Bearish Engulfing Pattern

A bearish engulfing pattern is a two candlestick trend reversal pattern that follows an uptrend. The bearish engulfing pattern criteria are:

• The first day should be a bullish candlestick, but can be a doji.
• The second day candle is bearish and is taller than the first day’s candle.
• The open and high of the second day should be greater in price than the first day’s close and the second day’s close and low should be less than the first day’s opening price.
• The strictest definition of a bearish engulfing candlestick pattern necessitates that the real body of the second day be larger than the first day’s candlestick (including the upper and lower shadow).

Occasionally the bearish engulfing pattern is referred to as the three outside down pattern. The difference is the addition of a third bearish candlestick that closes below the low of the second day’s bearish candlestick.

Traits That Improve the Bearish Engulfing Pattern's Effectiveness

Nison, in his book Japanese Candlestick Charting Techniques (1991, p. 39) states that the following factors increase the likelihood that the bearish engulfing pattern is an important trend reversal indicator:

• The first day candlestick has a very small real body and the second day candlestick has a very long real body.
  Reasoning: After an uptrend, a small bullish candle appears showing that bulls are unable to push prices very much higher as they have been able to do previously. As a reminder, a small bullish candlestick shows bulls having less power compared to large bullish candlestick which shows bears having more power. Similarly, a large bearish candlestick that appears after an uptrend shows that bears are able to come back into the market and the bulls were unable or unwilling to stop this bearish assault. The longer the bearish candlestick is, the more powerful the bears were.
• The bearish engulfing pattern takes place following a long uptrend or a rapid move higher.
  Reasoning: It can be reasoned that after a long upward move, that most traders who are going to buy have already done so, this leaves fewer traders to buy and push the price higher. This is why a small bullish candlestick or doji is important as the first day in the pattern; it shows that bulls are getting tired. In contrast, explosive moves higher are often overbought and are vulnerable to reversals downward. The bearish engulfing pattern can signal that the move was too fast and too much and the trend is about to change.
• Volume on the second day candlestick is very large.
  Reasoning: Generally, high amounts of volume transacted on a large bearish candlestick indicates that there was a large turnover of shares throughout the day and that traders had to sell at the asking price of buyers, therefore decreasing prices were required in order to complete a transaction, this is very bearish. Clarifying this using the concepts of supply and demand, if there are more traders willing to sell their shares (ie more supply) and there are less traders willing to buy shares (ie less demand), then prices should fall, consequently creating a bearish candlestick where prices opened and fell during the trading day to close lower.
• The real body of the second day is larger than candlestick height (including shadows/wicks).
  Reasoning: Multiple small candlesticks show uncertainty. The appearance of a large bearish candlestick that is larger than the previous short candlesticks shows that the market has finally decided to move downward.
• The bearish engulfing pattern occurs in an area of resistance.
  Reasoning: Resistance is a historical area in which bears previously have come into a market to sell at a certain price level. If the bearish engulfing pattern occurs at this resistance price level, then a trader might feel more confident selling short because the resistance acts as yet another bearish confirmation that the trend could be changing.

Invalidated Bearish Engulfing Pattern

Nison (1994) states that the bearish engulfing pattern is no longer valid when prices close above the top of the bearish engulfing pattern which includes the upper shadows; in fact he states that the outlook turns from bearish to bullish (p. 78).

Bearish Engulfing Blended Candle = Shooting Star

When combined into one candlestick, the first and second day of the bearish engulfing pattern look like a shooting star candlestick which is a bearish reversal candlestick.

Bearish Engulfing Pattern Confirmation of Resistance

The chart above of the Energy SPDR ETF (XLE) demonstrates how the blue resistance line acted as resistance for the high of the second day of the bearish engulfing pattern. Once the upper shadow of the bearish candle reached the resistance area, the bears took charge for the rest of the day. Confirmation of resistance plus the bearish engulfing pattern were a potent combination for the bears who took the ETF downwards for the next few months. The bearish engulfing pattern in this chart was a good example of the second day candle’s real body being larger than the entire first day candle. It was also good that the bearish candlestick on the second day was so large, showing much force behind the bearish move downward.

Bearish Engulfing Pattern Creating New Resistance

Nison (1994, p. 78) suggests that bearish engulfing patterns can become an area of resistance for future prices. The chart above of the Energy SPDR ETF (XLE) illustrates a bearish engulfing pattern with many solid traits: the first day candle is small; the second day candle is very large engulfing five candlesticks prior to it; and it occurs after a long, continual uptrend. After the bearish engulfing pattern, prices fall but after a week prices begin to trend back up until they reach a high equal to the high of the bullish engulfing pattern’s second day candle close. An aggressive trader could attempt to sell short at the price level established by the bearish engulfing pattern over 17 trading days prior. In the example above, the trader would have been rewarded with a profitable trade. It is noteworthy that the candlestick that approached the resistance was almost a bearish engulfing pattern in and of itself. The precise candlestick definition for that two candlestick pattern is the Dark Cloud Cover.

Bearish Engulfing Pattern 2nd Day High Volume Confirmation

Notice on the chart above of the Dow Jones Industrial Average ETF (DIA) how the second candle of the bearish engulfing pattern had the second highest volume of any of the day’s shown in the chart. It is important confirmation to see high volumes accompany the second day large bearish candlestick in the bearish engulfing pattern. This shows that bears were serious about selling that day. Also note that the two days prior to the pattern were very low volume and were very small candles. It can be inferred that bulls were running out of energy (small candlesticks) and weren’t interested at buying at these higher prices (low volume). The large bearish candlestick with high volume proved that the bulls had no energy left and prices subsequently wandered downward for weeks thereafter.

Works Referenced

1. Nison, S. (2003) The Candlestick Course. Hoboken: John Wiley & Sons.
2. Nison, S. (1994) Beyond Candlesticks: New Japanese Charting Techniques Revealed. New York: John Wiley & Sons.
3. Nison, S. (1991) Japanese Candlestick Charting Techniques. New York: New York Institute of Finance.
4. Rhoads, R. (2008) Candlestick Charting For Dummies. Hoboken: Wiley Publishing.
5. ThinkorSwim. (2011). ThinkorSwim Resource Center: Candlestick Patterns Library.