Engulfing and Piercing Patterns in Forex Explained
After morning and evening stars, two other important reversal patterns under the Japanese Candlestick Techniques are the engulfing and piercing ones. To many people they seem to be similar to each other, but they are quite different, and their interpretation should be different as well. The interpretation refers to the price action to follow such patterns. The engulfing pattern is far more powerful than the piercing one, in terms of the new trend that is about to start. While hammers and doji candles are one-candle patterns, the engulfing and piercing patterns are two-candle patterns, and represent a major reversal signal, with opposite colours for the bodies of the candles forming this pattern.
Types of Engulfing and Piercing Patterns
Before discussing the different types of engulfing and piercing patterns, it is important to define what they are. In an engulfing pattern, the second candle wraps around, or engulfs, the previous candle’s body. This shows buying pressure if the pattern forms after a bearish trend, or selling pressure if it forms after a bullish one. On the other hand, in the piercing pattern, the second candle fails to completely retrace the previous one. This is the main reason why the piercing pattern is less powerful than the engulfing one.
Bullish and Bearish Engulfing
The engulfing pattern forms when the following conditions are met:
- The market is in a clear uptrend or downtrend, regardless of whether the trend is a short-term or medium-term one.
- There are two candles that move in opposite directions, with the second candle totally retracing and engulfing the previous candle’s body.
- The second candle must be different from the previous one. This means that if the first candle in the pattern is a bearish one, the second one needs to be a bullish one, and vice versa.
Having said that, a bullish engulfing pattern forms at the end of a bearish trend, with the first candle being a candle that goes in the same direction as the previous trend, a bearish one, and the second candle being a big green one that totally engulfs the previous candle. There is a small difference between what the definition of an engulfing pattern shows and how the pattern looks when analysing the Forex market. The reason for this comes from the fact that under the original definition, the second candle in the pattern should gap a bit lower in the case of a bullish engulfing, this being the reason why the engulfing is happening. Such a thing is not possible in the Forex market these days, as execution is so accurate that by the time one candle closes, those gaps are virtually impossible to form. By gaps, we’re talking about a significant and meaningful distance visible between the closing and the opening prices of two consecutive candles.
A bearish engulfing pattern is like a bullish one, except that conditions should be considered in reverse. This means that everything we stated on the bullish engulfing pattern is valid here as well, only the other way around: We need a bullish trend, the first candle is a green one, and the second candle is a big red one that totally engulfs the previous one.
The image above shows what a bullish engulfing pattern looks like on the Forex market, and the way to trade such a pattern is to buy at the close of the second candle, having a stop loss at the lows and a take profit that should respect the 1:3 risk/reward ratio. This means that for every pip that is risked, there are 3 pips profit targeted.
The Piercing and Dark-Cloud Cover Patterns
It is worth mentioning right from the start that the piercing pattern can only be a bullish one. The equivalent of the piercing pattern is the dark-cloud cover that appears after a bullish trend.
The Piercing Pattern
The piercing pattern is almost like the engulfing one, with the difference that the second candle does not engulf the previous one, but only goes into the territory of it. As a rule of thumb, the body of the second candle should retrace a minimum 50 percent into the territory of the previous one.
As was the case with the engulfing pattern, trading the piercing or the dark-cloud cover should be the subject of going long (in the case of the piercing pattern) with a stop loss at the lows of the candle and a take profit that should respect the 1:3 risk/reward ratio.
The Dark-Cloud Cover Pattern
In contrast to the piercing pattern, the dark-cloud cover is a bearish reversal pattern, meaning it will form at the end of a bullish trend. This pattern will always have the second candle going into the territory of the previous one, with the second candle being a red bearish one, and the first one a green, bullish one. The dark-cloud cover pattern is usually followed by a stronger trend than in the case of a piercing pattern. This is because the market is travelling faster to the downside than to the upside, with the panic factor influencing prices. This is especially true when it comes to trading the Forex market.
With this article, we’re finishing up the section in our Forex Trading Academy dedicated to Japanese Candlestick Techniques. We’ve covered here the most important candlestick patterns that offer nice trading potential. However, there are many other things to consider with candlesticks, as multiple formations and groups of candles are still part of this wonderful trading theory. Nevertheless, the ones we’ve treated here are the most representative ones, and, as reversal patterns, they allow a trader to be disciplined, offering a positive risk/reward ratio for a trade.
Other educational materials
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Special Types of Triangles
- Types of Expanding Triangles
- Trading with X Waves
- The Concept of a Running Correction
- Double Three Running Patterns
Recommended further readings
- “Are candlestick technical trading strategies profitable in the Japanese equity market?.” Marshall, Ben R., Martin R. Young, and Rochester Cahan. Review of Quantitative Finance and Accounting 31, no. 2 (2008): 191-207.
- “Are candlestick trading strategies effective in certain stocks with distinct features?.” Zhu, Min, Said Atri, and Eyub Yegen. Pacific-Basin Finance Journal 37 (2016): 116-127.