Engulfing Bar Candlestick Pattern
In this strategy, we are going to be looking at the use of candlesticks as a means of determining price action and potentially identifying reversals. This strategy is highly useful when you are looking to track entry and exit points. Generally speaking, you are tracking price action over a given period of time in such a way that you are looking to determine where the price of a currency pairing will change trend.
There are two types of patterns, a bullish and bearish trend.
The bullish trend refers to price action that is going up. Therefore, you can expect the reversal to indicate a trend back downward. On the whole, you are looking to track the trendline as it hits the highest point of the resistance level. When this happens, the trend would be expected to revert down to mean.
The bearish trend refers to price action that is going down. As such, you expect the reversal to indicate price action moving back up. In general terms, you are looking to identify the exact point in which the trendline hits the lowest point of the resistance level and then changes course.
In both of these approaches, the candlesticks track the trendline indicate when the actual reversal has taken place.
To identify this exact point, track the trendline down to the lowest or highest point. You will notice a very short candlestick. The reversal official occurs when the next candlestick is much larger than the previous one. Thus, the next candlestick “engulfs,” that is, it completely covers the previous one.
Let’s assume a bearish pattern. In this case, you have the trendline moving downward. If you have been tracking the price action for any length of time, you may have an expectation of where the support level would be. As you observe the trendline moving toward the support level, you will find that the candlesticks are progressively getting shorter and shorter. Then, you will find a very short candlestick followed by a large one immediately following it. This is the reversal. This is the engulfing candlestick. This could serve as an entry point for a trade.
Now, let’s assume a bullish pattern. In this situation, you are tracking the highest point in the trend. Thus, you are essentially looking to track an exit point. As the trendline approaches its highest point, that is the resistance level. You will notice every candlestick getting shorter and shorter. Eventually, the shortest candlestick will be followed immediately after by a much longer candlestick that engulfs the previous one. This is the official mark of reversal and should be your exit point. Ideally, you should exit the trade at the point of the shortest candlestick. This is the highest possible point you could achieve before your profit begins to dwindle. Of course, it’s virtually impossible to track the exact point of reversal, but anything close to that point would serve well to maximize your profits.
Please note that most trading platforms use red-colored candlesticks to indicate a bearish pattern, while green-colored ones are used to mark a bullish trend. This color-coded system is very useful in helping you figure out how to spot reversals in trend.
Risk Management With Price Action
Risk management is an integral part of any kind of investing. When you follow tried and true risk management practices, you are able to hedge yourself from making mistakes that could wipe out your investment capital.
So, let’s take a look at some risk management guidelines which you can implement when you are using Price Action as your main FOREX investment strategy.
- Beware of volatility
Volatility is the biggest enemy of the Price Action strategy. When you are using Price Action as your main investment strategy, it’s important to keep in mind a high degree of volatility can lead to unusual shifts in Price Action. Since prices always tend to revert to mean, you can reasonably assume this will happen eventually. However, when there is a high degree of volatility, prices may return to mean faster or longer than anticipated. As a result, you need to keep your eye on this indicator even though it is not necessary to do so.
- Watch for false signals
There are times when you get false signals of reversals. For instance, you may get an engulfing candlestick well before the trendline hits the expected resistance or support level. While this is entirely possible, beware as it could simply be the result of unusual trading volume. If you spot a possible reversal well before expected levels, watch out for confirmation. Investors who jump in at the first sign may be in for an unexpected result.
- Always seek confirmation
On the subject of false signals, always make sure that you get confirmation. If you see a potential reversal that does not fit the usual trading patterns, then it would be best to wait for a confirmation. Confirmation is needed to determine if there might be a new support or resistance level. Three consecutive hits can serve to confirm a new level. Some investors wait for only two hits before assuming there will be a third hit. If you are more risk-tolerant, you can go on two hits before assuming the third hit.
- Be careful with countertrend investing
When you are starting out, it’s best to avoid countertrend investing. The main drawback of this approach is that you anticipate reversals at points in which there may be no technical information to support this assumption. You can go on a hunch, or perhaps as a result of spotting engulfing candlesticks. Still, this is a risky type of investment that you must study carefully.
- Avoid analyzing lower timeframes
When you are analyzing timeframes, always take higher timeframes. Most FOREX analysts recommend looking at periods of at least one hour. However, this would be too high. Ideally, looking at 20 periods, that is at least 20 hours, is the best way of tracking your strategy. In this book, we recommend looking at charts from 24 to 48 hours so that you can get ample confirmation of your strategy. On the whole, 24 hours is a good timeframe. However, 48 hours will allow you to filter out any price action derived from unusual trading activity.