A Simple, But Profitable Candle Pattern

11/13/2015 7:00 am EST

Focus: STRATEGIES

Huzefa Hamid

Senior Analyst, DailyForex.com

Huzefa Hamid, contributor to DailyForex.com and co-founder of The Forex Room, outlines an easily identifiable chart pattern that works on any market with high volume.

This Engulfing setup produces a simple but highly reliable trading strategy. Along with my Pin Bar Entry, it forms the core of my currency trading strategies. However, this technical analysis strategy works well on any chart and any market, as long as the market has substantial volume.

The Engulfing candle pattern is a two bar pattern that is quite easy to visually spot. The term "Engulfing" refers to one candle's body engulfing or covering the range of the previous candle's body, like so:

chart
Click to Enlarge

The above is an example of a "Bearish Engulfing" setup. The first candle has an Open higher than its Close; the second candle reverses that momentum and Closes Below its Open. Crucially, the second candle's body completely engulfs or covers the range of the first candle's body.

A Bullish Engulfing setup is just the other way around: a black (bearish) candle is followed by a hollow (bullish) candle.

In order for an Engulfing setup to be valid, both candles must have short wicks. Precisely, we require the total length of the wicks to be no more than 33% of the entire candle's length. In other words, the majority of the candle must be body. Long wicks represent indecision rather than sustained direction. (Some traders prefer to use a stricter definition of wicks being no longer than 25% or even 20% of the entire candle length.)

Secondly, we give some allowance on how much the first candle's body is covered. We accept a setup if at least 90% of the first candle's body is covered by the second candle's body.

Let's look at an example of this in action on the AUD/USD daily chart:

chart
Click to Enlarge

A Bearish Engulfing setup appeared on the AUD/USD daily chart (highlighted in blue) after the price had been trending down for the last six or seven candles. Notice also that the top of the Engulfing setup lined up well with the previous broken support, now being tested as resistance (marked by a dashed red line). Tying this setup with price action gives you as a trader greater confirmation and confidence.

The entry would be the open of the next candle and the stop-loss above the high of the second candle in the setup. As a minimum, aim for a 1:1 risk/reward ratio. In this case, the potential first profit target was hit quickly and cleanly.

The conditions for an Engulfing setup are quite strict, and valid setups take time to appear. The temptation is to move down to lower time frames to find them. However, in our experience their accuracy is particularly potent on hourly charts and above.

In fact, we regularly trade them on four-hour and daily charts for our longer-term signals. The advantage with higher time frames is that spreads matter less because of higher profit targets-this allows you to monitor more pairs that you may not usually consider.

In summary:

  • An Engulfing setup is a two-candle setup whereby each candle has short wicks and the second candle's body covers the range of the first candle's body.
  • The setup is easy to spot visually, and can be traded in isolation or tied in with surrounding price action.
  • Higher time frames, such as the daily chart, produce more accuracy.

Huzefa Hamid is a contributor to DailyForex.com and co-founder of The Forex Room.

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