Understand Bearish Engulfing Patterns in Detail

Candlesticks are one of the best tools available to traders that help them predict future price movements. Many patterns are available to traders. One of the popular patterns is the Bearish Engulfing Pattern. In this article, we look into the details of this pattern - explaining what it is, how it is formed, and how traders can use it as a trading strategy.

Traders often employ the bearish engulfing pattern as a signal to open short positions. To manage risk, they typically place a stop-loss order slightly above the high of the engulfing candle (more details later). While this pattern is a potent indicator of potential market reversals, its effectiveness can be enhanced when combined with other technical tools like the RSI, MACD, or volume analysis. A diversified trading strategy that incorporates this pattern can provide greater value.

Read More: Candlestick Patterns Every Trader Should Know

What is bearish engulfing pattern?

A Bearish Engulfing Pattern is a candlestick pattern that indicates a potential reversal from a bullish to a bearish trend in the market. 

It is composed of two candles:

• The first candle is a smaller bullish (green) candle.
• The second candle is a larger bearish (red) candle that completely engulfs the body of the first candle. Engulfing means that the second candle's opening is higher than the first candle's closing price, and its closing price is lower than the first candle's opening price.

An essential characteristic of this pattern is the filling of a gap-up. When the opening price of a day is higher than the previous day's closing price, it is known as a gap-up. While this is typically bullish, the bearish engulfing pattern indicates a reversal, causing the gap to be filled quickly.

Interpreting bearish engulfing patterns

The bearish engulfing pattern reflects a change in market sentiment. We can have a breakdown of the psychological shift:

• First Candle: The initial bullish candle signifies continued buying pressure. Investors are confident, pushing the price higher. However, the size of the candle is relatively small, indicating that buyers are not particularly strong.
• Second Candle: The bearish candle opens higher, which may initially appear positive for bulls. However, as the trading session progresses, sellers take over, driving the price down significantly. By the close, the bearish candle completely engulfs the first candle’s body, signaling that sellers have overwhelmed buyers.

This shift from a bullish to a bearish sentiment indicates that the market may have reached a peak and could be poised for a downturn.

How to trade using a bearish engulfing pattern?

With the basics cleared, let us look at some strategies you can use when you spot a bearish engulfing pattern:

• Entering Short Positions: When you identify a bearish engulfing pattern, you may consider entering a short position, betting that the price will decline. The entry point could be just below the low of the bearish engulfing candle.
• Setting Stop-Loss Orders: You must set a stop-loss order just above the high of the bearish engulfing candle to limit potential losses if the trade goes against you.
• Confirmation with Other Indicators: To increase the probability of a successful trade, you must use the Bearish Engulfing Pattern in conjunction with other technical indicators for bearish markets such as the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), or Fibonacci retracement levels to confirm the reversal signal.
• Target Profits: You can use previous support levels, moving averages, or Fibonacci levels to determine potential profit targets. It is crucial to monitor the trade continuously, as market conditions can change.

Examples of bearish engulfing pattern

Let us assume stock of ABC Limited. It has been in a steady uptrend, with prices moving from Rs 100 to Rs 150 over several weeks. One day, a small bullish candle forms at Rs 150, followed the next day by a bearish candle that opens at Rs 152 but closes at Rs 145, completely engulfing the previous day’s bullish candle. This pattern indicates that the stock might be about to reverse and move lower. If, as a trader, you spot this, you can decide to sell or short the stock, anticipating further declines.

Pros and cons of trading using a bearish engulfing pattern

Below are the pros of using a bearish engulfing pattern:

• Clear Signal: When formed correctly, the bearish engulfing pattern provides a visually clear signal of a potential trend reversal.
• Early Warning: It can provide an early warning of a potential downtrend, allowing you to adjust your positions before a significant price drop.
• Reliability: The pattern can be a reliable indicator of market sentiment and potential price declines, especially when combined with other technical indicators (very critical point)
• Versatility: The pattern can be used in various market conditions, including stocks, commodities, and currencies.

Below are some cons associated with the bearish engulfing pattern:

• False Signals: Bearish engulfing patterns can sometimes generate false signals, and if you follow and sell your position, it can lead to unnecessary losses.
• Confirmation Needed: The pattern often requires confirmation from other indicators or price action to increase reliability.
• Market Volatility: In highly volatile markets, the success rate may go down as it may be less effective, as price fluctuations can obscure its significance.
• Risk Management: You need to implement proper risk management strategies, such as stop-loss orders, to mitigate potential losses.

Before you go

As you would have figured out from our discussion, the bearish engulfing pattern is a powerful tool for traders looking to identify potential reversals from bullish to bearish trends. However, it would help if you used it in conjunction with other indicators and to exercise caution to avoid false signals. As with all trading strategies, it is essential to conduct thorough research and maintain a disciplined approach to manage risks effectively.