A highly reliable two-session candlestick indicator is called the engulfing pattern -- the second session is longer on both sides, “engulfing” its opposite-colored predecessor. Two attributes are needed to make it a true engulfing pattern. First, the real body of the second session is extended higher and lower than the previous day and has the opposite color. Second, both upper and lower shadows should also be longer both above and below the previous day.
A bullish engulfing pattern begins with the signal session in black, followed by the set-up session larger and white. Extensions of real body as well as of shadows must exceed the previous session. Before acting on this indicator, you need confirmation. This may show up in the next session gapping upward or simply reversing the downtrend into a new upward-trending move.
A bearish engulfing pattern is the opposite. The signal session is white, followed by a black set-up signal. Extensions have to exceed the prior day, both for real body and for shadows. It shows up at the top of an uptrend and foreshadows a reversal to a downward-trending move. A strong confirmation occurs when the next day moves downward or - even stronger - if it gaps downward.
These engulfing patterns are quite reliable but, like all candlesticks, you need confirmation before acting on the signal. This occurs through price gaps, breakouts above resistance (bullish) or below support (bearish), narrow-range days or volume spikes. You may also confirm the engulfing pattern with traditional technical chart patterns; or use engulfing patterns as the confirming indicators for those traditional reversal signals.
The expansion of the trading range you find in the engulfing pattern, coupled with the change in color, combine to provide very strong indication of a reversal, reliable about 80% of the time. The close of day one and open of day two have a gap in all cases and although it may be only a small gap, it adds to the strength of the pattern. However, all indicators such as these can also fail, so you have to rely on confirming, independent signals before entering or exiting a position.
Reliable candlestick reversals fit nicely into short-term trading strategies (day trading and swing trading) because they are easy to find, are reliable, and work into the short-term trading rules followed even by those who do not follow candlesticks. These independent indicators are the doji (narrow range day), reversal days (engulfing is an example), and volume spikes.
Candlestick patterns don’t answer all of the timing issues you face in your trading strategy. But they are great hints that improve your entry and exit timing.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com.