The Study Of Stock Market Through Technical Analysis

Lesson -> The Multiple Candlestick Patterns(Beginning)-Section 1

8.1 - Define Engulfing Method.

A trader only needs one candlestick to spot a trading opportunity in a single candlestick pattern. To identify a trading opportunity, however, a trader must analyze multiple candlestick patterns. The trading opportunity develops over at least 2 trading sessions.

The engulfing is the first pattern of multiple candlesticks that we should be looking into. To evolve, the engulfing patterns requires two trading sessions. A typical engulfing candle pattern will have a short candle on day 1, and a longer candle on the second day. This makes it appear as if it is swallowing the candle on day 1. The "Bullish Engulfing” pattern is the one that appears at the bottom end of the trend. The "Bearish Engulfing” pattern is used if the engulfing patterns appears at the top of the trend.

8.2 - What does Bullish Engulfing mean?

Two candlestick patterns that appear at the bottom end of a downtrend are the bullish engulfing and bearish engulfing patterns. This pattern is bullish and prompts traders to take a long position. Below is the chart that shows the two-day bullish, engulfing pattern. These are the prerequisites to this pattern:

  1. The previous trend should be a downward trend
  2. The red candle that confirms the bearishness of the market on the first day (P1) should be the one for the pattern.
  3. The blue candle for the 2 nd day (P2) should not be shorter than the length of the red candle.
  4. This is how the bullish engulfing process works:
    1. The market is currently in a downtrend, with prices moving steadily down
    2. The market opens at a low level on the first day (P1) of the pattern. It then makes a new low. This creates a red candle.
    3. The stock opens at the close of the previous day's pattern (P2) and attempts to make new lows. The price rises due to a sudden buying interest at the low end of the day. This price action creates a blue candle
    4. Price action on P2 suggests that bulls tried to break the bearish trend with a sudden and powerful attempt. The long blue candle in P2 is a clear indication of this.
    5. The bull's sudden P2 action was not something the bears expected. This is why the bull's actions rattled the bears, causing some nervousness.
    6. Bullishness is expected for the next few trading sessions. This will drive the prices higher, and therefore the trader should continue to look for buying opportunities.

    This is the trade setup for the bullish-engulfing pattern.

    1. Over two days, the bullish engulfing trend develops
    2. The close price of the blue candles is the suggested buy price, which is i.e. On P2
      • After ensuring that P2 is completely engulfing the P1, risk-taker opens trade on P2 himself
      • The trade is initiated by the risk-averse on the following day. The day following P2 at the closing price. After confirming that the day is forming blue candles,
      • The risk-averse trader who trades on the day following P2 will not trade if it is a red day. This is due to rule 1 (Buy strength, Sell weakness).
      • Personal note: In multiple candlestick patterns, where the trade evolves over more than 2 days, it is worthwhile to be a risk-taker rather than a risk-averse trader
    3. Stop loss for trades would be at the lowest level between P1 & P2

    You will need to wait until either the target is reached or the stoploss is breached before you can initiate a trade. To lock in profits, you can always follow the stop loss.

    Take a look below at DLF's chart; the bullish-engulfing pattern can be seen.

    The OHLCP1- Open = 163, Low = 168, High = 168, Low= 158.5, Close = 160 OnP2The OHLC details include: Open = 159.5; High = 170.2; Low = 159; Close = 169.

    This is the trade setup for the bullish-engulfing pattern.

    1. Risk-takers would take a long position on P2 at 169. This can be done by validating P2 in an engulfing fashion. There are two conditions that P2 must meet to be validated as an engulfing-pattern.
      • One, the market price at 3:20 pm on P2 should be greater than P1's open.
      • The second is that the open on P2 should equal or be lower than P1’s close.
    2. After ensuring that P2 is a blue day, the risk-averse trader will open the trade the day after P1. If there is a fall of P1 on Monday,the trade will be initiated through risk -averse on Wednesday at 3:20 pm. As I mentioned, trading on multiple candlestick patterns can be risky so it might be worthwhile to initiate the trade on the pattern completion day. P2
    3. This trade's stop loss will be determined by the lowest possible low between P1 (or P2) In this example, P1 is at 158.5.

    Both the risk-averse as well as the risk-taker in this case would have been financially successful.

    This is an example showing a bullish engulfing structure formed on Cipla Ltd. A risk-averse trader would have totally missed a great trading opportunity.

    It is not always clear whether the candle should be able to engulf the entire candle or just the body. According to my experience, as long as the actual bodies are engulfed, I would consider the candle a bullish-engulfing pattern. Candlestick skeptics might object, but it really doesn't matter how much you trade with a particular pattern.

    So, based on that thought, I would be happy to classify this pattern as a bullish-engulfing pattern even though the shadows have not been engulfed.

    8.3 -What does Bearish Engulfing mean?

    Two candlestick patterns that appear at the top of a trend are called the bearish engulfing.One must think about it from a shorter perspective as the bullish engulfing pattern is very similar.

  5. The bulls have absolute control and are pushing prices higher.
  6. As expected, P1 sees the market move up and make a new high. This confirms a bullish trend.
  7. This would be the trade setup:

  8. The bearish engulfing patterns suggests a short trade.
  9. After confirming two conditions, the risk-taker initiates trades on the same day.
    • The P2 open is greater than the P1 close.
    • At 3:20 PM P2, the market price is lower than the open price for P1. It would make sense to conclude that the pattern is a bearish-engulfing one if both conditions are met.
  10. Risk-averse traders will only trade the day after P2 if it is a red candle.
  11. The bearish engulfing is a 2-day pattern. It makes sense to take risks. This is dependent on each individual's risk appetite.
  12. Below is the OHLC data for bearing engulfing (encircled at top of the chart).

    P1: Close - 218.75

    P2: Close - 209.4

    Based on the bearish-engulfing pattern, the trade setup for the short trade is as follows.

    1. After ensuring that P1 and P2 are combined, the risk-taker would open the short trade at 209 on P2 by 3:20 PM.
    2. Risk-averse traders will trade the day after P2, provided that it is a red candle.
    3. In both cases, the stoploss will be equal to the highest P1 or P2 value. This case's P1 is 221.

    In this case, both the risk-averse as well as the risk-taker would have made a profit.

    8.4 - Occurance of Doji

    Here's a fascinating chart. Based on my personal experience, Two candlestick patterns that appear at the top of a trend are called the bearish engulfing.One must think about it from a shorter perspective as the bullish engulfing pattern is very similar.
    charts such as the one below can be very profitable. These trading opportunities should not be missed

    Take a look at this chart. What are the highlights?

    1. A clear uptrend has been highlighted
    2. An engulfing bearish pattern at the top of the upward rally
    3. The day after P2 was over, a doji formation was formed

      Let's take a look at this chart, event by event.

    4. The bulls have absolute control of the chart, as evidenced by the long-term uptrend.
    5. A blue candle forms on P1 confirming the bull's dominance of the markets.
    6. The bulls are comforted when P2 markets open higher. However, the price closes below the P1 opening prices at the peak.
    7. Bulls are feeling a little panicked by the trading activity on P2, but they have not been shaken.
    8. Let's call it P3 on day 3. Although the opening is weaker than P2, it is still not that much lower than P2’s close. The bulls are not too happy with this as they expect markets to grow stronger.
    9. The market attempts to move higher during P3 (Doji's lower shadow); however, it is not sustained. Even though the low does not last, eventually the day ends flat and forms a Doji. Dojis, as you may be familiar with, signify indecision on the market.
    10. Bulls in P2 panicked, and bulls in P3 were uncertain.
    11. Panic and uncertainty are the perfect ingredients for disaster. This explains why the Doji has a long red candle.
    12. Based on my personal trading experience, I can confirm that a doji following a recognized candlestick pattern opens up more opportunities. This is why I want to highlight chart analysis methodology. In this chart, we didn't just focus on what was happening at P1 and P2. We went further than that to create a complete market view by combining two distinct patterns.

      8.5 - Take a look to Piercing Design

      With a slight variation, the piercing pattern looks very similar to the bullish-engulfing one.P2's blue candle will completely engulf the red candles of P1. In a piercing pattern, however, P2's blue candles partially engulf P1's red candle. Engulfing should not exceed 50%. This can be verified visually or calculated. If P1's range (Open Close) is 12, then P2's should be at minimum 6 or higher, but not below 12.

      This condition must be met in order to continue with bullish engulfing. The trade setup can only be initiated if the condition is met. The trade would be initiated by a risk-taker at the close. Risk-averse traders would only initiate trades the day after P2 close, after ensuring that a blue candle has formed. The low point of the pattern would be the stoploss.

      8.6 - The Dark Cloud Cover-Intro

      With a slight variation, the dark cloud cover looks very similar to the bearish-engulfing pattern. The red candle on P2 is able to engulf P1's blue candles in a bearish-engulfing arrangement. In a dark cloud, however, the red candle of P2 can engulf 50 to 100% P1's blue candles. The trade setup is identical to the bearish engulfing patterns. The dark cloud cover is the opposite of a piercing pattern.

      8.7 - A viewpoint to select a trade

      Stocks in the same sector tend to have similar price movements. Think about TCS and Infosys, ICICI Bank or HDFC Bank. Because they have similar businesses and sizes, their price movements are similar. This does not necessarily mean that their stock prices will move in the same direction. Bank stocks will fall if there are negative news stories in the banking sector. If the stock price at ICICI Bank drops by 2%, then it's not necessary that HDFC Bank's stock prices also drop exactly 2%. The stock price of HDFC Bank may drop by 1.5% to 2.5%. The two stocks could form two different, but somewhat similar candlestick patterns. For example, a bearish-engulfing pattern and dark cloud cover.

      These are both easily identifiable candlestick patterns. However, I chose one of the two to start a trade. I'd rather bet on the bearish-engulfing pattern than a dark cloud covering. Because it engulfs every candle from the previous day, the bearishness of a bearish-engulfing pattern can be more prominent. A bullish engulfing or piercing pattern would be my preference.

      There is however an exception to the selection criteria. In the next module, I will present a 6-point trading checklist. To be qualified, a trade must satisfy at least 3-4 points of this checklist. This is a good example of how to put this in perspective. Let's say that the ICICI Bank stock forms a piercing structure and the HDFC Bank Stock forms a bullish engulfing shape. The bullish engulfing pattern would naturally be tempting to trade. However, if the HDFC Bank stock meets 3 checklist points and the ICICI Bank Stock meets 4 checklist points, then I would still recommend ICICI Bank stocks, even though it forms a less compelling candlestick pattern.

      If both stocks meet the 4 criteria, I will trade the HDFC Bank.

      Key points:

    13. Over two trading days, multiple candlestick patterns can be created.
    14. Over two trading days, the bullish engulfing trend develops. At the bottom end of the downtrend it can be found. Day 1 is P1, day 2 is P2.
    15. In a bullish-engulfing pattern P1 is a red candle and P2 a blue candle. P2's blue candle completely covers P1's red candle.
    16. After ensuring that P1 and P2 form a bullish Engulfing Pattern, a risk-taker will initiate a long trade. The trade will be initiated by a risk-averse trader the day after P2, close to the end of the day.
    17. The lowest point between P1 and 2 is the stoploss in the bullish engulfing patterns.
    18. At the top of an uptrend, you will see the bearish engulfing patterns. The red candle of P2 completely covers the blue candle of P1.
    19. After confirming that P1 and P2 form a bearish engulfing structure, a risk-taker will initiate a short trade. After confirming that the day has a red candle, the risk-averse trader will open the trade the next day.
    20. For a bearish engulfing, the stoploss is formed by the highest P1 and P2 highs
    21. A doji placed after an engulfing design tends to stimulate its evolution.
    22. The piercing pattern functions very similarly to the bullish-engulfing design, except that P2’s blue candle engulfs 50% and less than 100% of P1’s red candle.
    23. The dark cloud cover is similar to the bearish-engulfing pattern except that P2’s red candle engulfs 50% to below 100% of P1’s blue candle.
  14. As expected, P2 opens higher and attempts a new high. Selling pressure begins at this point. This sells unexpectedly and tends to displace bulls.
  15. The stock closes below its previous day's (P1) open because the sellers are pushing the prices down. This causes nervousness among bulls.
  16. The bulls may have broken down P2, and the market could continue to see selling pressure in the coming days.
  17. To capitalize on the expected decline in stock prices, you can shorten the index or the stock.