On 15 December 2022, the shares of State Bank of India (SBI), India's largest public sector bank, climbed to a fresh all-time high, signalling a a continuation of ongoing bullish sentiment and optimism among the buyers.
This optimism carried over into the next trading session. On 16 December 2022, SBI opened with the same bullish enthusiasm and even pushed to another intraday all-time high, but as the day progressed the gains were wiped out and the stock closed below the previous day’s low- completely covering the previous day’s candle. See the chart below.
In the days that followed, the stock declined by nearly 10%, and overall descent eventually extended for almost three and a half months before buyers regained control.
The question here is, what made market sentiment change so dramatically in just two days? secondly, was there an warning signal on the charts when the bearish reversal started on 16th December 2022. While we may never know the exact reason of an abrupt change in market sentiments, but what we do know is that the market left behind a clear clue.
On the chart, that shift in sentiment was reflected through the formation of a Bearish Engulfing pattern, warning that the bulls were losing control and the bears were beginning to take charge.
This is the theme for today’s post- The Bearish Engulfing pattern. So, let’s begin without wasting another second.
What is a bearish engulfing pattern?
A Bearish Engulfing pattern is a two-candlestick bearish reversal pattern that appears after an uptrend and signals a change in sentiment from bullish to bearish.(as it happened on on 15th and 16th December 2022 in the SBI stock)
Although the pattern does not guarantee a bearish trend reversal, it often serves as an early warning that upward momentum is weakening and a decline may follow.
How to identify a bearish engulfing pattern?
As I mentioned earlier, a bearish engulfing is a two candle pattern, that is, two candles are required to make this pattern.
The first candle of bearish engulfing pattern is a green candle, reflecting the ongoing uptrend signifying optimism among buyers.
The second candle is a red candle which opens at or above the previous candle's close and then reverses sharply, closing below the previous candle's open so that its real body completely engulfs the real body of the first candle. See in the SBI chart above that the first candle is green and in continuation with trend and second candle is red candle that covers the body of the first candle. See the image below.
While the wicks of the first candle do not need to be engulfed, a larger bearish body of the second candle that engulfs the wicks of the first candle indicates stronger selling pressure.
How to confirm a Bearish Engulfing pattern?
Never trade a Bearish Engulfing pattern in isolation as all engulfs don’t result in a reversal.
One of the ways to confirm a Bearish Engulfing is to wait for the third candle. If the third candle closes below the low of the second candle, chances of reversal increases.
Higher-than-average trading volume during the engulfing candle further strengthens the signal by showing genuine selling interest rather than temporary profit booking.
Further an engulfing pattern formed near a significant resistance holds more significance than the one which appears elsewhere in the chart.
A pattern formed in conjunction with other bearish indicators such as a bearish RSI divergence, MACD bearish crossover, is considered stronger than the pattern formed in isolation. When multiple factors align, the probability of a successful bearish reversal increases considerably.
See the chart below for a better understanding.
The chart above is the same SBI chart we used in the earlier example in this post. Notice how the bearish engulfing pattern develops after an uptrend, appears right at a resistance zone, while the RSI simultaneously shows a bearish divergence. These confluences provide strong confirmation of the pattern.
How to trade Bearish Engulfing pattern?
Trade a Bearish Engulfing pattern as a high probability bearish reversal setup and not as an immediate sell signal. Most conservative traders usually wait for confirmation by allowing the next candle to close below the low of the engulfing candle before entering a short position or exiting long trades.
However, aggressive traders may enter as soon as the engulfing candle closes, but this approach carries a higher risk of false signals.
It is also advised to look for other indicators and overall trend before entering a trade. When multiple indicators point towards the same setup, the probability of a successful trade increases.
Once you have entered a trade, place stop-loss slightly above the high of the second candle of the pattern.
Profit targets can be set at the next major support level, a predefined risk-to-reward ratio (such as 1:2 or 1:3), or by trailing the stop-loss to capture a larger downtrend.
See chart below for a better understanding.
The chart above is the same SBI chart thaat we used in our earlier example. It illustrates the entry points (aggresive and conservative entries), stop-loss, and profit target for trading the Bearish Engulfing pattern.
How reliable is Bearish Engulfing candlestick pattern?
Studies on candlestick patterns suggest that Bearish Engulfing pattern is not a guaranteed reversal signal when used alone for trading. However, its reliability increases substantially when there is confirmation from other indicators or when pattern forms near a key price level. The surrounding market context is often more important than the pattern itself.
Summing it up
A Bearish Engulfing pattern is a two candle reversal pattern. The first candle is a green candle and is in continuation with the ongoing uptrend. The second candle of the pattern opens above the 1st candle’s close but closes below the open of the previous candle.
While this pattern can provide an early signal about a possible bearish reversal, it should not be traded alone. The reliability of the Bearish Engulfing pattern improves when the pattern is confirmed by other factors like, overall trend, support and resistance, volume and other indicators like RSI, MACD.
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