There are primarily two types of participants in the stock market—investors and traders. The investors have a long-term view and hold the financial assets they buy, while the traders generally buy and sell in a short span of time. As opposed to analysing the fundamentals of a company for long-term investing, traders need to identify short-term price movements. Short-term price trends can be predicted by identifying patterns on technical charts.
One of the most popular charts for trading is the candlestick chart. The candles form various patterns like the piercing pattern, shooting star pattern or the bearish engulfing pattern. Traders take cues from these patterns for price movements and act accordingly. The bearish engulfing candlestick pattern is an important pattern that forms at the top of an uptrend and signals a reversal in the price movement. Before moving ahead with the bearish engulfing pattern, let us briefly try to understand candlestick charts.
Candlestick Charts
Candlestick charts were invented in Japan and they depict price movements through different colours. A chart consists of various candles that depict the opening, closing, high and the low price for a particular interval. The candlestick has a rectangle part, called the real body, which depicts the difference between the opening and the closing prices. Two lines protrude on both the ends of the real body. The lines, known as shadow or wicks, tell about the highest and the lowest price for an interval.
When the closing price is lower than the opening price, it is known as a down candle and filled with red colour. On the contrary, when the closing price is higher than the opening price, it is known as the up candle and shaded green.
Bearish engulfing pattern
A bearish engulfing pattern is formed at the end of an uptrend and signals a reversal in the trend. It means the sellers will overpower the buyers and would drag the price down. Two candles together form the bearish engulfing pattern. When a green or up candle is followed by a red or down candle that completely overtakes or engulfs the up candle, it is known as the bearish engulfing pattern.
The bullish engulfing pattern signals a strong change in sentiment. During the formation of the bullish engulfing pattern, the gap up on the opening of the market is filled up and the down candle formed engulfs the preceding up candle. The gap up is formed when the opening price on a day is higher than the closing price on the previous day. It is considered a bullish sign, but since the bearish engulfing pattern is a reversal of trend, the gap up fills up fast.
Reliability of bearish engulfing pattern
The patterns formed on a candlestick chart are not always clear as they are in theory. A bearish engulfing candle is more reliable when the opening of the engulfing candle is well above the close of the previous candle. It essentially means the presence of a substantial gap up. Additionally, the closing of the down candle should be well below the opening of the up candle. The bearish engulfing candlestick pattern is also not reliable in a choppy market as it will lead to the formation of many engulfing patterns, without adequate clarity.
How to use a bearish engulfing pattern
The bearish engulfing pattern is a potential sell sign and traders generally take short positions after the formation of the pattern. However, in a real-life situation, a trader can take various approaches. For the sake of understanding, let us take a daily candlestick chart where each candle indicates the price movement in a day.
– If the volume increases significantly during the formation of the engulfing candle, it could be a signal of a stronger downward trend. Aggressive traders sell at the end of the day on which the engulfing candle is formed.
– Some traders wait for a day after a bearish engulfing pattern is formed to confirm the trend. It becomes necessary when the bearish engulfing pattern is not very strong.
– Most traders look for signals other than the bearish engulfing trend like price break below the upward support line. The bearish engulfing pattern becomes more credible when combined with other signals.
Conclusion
It is always advisable to take action on a bearish engulfing pattern only in conjunction with other indicators. Always use a stop loss and take calculated risk while trading.
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