One of the more popular price action forex reversal patterns people trade today is the engulfing bar reversal pattern which is one of many two bar reversal patterns or AB reversal patterns (AB as in it has an A bar and B bar as part of the pattern) available.  Although this is a commonly traded pattern, many traders fail to find the best entry or are able to gauge a proper target using any sort of quantitative data.

 

The goal of this article is to break down the engulfing bar from an order flow perspective, talk about why it is such a useful pattern when applied properly, and how to get a more premium entry on the setup, allowing you to have lesser risk and greater reward.  We will also talk about how it performs across various time frames on the EUR/USD and which time frames it performed most optimally, based on the last 10 years of quantitative data we have.

 

But, before we get into this, we have to give a very simple definition of the engulfing bar pattern.
 

For a bearish example of an engulfing bar pattern:

-the A bar is a bull bar (bar that closed up) and the B bar is a bear bar, whereby the high of the B bar is above the high of the A bar, but the close of the B bar is below the low of the A bar.  If the low of the B bar is below the low of the A bar, but closes inside the price action of the A bar, then it is an outside bar pattern which is a different reversal pattern.

 

For a bullish example of an engulfing bar pattern:

-The A bar is a bear bar, and the B bar is a bull bar, whereby the low of the B bar is below the low of the A bar, and the close of the B bar is above the high of the A bar.  If the high of the B bar is above the A bar, yet the B bar closes inside the price action of the A bar, then it would be a bullish outside bar pattern.
 

Below are two visual examples of Bearish and Bullish Engulfing Bars:
 

Technically, the bullish engulfing, or B bar, in the pattern does not need an open below the low of the A bar, and inversely the bearish engulfing bar (B bar) does not require an open above the high of the A bar. Although it can in other markets such as futures, stocks, indices, or commodities, in forex this is a much lesser probability due to the infrequency of gaps in the market.

 

Now that we have discussed the basic ingredients of an engulfing bar, I will first explain why this is a good reversal pattern and what it means from an order flow perspective.  Then, I will get into the the more common methods espoused to trade this pattern, then describe a more effective method for getting into these patterns based on our quantitative data across every time frame from the 1m up to the daily charts.

 

From an Order Flow Perspective

If you think about it, imagine price action is in a strong impulsive downtrend with the bears solidly in control.  This is due to there being an imbalance between the buyers and the sellers. Until the buyers come in with a strong push against the trend, the bears will continue to dominate the direction.

 

But then out of nowhere, perhaps at a support level, perhaps not, after a solid bearish bar and strong close, the following bar produces a new low in the trend, then reverses all the losses from the prior day, to not only break the prior days high, but close above it.

 

One has to immediately ask, how did the bears give up control of the bar so easily?  What happened to all the sellers who were dominating the price action?  Where did they go?

 

When you start to ask these questions, you realize for the bulls to produce such a strong reversal bar in the face of a consistent downtrend, it is unlikely due to profit taking, which usually looks more corrective (unless there was a mass exodus of sellers who left the market at the same time - unlikely).

 

Remember, trends have momentum, and momentum like in physics, is a force which needs a strong opposing force to counter-act it.  In the case of the buyers and sellers, the buyers will have to overwhelm an existing imbalance and presence of sellers in the market.  This is not always easy and generally takes two things to make it happen;

a) a large amount of money to overwhelm the sellers

and

b) a lot of buying orders (transactions) to counter-act the number of sellers already present in the market
 

More often then not, both ingredients are behind an engulfing bar, especially when the A bar is of a good size and the B bar is even larger, possibly perhaps larger then the average daily range.

 

Regardless, for this pattern to occur, in most cases it represents a sudden shift in the order flow which can often be a telling sign of a strong reversal coming and thus why this can be a highly effective price action reversal pattern.

 

Examples of Engulfing Bar Reversal Patterns

 

Below is a chart of the NZDUSD on the 4hr time frame whereby the top and bottom of this chart is marked by engulfing bars, both bearish and bullish.

 

Starting at the top left of the chart, we can see price is above the 20ema and there are 3 out of 4 bull candles in a row as part of a strong bull trend.  However, price then forms a new high, but immediately rejects those new highs possibly trapping short term traders long.  The candle closes the day below the low of the A candle forming a bearish engulfing bar.

 

Price continues to sell off aggressively the next day signaling the bullish momentum has been interrupted and the bears have taken control of the market.

 

On the bottom right of the chart, we see a bullish engulfing setup with the B bar forming new lows in the prior downmove, creating a false break, then closing above the highs of the A bar which was also an inside bar after an impulsive-like climax bar, followed by two inside bars or an ii pattern.  The false break, combined with the bullish engulfing bar offered a great setup to go long.

 

One last example which I used as an entry trigger to get short on the DOW is in the chart below, whereby you can see price was already in a strong uptrend.  Then in the middle top part of the chart, we see a combo bearish engulfing bar which was also a pin bar setup closing on the lows.

 

After a small pullback into the engulfing bar, price then sold off reversing most of the prior uptrend.

 

Common Entries and More Premium Entries


One of the most common entry methods for getting into an engulfing bar is to sell on the open or sell on the break of the lows of the bearish engulfing bar.  It would be the opposite for a bullish engulfing bar, whereby you buy on the open of the next bar immediately after the engulfing bar, or on a break of the highs of the engulfing bar.

 

But we actually find this to be a non-premium entry and a lack of understanding trends as a whole, so we will discuss why and then talk about a more premium entry.

 

First off, trends rarely stop on a dime and the first rejection in a trend is often considered an opportunity to get back into the trend at a cheaper price.  This is because those in control are rarely going to concede control on the first pullback and will usually take a second attempt to make new highs (or lows) and continue the trend.  So if an engulfing bar is the first pullback or reversal attempt in a trend, the market will often shortly after take out the highs of the engulfing bar likely stopping you out.

 

This is why V-bottoms are so uncommon in the market because most trends as a whole do not reverse on a dime and usually make a second attempt to continue the trend.

 

Second, looking at the chart below, if you think about the engulfing bar itself, you have to cover the entire engulfing bar as your risk which can often be a lot since engulfing bars as a whole tend to be large bars.

 

This not only increases your risk, but also reduces your reward since you have less downside to work with.

 

I actually recommend taking a pullback into the engulfing bar, and if you look at all of the examples I used, they all pulled back into the engulfing bar itself which would have increased your reward while reducing your risk.

 

Quantitative Data on Engulfing Bars

My programmer and I have actually built an algo which can test engulfing bars on any time frame for any pair.  After spending the last 3 days crunching the data, not only does this confirm the pullback is the far superior entry, but we were able to determine based on several metrics which time frames the pattern performed best, along with what were the optimal targets based on time frame, volatility, along with what is an optimum entry level.

 

What was interesting to note is the pattern by itself (with a few filters) was able to give profitable setups with 60% accuracy or better on the daily, 4hr and 1hr time frames.  However, below these time compressions, we were unable to find any of these patterns in isolation that performed above 55% accuracy using a minimal 1:1 reward-to-risk ratio, telling us by itself, the pattern only works best on medium/higher time frames.

 

This makes sense if you think about it, whereby an engulfing bar setup on a 5min time frame will only be engulfing 10 minutes of price action which may not be that significant.  But 4hrs of price action is half a trading session and that is a lot of sentiment, order flow and transactions that have just been reversed with the engulfing pattern, so it carries more weight.

 

This is not to say one cannot use this effectively on lower time frames.  It simply means more variables have to be used in conjunction with the engulfing pattern by itself to make it more effective.  In reality, price action patterns work across all time frames, but when using them in pure isolation, they traditionally test better statistically on 1hr, 4hr and daily time frames.

 

Summary

To review what we have covered in this article, we discussed the basic definition of an engulfing pattern, what it tends to represent from an order flow perspective, why it can be a highly effective reversal pattern, what are the traditional and more premium entry methods, and how the quantitative data pans out for these patterns.

 

Obviously, like all price action setups and patterns, they perform better when used in conjunction with key support and resistance levels, when following an exhaustion move or climax bar, after several consecutive candles in a row of one type (bull or bear), or when the price spread between the 20ema and price action has become over-extended.

 

There are many ways to combine these with other price action patterns and setups to increase the effectiveness of them, but this should give you a good start and understanding how to use them.

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Kind Regards,
Chris Capre
2ndSkiesForex.com
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