There are few candlestick patterns that give a fairly accurate warning about an impending reversal in prices. Bullish and bearish engulfing patterns belong to this class of candlestick patterns.
The ease with which they can be identified also contributes to their popularity and wide usage. To form the bullish and bearish engulfing patterns, what is needed is a pair of candles.
A bullish engulfing candle occurs following a significant downtrend when a large white candlestick’s body absolutely covers a smaller black candlestick formed in the previous session.
It is enough if the body of the first candle is covered or engulfed by the second candle. It is not imperative that the shadows of the previous candle are covered.
This pattern is more successful when it is formed in the oversold area that occurs at the end of an extensive downtrend.
The larger the candle that is engulfed, the more effective the reversal signal is. Since the second candle is formed when the price opens lower that the previous day’s close and closes strongly above it, it implies that the investor sentiment is turning bullish.
Let us illustrate bullish engulfing pattern with an example. Refer to the Bank of India chart below. The stock was on downtrend from mid-May to early-July 2008 low.
After forming a large bullish engulfing candlestick pattern at around Rs 200, the downtrend got arrested. Subsequently, the stock began to rally higher.
A bearish engulfing candle occurs towards the end of a significant up trend. When the body of a large black candlestick completely covers a smaller white candlestick’s body, such a pattern is known a bullish engulfing pattern.
This pattern is more successful when it is formed in the overbought area that appears at the end of an prolonged uptrend.
Chennai Petroleum’s chart represents bearish engulfing candlestick pattern. After finding support at around Rs 245 in mid-March 2008, the stock rallied up to Rs 400 levels.
However, after reaching an overbought level, the stock reversed direction forming a bearish engulfing candlestick pattern.
There was a change in investor sentiment at that peak which was indicated by the black engulfing candle. Later on, the stock’s decline prolonged and it reached Rs 245