A bullish engulfing candlestick shows a pattern of trading prices for a particular security, indicating a reversal in price trends. A candlestick is a type of chart that represents the four important prices for intraday trading: opening, closing, day’s high and day’s low, for any security.
A bullish candlestick pattern shows a reversal in the trend of stock prices, from a downward to an upward trend.
In the phenomenon, a red candlestick showing a downtrend is completely engulfed by a larger green candlestick showing an uptrend on the next day.
The bullish engulfing candle encourages traders to assume a long position; that is, they should buy the stock and hold on to it, with the intention of selling it in the future at a higher price.
Understanding Bullish Engulfing Candlesticks
When a security closes at a higher price than that at which it opens, the body of the candlestick is colored in green, or left hollow, and is called a green or a hollow candlestick. On the other hand, when the closing price is less than the opening price, the candlestick is colored in red, or black, and is called a red or a black candlestick.
A red candlestick indicates a downward trend in prices and represents a bearish phase in the market. Sometimes, a red candlestick is followed by a green one, such that the opening price on the second day is lower than the closing price on the first, and the close on the second day is higher than where it opened on the first.
Graphically, the green candlestick is seen to engulf the red one. It is a bullish engulfing candlestick pattern.
Bullish Engulfing Candlestick Example
Consider the prices of Stock XYZ on two consecutive days, which are as follows:
The candlestick graph for the stock will look as follows:
The pattern signifies a change or a reversal in the ongoing trend of the prices of a particular security. Generally, the bullish engulfing candle is preceded by more red candles, representing a bearish phase in the market. In fact, the bullish engulfing candle usually represents the bottom of a downward trend in prices, after which the prices begin to show an uptrend.
In such a situation, investors are initially pessimistic about the market during the downtrend, and try to gain by selling their securities. Such investors are referred to as bears in stock market parlance.
When the downward trend in prices is followed by a green candle that engulfs the red one of the previous day, it is suggestive of a reversal in the price trends. It means that despite the presence of bears, there are some optimistic investors, or bulls, who continue to buy the stock and finally manage to raise its trading price.
Basically, the second day starts with a bearish market, but active buying by bullish investors drives up the closing price above the opening price. There is a reversal in the price pattern from a downward to an upward trend.
How Should Traders Respond?
The response of traders to a bullish engulfing candle depends on whether they’ve been holding a long or a short position in the market. Since the event is preceded by a downward trend in prices, most traders short the stock in the bearish phase.
Shorting refers to when the trader sells a particular stock at present, with the intention of making profits by repurchasing it at a lower price in the future. Traders assume a short position when they expect the price of a stock to fall in the future.
With a reversal in price trends, short traders need to change their strategies accordingly. The bullish engulfing candle encourages traders to assume a long position. It means that traders should buy the stock and hold on to it, with the intention of selling it in the future at a higher price.
Since stock prices are likely to increase further after the candle, it will be profitable for traders to buy the stock at present. In fact, traders can make the maximum gain when they buy at the lowest intraday price on the second day of the candle.
An upward trend in prices cannot always be guaranteed after a bullish engulfing candle. Sometimes, the difference between the opening and closing prices on the red candle is very less, making the body of the candle very narrow.
If the candle is engulfed by a green candle on the following day, it might not necessarily result in a trend reversal. It is because the closing price of the green candle can be marginally higher than the opening price, and still engulf the preceding narrow red candle.
In such a case, the volume of trading has not changed significantly; rather, the engulfing candle has been brought about by minor fluctuations in trading volumes. In order for prices to rise in the future consistently, there must be a considerable increase in the purchasing of the stock so that its closing price ends up much higher than the opening price.
In order to ensure a definite reversal in trends, some traders wait for a day before they decide to switch to a long position. The traders miss out on one day’s profits in exchange for the guarantee that the market trend has indeed changed.
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