USING BULLISH AND BEARISH ENGULFING CANDLES TO SPOT TREND CHANGES BEFORE THEY TAKE PLACE

Last week we explored the first -- and perhaps most important -- of the reversal candlesticks, the doji. In doing so, we covered the four primary kinds of dojis: common, long-legged, gravestone and dragonfly. The ability to recognize these candles, I argued, is vital to picking up on trend reversals.

If the doji wins the race as the most important candle to recognize, then the "engulfing" candle comes in a close second. Whereas the doji is a single candle pattern, the engulfing consists of two candles.

An engulfing candle often warns of the approaching reversal of a Minor, or short-term, trend. As you may remember, the Minor trend typically lasts between three and 15 days. As the Minor movement approaches 15 days, I think of it as getting "long in the tooth," and therefore having a significant chance of reversing. When an engulfing candle appears around this time, it often signals the beginning of a reversal.

The engulfing candle must completely "consume" the real body of the previous candle. Because stocks have fewer gaps than commodities, an engulfing candle may violate this rule very slightly by being just above or below the top or bottom of the previous candle. In most cases, you should interpret this as an engulfing pattern.

A bullish engulfing candle occurs after a significant downtrend. Note that the engulfing candle must encompass the real body of the previous candle, but need not surround the shadows. Below you will find an illustration of a bullish engulfing candle:

A bearish engulfing candle occurs after a significant uptrend. Again, the shadows need not be surrounded. Below you will find an illustration of a bearish engulfing candle:

The power of the engulfing candle is increased by two factors -- the size of the candle and the volume on the day it occurs. The bigger the engulfing candle, the more significant it is likely to be. A large bullish engulfing candle says the bulls have seized control of the market after a downtrend. Meanwhile, a large bearish engulfing says the bears have taken command after an uptrend. Also, if volume is above normal on the day when the signal is given, this increases the power of the message.

Candles belong to the category of leading, rather than lagging, indicators. For example, a moving average is a lagging indicator -- it shows trend change after it has already taken place. By contrast, a candlestick pattern leads the market. It warns in advance that a reversal may be happening. When that warning is subsequently confirmed by moving averages, it often provides a powerful trading signal.

Below you will find a recent daily chart of the S&P 500 updated through Thursday, October 23rd. In early October note the appearance of a bullish engulfing candle. At this time prices had gone outside the Bollinger band, indicating the market was oversold. The oversold condition was confirmed by stochastics, which were below 20.

The reversal day took place on October 1st (I've labeled this as point #1 on the chart). The previous minor downtrend started on September 19th and was eight days old. (In Primary uptrends, such as the one the market is in now, Minor downtrends tend to be relatively short.) The bullish engulfing candle that then took place was absolutely huge. The volume bar was slightly above the exponential moving average, indicating that the potential reversal had power.

Note that on the next day, moving averages confirmed a Minor trend reversal signal when the four-day moving average penetrated up through the nine. On this day, the ADX indicator gave a buy signal, as +DI crossed above –DI and MACD gave a buy signal as well.

The Minor uptrend lasted twelve trading days before being reversed by a bearish engulfing candle on Friday, October 17th (I've labeled this as point "2" on the chart). Volume on that day was relatively tame. While price closed below the four- and nine-day moving averages, the averages themselves did not negatively cross over until Tuesday, October 21st.

Note that the trend-following ADX and MACD did not issue a sell signal until Wednesday, October 22nd. On Wednesday, what may be called an "engulfing-like" candle appeared. Note how it reversed the two rally days of Monday and Tuesday and brought the index down to the 20 and 30-day moving average lines. The strong volume on this day gave it additional significance.

Bullish and bearish engulfing candles warn of trend change before it happens. Combine the appearance of these candles with moving averages and other trend-following tools such as ADX and MACD, and you should quickly pick up on Minor trend changes. The ability to spot the Minor trend change is key to positioning yourself on the right side of the market, and this, of course, is vital for swing trading success.

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