has a higher high and lower low. They develop after both down- and uptrends and represent exhaustion. They could be bullish engulfing bars which close higher than the open, or bearish engulfing bars which close lower than the open. A bullish engulfing bar forms at bottoms while a bearish engulfing bar forms at tops. Below is a gold chart illustrating a bullish engulfing bar. Notice how it has a higher high and lower low.
Determining the significance of engulfing bars: The following factors are used to determine the significance of an engulfing bar. If at least 3 points are satisfied, I consider the setup a high probability one.
1. The wider the engulfing bar is relative to the preceding ones, the stronger the signal: This arises from that fact that the engulfing bar or outside bar is supposed to reflect a change in the balance between buyers and sellers.
2. The sharper the trend preceding the engulfing bar, the more significant the bar: This is because the engulfing bar represents change, therefore there must be something to change. Therefore, the stronger the preceding trend, the stronger the implied sentiment dominating that trend.
3. The more bars encompassed, the better the signal: In most situation, only one bar is encompassed. However, when it encompasses several bars, the signal that the balance has shifted from buyers to sellers at a top, or from sellers to buyers at a bottom, becomes that much stronger. The encompassed bars become a small price pattern in themselves.
4. The nearer the price closes to the extreme point of the bar that is away from the direction of the previous trend, the better: For example, if the previous trend was down and the price closes near the high, this is more favorable than if it closes near the low, and vice versa. This is because the engulfing bar is supposed to signal a reversal in the sentiment and a change in trend. The fact that the closing in this example develops near the high emphasizes the strength of the buyers, thereby adding to the validity of the signal. Note: If the close develops near the high in a rising trend or near the low in a falling trend, then the engulfing bar is not consistent with a change in psychology. In this case, it has become a consolidation, and not a reversal pattern. Notice the same gold chart that had a huge rally. See how it closed near its high.
5. The engulfing candle should be of the opposite color from the candle it engulfs.
An important question to ask yourself when considering any bar pattern is: “What is the price action of this bar telling me about the underlying psychology?”
Note: Not all engulfing patterns result in a reversal in trend. Some, for example, may be followed by a change in trend which can be seen after a pullback as price consolidates or has a correction. In this case, the engulfing pattern becomes a continuation pattern.
Sometimes, after an engulfing bar is signaled, price can do a retracement before continuing in the direction indicated by the engulfing bar. This usually gives low risk and higher risk:reward ratio but this occasions are rare and if the retracement is more than 50%, then it is a case for concern.
How to trade engulfing bars: Use pending orders.
1. Place a pending order a few pips above the high of the bullish engulfing bar and a few pips below the low of a bearish engulfing bar.
2. Stop Loss (SL) is safely a few pips beyond the opposite end of the engulfing bar. That means, if a bullish engulfing bar, a few pips below the low of the bar, and if bearish engulfing bar, a few pips above the high of the bar. This strategy gives the trade room to breathe.
3. The take profit (TP) should be on the next key level of support and resistance, or when a candlestick reversal pattern opposing the position is found.
Example 1: Where to set entry parameters for a bullish engulfing bar.
Example: Where to set entry parameters for a bearish engulfing bar.
