Engulfing Pattern Signals a Trend Change: Yes or No?

Let us draw your attention to the study on the Engulfing pattern graphical analysis.

Steve Nison, the author of the book entitled "Japan candlesticks", refers the pattern to trend reversal models.

The pattern is a combination of two candlesticks, a small and a large, that move in the opposite directions. The body of the larger candlestick engulfs the smaller one.

The smaller the candlestick size engulfed by the large one, the more likely it is that a trend reversal will occur.

Let us explore whether this is true.

There are two types of Engulfing patterns: a bullish-engulfing pattern (appears in a downtrend) and a bearish-engulfing pattern (appears in an uptrend) (Fig. 1).

Method for Event Detection

We define the patterns in the following way (for a Bullish Engulfing pattern)

• We find a downtrend by determining several successively decreasing candlesticks:

Low3 < Low4

Low2 < Low3

Low1 < Low2

• We set a combination of two candlesticks, the first of which is of a small size (the black), the second is large (white) with a body larger than the entire previous candlestick, and they are directed in the opposite directions (the shadows of the large candlestick overlap the shadows of the small one):

High1 > High2

Close1 > Open2

Open1 < Close1

Open2 > Close2

• The closure must be at the top of the UZ % with respect to candlestick 1:

(High1 - Close1) * 100 / (High1 - Low1) <= UZ

• The overlap percentage (PP %) must be less than the preset parameter:

PP < PPMax

PP = (Open2 - Open1) * 100 / (Close1 - Open1)

• The pattern is formed – place a buy-to-open position

The method presented above helps to spot a bullish Engulfing pattern. The formation of a Bearish pattern is a mirrored version of these conditions.

We test the signals generated by the Engulfing pattern on a large volume of historical data referring to various financial instruments on two timeframes.

In addition, we test this pattern in its four combinations optimising the conditional parameters such as the closing level, the percentage of candlestick overlap, UZ and PP respectively.

The Engulfing model with the above parameters looks the following way:

The figure illustrates the Engulfing pattern formed in a downtrend, and an uptrend is a mirrored image of the pattern.

So, what do the set conditional Engulfing parameters mean?

• The upper shadow length of a Bullish candlestick (the lower shadow of a Bearish candlestick in an uptrend) is at the closing level. The smaller the coefficient, the shorter the shadow, and then the more noticeable the Engulfing pattern.
• The percentage of candlestick overlap is the size of candlesticks relative to each other.
• The smaller the percentage overlap, the shorter the engulfed candlestick is (black candlesticks in Fig.2) compared to the engulfing one (white candlestick on the Fig.2), and then the more noticeable the Engulfing pattern is.

Now, we review the conditions for opening and closing a trading position.

Opening a position:

After the signal is formed, a position is opened at the opening of a new candlestick:

• a Bullish Engulfing is a buy signal;
• a Bearish Engulfing is a sell signal.

Closing a position:

In all conditions, the position lifetime is set to 5 or 10 candlesticks.

Having defined all the conditions and set the necessary parameters, let's go down to testing!

Analysis of the Results

Firstly, we estimate the results by the sample size:

For the 1-hour timeframe (H1):



For D1 (daily) timeframe:

Total: 2,124,495 candlesticks and 16,606 events (Engulfing patterns).

Next what we analyse is the share (%) of Engulfing patterns with different parameters in the total number of initial candlesticks by aggregating data from the two timeframes:

The results of grouping show that the distributions of Engulfing patterns are roughly the same regardless of the type of the financial instrument.

• The Engulfing pattern with the UZ, PP parameters: 10, 30 ranged between 0.03 and 0.06 % of the total number of candlesticks;
• The Engulfing pattern with the UZ, PP parameters: 20, 30 ranged between 0.06 and 0.11 % of the total number of candlesticks;
• The Engulfing pattern with the UZ, PP parameters: 10, 60 ranged between 0.24 and 0.29 % of the total number of candlesticks;
• The Engulfing pattern with the UZ, PP parameters: 20, 60 ranged between 0.39 and 0.50 % of the total number of candlesticks;

Also note that the more noticeable the Engulfing pattern is, the smaller is its share in the total number of candlesticks.

The next step is to analyze the results on the handled trading signals received from the Engulfing pattern.

We estimate the results according to two criteria:

• Momentum (m) – reflects the average increment rate of financial quotes when fixing positions, in %. The positive momentum value indicates profitability of the handled signal, a negative value indicates a loss.
• SPP – the share of profitable positions, %.

The momentum (in %) and the share of profitable positions (in %) in terms of holding positions, timeframes and the Engulfing parameters:

The momentum (in %) and the share of profitable positions (in %) by financial instrument types:

10 out of 12 average impulse values are negative.

We also can outline some peculiarities.

To do this, we can visualize the results in the form of momentum distribution (m) over each parameter (a close-position candlestick, timeframe, the Engulfing pattern parameters (UZ, PP), type of financial instruments):

The diagrams above represent the distribution of momentum depending on the analyzed parameters. The diagram consists of two parts: a "box" and "tails" or "whiskers". 50% of the observed values are placed within the box, the remaining 50 are represented with tails. The end of the lower tail shows the smallest of the observed values, the end of the upper tail is the largest one. The cross shows the average value.

The analysis of the results allows us to make the following preliminary conclusions:

• the average momentum value when closing a position on the 10th candlestick is higher than the average value on the 5th candlestick, so losses are minimised when closing positions on the 5th candlestick (the momentum is negative);
• the average momentum value on the hourly timeframe is higher than on the daily one, which indicates that acting on the signalis more profitable on the hourly charts and is loss-making on the daily charts;
• a minimal loss (compared to others) is noted at the following Engulfing pattern parameters: the position closing level is not more than 20% and the overlap percentage is not higher than 60%; a significant loss is at the position closing level of not more than 10% and when the overlap percentage is not higher than 30%.
• the best momentum (comparing to other financial instruments) is observed on the Currency pairs, the lowest is on the Indices.

Let’s review the results in terms of holding positions, timeframes, the Engulfing pattern parameters (a closing level, the overlap percentage) and types of financial instruments.

Take the notation keys:

«H1 / 5» – fixing the position on the 5th candlestick when working on the 1- hour timeframe;

«H1 / 10» – fixing a position on the 10th candlestick when working on the 1-hour timeframe;

«D1 / 5» – fixing a position on the 5th candlestick when working on the daily timeframe;

«D1 / 10» – fixing a position on the 10th candlestick when working on the daily timeframe;

SPP – the share of profitable positions, %,

UZ - closing level, %;

PP - overlap percentage, %.

The number of events, momentum in %, the share of profitable positions (in %) in terms of timeframes and closing positions with the following Engulfing pattern parameters: UZ <= 10, PP<= 30

The number of events, momentum in %, the share of profitable positions (in %) in terms of timeframes and closing positions with the following Engulfing pattern parameters: UZ <= 20, PP<= 30

The number of events, momentum in %, the share of profitable positions (in %) in terms of timeframes and closing positions with the following Engulfing pattern parameters: UZ <= 10, PP <= 60

The number of events, momentum in %, the share of profitable positions (in %) in terms of timeframes and closing positions with the following Engulfing pattern parameters: UZ <= 20, PP<= 60

Summary of all the results using diagrams:

So, we can draw the following conclusions.

The highest momentum of 0.089 % was observed with the signals generated by the Engulfing pattern on the 1-hour timeframe, with the following pattern parameters: the closing level is no more than 20 %, the percentage of candlestick overlap does not exceed 30 % when fixing a position on the 10th candlestick.

But the momentum value is as low as other values on the hourly timeframes.

Daily timeframe shows that the momentum values are negative at any Engulfing pattern parameters.

The absolute negative momentum values are negative at the following Engulfing pattern parameters: the closing level is no more than 20 %; the overlap percentage does not exceed 30 %.

The lowest momentum of -1.711% is seen when fixing a position on the 10th candlestick.

Overall, the signal of the Engulfing pattern yields no profit.

The formulated hypothesis has been disproved.

Thus, the Engulfing patternis not a trend reversal model, but rather its continuation.

Detailed results are presented in the appendix:

XLSX (0.47 MB)Application to the article 'The Engulfing model is a signal of trend change. Is that so' eng.xlsx