The bullish engulfing pattern is known as one of the most reliable reversal patterns in technical analysis, usually marking a shift from bearish to bullish. But investors always find themselves at a loss in identifying the trend and often end up on the wrong side of the signal given by this pattern. In this post, you will learn the steps and strategy to validate a bullish engulfing pattern qualitatively, along with examples of stocks that meet our criteria.
Analyze Candle Formation
The bullish engulfing pattern is made up of two candles:
- The first candle represents the current downtrend and is a red (bearish) candle. For example, the opening price of candle 1 was $100, and it closed at $90, showing a loss of 10%.
- The second candle is a green bullish candle, and its body must significantly engulf the previous red bearish candle’s body. For instance, the second candle may open at $85 and close at $105, representing a 15% increase. This not only surpasses the close of the first candle but also opens higher, signaling a potential reversal.
Here, the body of the second candle wraps around that of the first: If candle 1 opens at $100 and closes at $90, and candle 2 opens at $85 and closes at $105, this is clearly a bullish engulfing pattern.
Observe Volume Changes
A bullish engulfing candle is confirmed by volume. The formation of a bullish engulfing candle accompanied by high trading volume often suggests aggressive buying. A volume increase within the setup candle can signify that high-pressure buying is occurring during this period. This volume spike can also indicate the point when the price turns or reverses.
Confirm Key Support Levels
Another important step in confirming a bullish engulfing pattern is to check for key support levels. If a stock has repeatedly tested a support level of $80 over the past three months, and a bullish engulfing pattern forms at this level (e.g., the previous day’s low was $79, and the current candle’s low is $80), it makes the pattern more robust.
If a stock shows a bullish engulfing pattern just above the 200-day moving average (for example, around $80), this confirms important support at this level and increases the conviction of a potential reversal.
Confluence: If the stock is in the S&P 500 and the volume has increased by more than two times compared to yesterday’s trading activity, this indicates strong buying pressure. Traders may be 85% certain that a reversal is imminent.
Incorporate More Technical Indicators
To add more weight to the bullish signal created by an engulfing pattern, you can use technical indicators. For example:
- RSI: If the RSI is below 30 when a bullish engulfing pattern occurs, it suggests the stock is oversold. For example, if the RSI is 28 and a bullish engulfing pattern forms, there is a good chance the market may rebound from this level.
- Moving Averages: If the bullish engulfing pattern forms near the 50-day or 200-day moving average, the price is more likely to move upwards. For instance, if a stock is near its 50-day moving average at $82 and the second candle closes above $82, it confirms the retracement.
- Bollinger Bands: A bullish engulfing candle near the lower Bollinger Band at $81 can indicate a potential price reversal.
Confirmation: For instance, if a bullish engulfing pattern forms near the lower Bollinger Band at $81, and the stock’s average true range (ATR) is around $80, this increases the likelihood of a successful reversal.
Wait for the Next Candle to Confirm
To further confirm the bullish engulfing pattern, it is crucial to wait for the next candle to close. If the closing price of the next candle is higher than the highest price of the bullish engulfing pattern, the market has confirmed the reversal trend. For example, if the second engulfing candle reaches a high of $105 and the next candle closes at $108, this confirms the bullish turn.
Top key confirmation: If a bullish engulfing pattern forms with the next candle closing at $108, confirming the uptrend, the trader can confidently enter the market.
Observe Market Context
Considering the market context is crucial for confirming the bullish engulfing pattern. If the pattern occurs after a prolonged downtrend, the reliability of the reversal signal is higher. For example, if a stock has fallen from $120 to $80 over the past three months, creating a clear downtrend, and a bullish engulfing pattern forms at the end of this price range, it may indicate the end of the downtrend.
Key confirmation: If a stock has dropped by 20% to 30% and forms a bullish engulfing pattern with a 200% increase in volume, the likelihood of a reversal greatly increases.
