Don’t you sometimes wish you had an alarm for the stock market?
We don’t mean the type that wakes you up – we mean the type that tells you, in no uncertain terms, that disaster is about to strike. That would be might useful – either in that you would exit your positions on time, or switch to the short side.
We’re not in the alarm business, but we do have something similar that you will find extremely useful. We’ve covered stock chart patterns before – and this is one you should definitely add to your repertoire.
The bearish engulfing candle is both reliable – leading to a reversal 79% of the time, and relatively frequent. On top of that, it isn’t complex – in fact, as it consists of only two candlesticks, it is one of the easiest chart patterns to spot.
As a bearish reversal pattern, this candle appears at the top of an uptrend and signals a reversal into a downtrend. This is a prime opportunity for short selling or long puts – but to get the best info and make use of this chart pattern, you’re going to have to give us a couple of minutes of your time.
Although options are often touted as risky, taking a closer look at any of those stories will reveal that they always deal with irresponsible, short-term gambits. Mastering today’s topic, as well as adopting a reasonable, risk-conscious approach can be a huge boon to your portfolio. So, let’s start at the beginning.
What you’ll learn
What Exactly is a Bearish Engulfing Candle?
Imagine a battle between buyers and sellers in the stock market. When a small bullish candle appears on the chart, it’s a sign that buyers are winning the battle, and the market is in an uptrend.
But suddenly, a larger bearish candle appears, completely engulfing the previous day’s bullish candle, like a monster swallowing its prey. This suggests that the sellers have suddenly gained the upper hand and are potentially taking control of the market, and this could push prices even lower.
What’s more, such a sudden and drastic change is likely to send the most risk-averse of the bulls on the run – which serves to further fuel the decline. Bearish engulfing candles are serious business – and they can lead to serious payouts if you know how to use them.
So, let’s be a bit more precise – when we say that a candle engulfs another, what we mean is that the real body of a candle (the difference between the open and the close) is larger than the real body of the previous candle. Let’s use an image as an example – these things are much easier to grasp visually.
Identifying a Bearish Engulfing Pattern
So long as a bullish candlestick (usually printed in white or green) is followed by a bearish candlestick (usually printed in black or red), and the second candlestick’s body is long enough to fully absorb or engulf the previous candle, you’re looking at a bearish engulfing pattern.
There are, as always, elements of finesse to trading various stock chart patterns. In general, traders should focus on the real bodies of the candles – so long as the second candle’s body engulfs the first candle’s body, the signal is worth investigating.
It should be noted, however, that when the real body of the second handle surpasses the shadows and wicks of the first, the signal is stronger. The same goes for overall height – the longer the second handle, the more promising the signal.
On to the second point – when trading in the stock market, context always matters. The bearish engulfing pattern occurs during a clear, long-term uptrend. If it appears during such a trend, it represents a significant signal that a reversal into a downtrend will occur.
However, the market often goes through long stretches of choppy or sideways trading – periods when neither an uptrend nor a downtrend is in motion. What happens if such a candle is printed in those circumstances?
To put it shortly, nothing much. The occurrence of engulfing patterns during sideways trading isn’t really significant and doesn’t represent a trading signal or opportunity. Our advice to you is this – if you see an engulfing pattern during a period of choppy price action, pay it no attention – look for a stronger signal.
What Does Bearish Engulfing Pattern Tell Traders?
In the conventional case – if it appears following a noticeable uptrend, the bearish engulfing pattern is a huge wake-up call – after a period of rising prices, a sudden, drastic shift downward occurs.
According to research by Tom Bulkowski, the bearish engulfing candle leads to a downtrend in 79% of cases. Such a huge correction in price usually means that the market has explored all upward options and that a new level of resistance has been reached.
However, even if it appears outside of that scenario, the bearish engulfing pattern can still give you some idea regarding investor sentiment. If it occurs during a downtrend, it serves as confirmation that sellers are by far outcompeting buyers and that the trend will continue holding strong.
Trading a Bearish Engulfing Pattern
The bearish engulfing candle pattern is quite a reliable signal of an upcoming downtrend – so you’ll be left spoiled for choice when it comes to how to trade it. Let’s go through a couple of the most common ways that this chart pattern is used in trading.
Because the bearish engulfing candle is such a strong indicator of a downtrend, the most straightforward way to use it is as a risk management tool. If you have any holdings in an asset that has printed this candle, selling it is usually a wise course of action that will prevent losses.
On the other hand, if you’re the more active sort, you can short the asset in question. If other indicators confirm that the downtrend will be significant, this is a great way to profit from falling prices.
Of course, the earlier you get in on the action, the better – but waiting for confirmation is another viable option. Once the downtrend is confirmed, you can make a much less risky (albeit also less profitable) move to profit from declining prices.
Since our service for trading alerts focuses on options trading, we can’t forget about put options. Being able to sell a stock at a predetermined price in a downtrend is a simple enough way to profit, but that isn’t your only option.
Since the bearish engulfing pattern usually signals a moderate, but short-term downtrend, using techniques like the bear put spread is another approach. Although slightly more complex, this strategy is well suited to the bearish engulfing candle.
Practical Example of Bearish Engulfing Candle
Now, to hammer things home, let’s take a look at a real-life example. In the chart below, you can see the price action of Shopify (NYSE: SHOP).
This is a pretty straightforward example – at the beginning of the chart, we can see plenty of signs of positive price action. The stock is obviously in an uptrend – prices keep getting higher, but once they reach the end of the uptrend, an immediate reversal occurs.
Keep in mind that this particular candle is just barely engulfing (pun intended) – but it still served as enough of a warning for the bulls to turn tail.
Now, let’s take a look at a less orthodox example, using the price action of Netflix (NASDAQ: NFLX).
Although this chart pattern is most significant when it occurs during an uptrend, as we can see in the image above, it also sometimes happens during a downtrend. Although it isn’t a sign of reversal, it does serve to confirm the strength of the downtrend – and being such a strong bearish signal, it often leads to further dramatic price drops.
The Difference Between a Bearish and a Bullish Engulfing Pattern
The main difference between a bearish engulfing pattern and a bullish engulfing pattern is the direction of the trend they indicate.
A bearish engulfing pattern appears on a stock chart when a small bullish candle is followed by a larger bearish candle that completely engulfs the previous day’s candle, indicating a potential reversal of an uptrend. The pattern suggests that sellers have taken control of the market, and will push the price lower.
On the other hand, a bullish engulfing pattern appears on a chart when a small bearish candle is followed by a larger bullish candle that completely engulfs the previous day’s candle, indicating a potential reversal of a downtrend. The pattern suggests that buyers have taken control of the market and that asset prices will rise in the period to come.
In both patterns, the second candlestick is larger than the first, and it completely engulfs the first candlestick, indicating a potential reversal of the trend. However, the bullish engulfing pattern indicates a potential reversal from a downtrend to an uptrend, while the bearish engulfing pattern indicates a potential reversal from an uptrend to a downtrend.
Apart from those basic fundamentals, there are a couple of additional facts worth pointing out. Both chart patterns are very common, with the bearish ranking 11th and the bullish ranking 12th overall in terms of frequency.
However, when it comes to reliability, things aren’t so evenly matched – the bearish candle leads to reversal 79% of the time, while the bullish candle leads to a reversal in 63% of cases – a notable difference.
Pros and Cons
|Easily recognizable||Not suited to sideways trading|
|Highly reliable||Short-term reversal|
Let’s go into a little more depth here regarding the points made in the table above.
- Easily Recognizable: Consisting only of two candlesticks, the pattern is incredibly easy to spot, allowing investors to take action swiftly.
- Highly reliable: According to Thomas Bulkowski, a renowned author expert on chart patterns, the bearish engulfing candle leads to a reversal in 79% of cases.
- Not suited to sideways trading: While it is incredibly reliable when spotted at the end of an uptrend, this chart pattern doesn’t provide a lot of actionable information when it occurs in periods of choppy or uneven price action
- Short-term reversal: The bearish engulfing pattern might be reliable, but in most cases, the downtrend that follows it doesn’t last long. While this isn’t a pure disadvantage, it does definitely make the pattern best suited toward swing trading as opposed to longer-term plays
Bearish Engulfing Candle: FAQs
How Accurate Are Bearish Engulfing Candles?
Bearish engulfing candles are among the more accurate candlestick chart patterns. According to Thomas Bulkowski’s analysis, based on 20,000 cases, the bearish engulfing candle leads to a downtrend in an incredible 79% of cases.
What Happens After a Bearish Engulfing Candle?
After a bearish engulfing candle, the market usually reverses from an uptrend to a downtrend. However, traders should use other technical indicators and analysis to confirm this lead before deciding to take action.
How Do You Confirm a Bearish Engulfing Candle?
To confirm a bearish engulfing candle, keep your attention focused on subsequent candles – if they are all bearish, then a reversal has likely occurred.
Is a Bearish Engulfing Candle Good?
A bearish engulfing candle is a strong indicator that an uptrend is going to reverse and that the price of an asset or security is going to drop. This isn’t “good” on its own – but traders that know how to spot and use these patterns can make money off of the upcoming downtrend.
What Are the Conditions for a Bearish Engulfing Candle to Appear?
For a true bearish engulfing candle, which signals a reversal from an uptrend or bull run into a bear run or downtrend, there must be a clear uptrend present, followed by a black or red candle that completely engulfs the previous green or white candle.
Can Engulfing Candles Be the Same Color?
No, engulfing candles cannot be the same color – both in the case of the bearish engulfing candle and the bullish engulfing candle.
What Time Frame is Best for Engulfing Candles?
There are no hard and fast rules as to what time frame is the best for engulfing candles. Some traders use them in timeframes amounting to minutes, while others look at entire days.
How Do You Spot an Engulfing Candle?
To spot an engulfing candle, look for a small, regular candle, followed by a candle that is longer both upwards and downwards, and is of the opposite color.
What is the Significance of an Engulfing Candle?
An engulfing candle is a reversal pattern – it signals that the thus prevailing trend is coming to an end. In other words, if we see an engulfing candle starting to form, we have an indication that we’re about to see the opposite of what was happening before.