The Engulfing Pattern Forex Strategy

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The Engulfing Pattern Forex Strategy

The engulfing pattern is a simple candlestick pattern that signifies either a thrust or a market reversal. It is a combination of two opposing candlesticks with the second candle’s body fully engulfing the first candle’s body. A bullish engulfing pattern is composed of a bearish candle followed by a long bullish candle fully eclipsing the bearish candle’s body. A bearish engulfing pattern, on the other hand, is composed of a bullish candle followed by and eclipsed by a long bearish candle.

Due to its simplicity, the engulfing pattern is a commonly recurring pattern, which is easy to spot. There will be a handful of trading opportunities to be taken in a day using the engulfing pattern.

The 100 Exponential Moving Average (EMA) Trend Filter

The engulfing pattern works best in conjunction with other indicators and filters to increase the probability of a winning trade.

One important thing to look for when trading the engulfing pattern is the direction of the trend. Trading the engulfing pattern with the trend increases the chances that the trade will be in profit.

For us to identify the mid-term trend, we will be using the 100 exponential moving average (EMA). The trend will be judged by the location of price in relation to the 100 EMA. If price is above the 100 EMA, the trend will be considered as an uptrend. If the price is below the 100 EMA, the trend will be considered as a downtrend.

Another consideration will be the slope of the 100 EMA. An upward sloping 100 EMA will be considered as having an uptrend, while a downward sloping EMA will be considered as a downtrend.

Long Trade Setups – Entry, Stop Loss & Take Profit

For a bullish engulfing pattern to be considered, the following rules must be ticked off:

  1. The 100 EMA is sloping upwards
  2. The price action is located above the 100 EMA
  3. The 100 EMA’s right end is not curling downwards
  4. A valid bullish engulfing pattern is recognized

The Candlestick Recognition Master indicator will be used for easier recognition of valid bullish engulfing patterns. The indicator will plot “L_E” on candlestick patterns recognized as a valid bullish engulfing pattern.

The stop loss should be placed a few pips below the pattern.

As for the take profit, we will set a take profit based on a risk-reward ratio of 2:1. This means that for every pip risked on the stop loss, we will be targeting a take profit of two pips.

Due to the number of opportunities available on the chart, we will just be marking the winning trades with “W” and losing trades with “L”, based on the above listed rules. Below is a sample of an uptrend with multiple opportunities.

On this chart you could spot 12 different trading opportunities using the bullish engulfing pattern. If trades were taken based on our rules of a stop loss a few pips below the pattern and a 2:1 take profit, there would have been nine trades won out of the 12 trades taken. If for example, your money management strategy is set to a fixed 1% of your capital for every trade taken, the nine winning trades would have gained you 18% while the three losing trades would have lost you just 3%, giving you a net gain of 15%. Not bad for a couple of trading days.

Short Trade Setup – Entry, Stop Loss & Take Profit

Just as the long trade setup, our short trade setup for the bullish engulfing pattern would still be somewhat the same, only that it is in reverse.

For our trading rules, the following should be ticked off for us to take the trade:

  1. The 100 EMA is sloping downwards
  2. The price action is located below the 100 EMA
  3. The 100 EMA’s right end is not curling upwards
  4. A valid bearish engulfing pattern is recognized

The stop loss would now be just a few pips above the bearish engulfing pattern.

The take profit targets would still be based on the 2:1 risk-reward ratio.

Again, due to the number of trades available, we will just be marking the winning trades as “W” and the losing trades as “L”.

On this particular chart, there are 13 bearish engulfing patterns that fit our trading rules. However, this is a real live chart, and in a live chart there are losing streaks. Out of the 13 trades, only seven were winning trades and six were losing trades. Not too attractive, right? But before you brush this strategy off, let us first try to compute. Remember, we are using a 2:1 risk-reward ratio. Again, let’s set our money management rule to just 1% risk per trade. The seven winning trades would have gained 14%, while the six losing trades would have lost you just 6% of your account. This still gives you a net profit of 8% growth on your trading account. And take note, it is just a couple of trading days.

Conclusion

Using this strategy with the engulfing pattern is like a machine gun fire. There will be a lot of trades that could be taken, there will be a lot of winning trades, and yes there will also be several losing trades. However, since the take profit is based on a 2:1 risk-reward ratio, even if the win ratio would fall to as low as 50%, the potential for profit is still there.

The law of average applies to this type of strategy. What I mean to say by this is due to the number of trades available, if every opportunity is taken, even though there will be losing trades and losing streaks, you could still grow your account due to the average times that you will be winning.

Due to the nature of this strategy, wherein the win ratio could fall, I would strongly suggest that you use a proper risk management strategy. Don’t put everything in one trade, that would be gambling. Trade wisely. Grow your account.

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