Engulfing Trading Strategy (Backtest)

Last Updated on January 6, 2023

There are different ways traders analyze the markets to find trading opportunities. While some use indicators, others study the price movements and the patterns made by candlesticks. One common candlestick pattern is the engulfing pattern. What is the engulfing trading strategy?

The engulfing trading strategy is a price action trading method that uses the engulfing candlestick pattern to find trading opportunities. It is a reversal candlestick pattern that consists of two candlesticks, with the second candlestick consuming (engulfing) the first one.

In this post, we take a look at the engulfing candlestick pattern. We present you with an engulfing trading strategy at the end of the article.

What is engulfing strategy?

The engulfing trading strategy is a price action trading method that uses the engulfing candlestick pattern to find trading opportunities. It is a reversal candlestick pattern that consists of two candlesticks, with the second candlestick consuming (engulfing) the first one.

Usually, it is the body of the second candlestick that completely engulfs the body of the first candlestick, but the range (body plus upper and lower wicks) of the second candle may also consume that of the first bar. A more powerful variant of the engulfing pattern — known as the outside bar (the opposite of an inside bar)— is formed when the body of the second candlestick completely engulfs the entire range of the first candlestick. The outside bar pattern is called a reversal day on the daily chart.

The significance of the engulfing pattern depends on where it occurs in the context of price movements — after a rally or a decline — and whether there is a support/resistance level there, which would favor a price reversal.

As you know, a support level lies below the current price and could mark a reversal from a downswing to an upswing, while the resistance level lies above the current price and could mark the reversal from an upswing to a downswing. An engulfing pattern occurring around a resistance/support is more likely to bring about a price reversal.

What timeframe is best for the engulfing candle?

You may think that candlestick patterns work well on all timeframes, but that is not really true. At least, not from our assessment of backtested results. Generally, candlestick patterns work better in some timeframes than in others.

From an assessment of backtested results, the best timeframe for trading candlestick patterns, including the engulfing candlestick pattern, is the daily timeframe, with relatively short holding periods of about one to ten days. As such, the engulfing pattern is most useful for short-term trading.

Types of engulfing candlestick

Based on the arrangement of the two candlesticks that make up the pattern and where the pattern forms, the engulfing candlestick pattern is classified into two:

  • Bullish engulfing
  • Bearish engulfing

The bullish engulfing pattern

A bullish engulfing candlestick pattern is formed by two candlesticks, as follows:

Bullish engulfing pattern strategy
Bullish engulfing pattern (engulfing trading strategy)
  • The first candlestick is bearish (red/black)
  • The second candlestick is bullish completely and engulfs the body of the first candlestick

Being a bullish reversal pattern, you look for it after the market has made a downswing, which is the bearish trend to reverse to the bullish side.

A bullish engulfing pattern represents the victory of the bulls over the bears. Let’s take a look at how the pattern forms:

The first candle is bearish, in line with the downswing preceding it. So, it seems like the bears are still in control. Then, the market gaps down to open for the next candle, implying that the bears are still in charge. However, sometime during the intraday session, the bulls gain strength and push the price higher, making the candle close higher than the open of the preceding bearish candle. It shows that the bulls have taken control of the trading session.

Below is an example of a bullish engulfing candlestick pattern that is followed by a few days with very strong performance:

Bullish engulfing trading strategy example
Bullish engulfing trading strategy

The bearish engulfing pattern

A bearish engulfing candlestick pattern is formed by two candlesticks, as follows:

Bearish engulfing pattern strategy
Bearish engulfing pattern (engulfing trading strategy)

A bearish engulfing candlestick pattern is formed by two candlesticks, as follows:

  • The first candlestick is bullish, in line with the preceding upswing
  • The second candlestick is bearish and completely engulfs the body of the first candlestick

Since it is a bearish reversal pattern, you look for it after the market has made an upswing, which is the bullish trend to reverse to the bearish side.

The bearish engulfing pattern represents the victory of the bears over the bulls. Here’s a breakdown of how it is formed:

In line with the upswing where the pattern forms, the first candle is bullish, which makes it seems like the bulls are still in control. The then market gaps up to open for the next candle, implying that the bulls are still dominating. However, sometime during the session, the bears gain strength and push the price down, so much so that the candle closes lower than the open of the preceding bullish candle. This shows that the bears won control of the trading session at the end. The bearish engulfing candlestick pattern is thus the opposite of the bullish engulfing pattern.

Candlestick backtests and research

If you are interested in candlesticks and would like to have them backtested and quantified, you might want to know that we have already done the job for you:

We have compiled backtests of all 75 candlesticks that exists:

Engulfing trading strategy (backtest)

Because this website is all about backtesting and making 100% quantifiable settings and trading rules, we’ll proceed to backtest a few trading strategies in S&P 500.

Our experience is that candlesticks have the most utility on stocks and are much less significant on other asset classes, like for example oil, metals, commodities, and forex. Perhaps the only exception is bonds, though.

Engulfing trading strategy no 1 (bullish)

We backtest the following engulfing trading strategy (trading rules):

  1. Yesterday’s close must be lower than yesterday’s open.
  2. Today’s open is lower than yesterday’s close.
  3. Today’s close is higher than yesterday’s open.
  4. If 1-3 are true, then go long at the close.
  5. We sell at the close when today’s close is higher than yesterday’s high.

The equity curve looks like this (what is a good equity curve?):

Engulfing trading strategy (bullish)
The equity curve of the bullish engulfing trading strategy shows a positive expectancy, but is not tradable.

The strategy has 217 trades but the average gain is pretty low at 0.22%. This might turn into a good trading strategy if we add some more parameter, but we believe there are better options out there so we skip it.

Let’s go on to backtest the bearish engulfing trading strategy:

Engulfing trading strategy no 1 (bearish)

We backtest the following engulfing trading strategy (trading rules)::

  1. Yesterday’s open must be lower than yesterday’s close.
  2. Today’s open is higher than yesterday’s close.
  3. Today’s close is lower than yesterday’s open.
  4. If 1-3 are true, then go long at the close.
  5. We sell at the close when today’s close is higher than yesterday’s high.

Based on the zillion backtests we have done in the stock market over the years, we believe the bearish engulfing trading strategy to perform much better. The reason is simple: Mean reversion trading strategies perform well on stocks.

The equity curve looks like this (what is a good equity curve?):

Engulfing trading strategy (bearish)
The bearish engulfing trading strategy performs much better than the bullish engulfing trading strategy.

The bearish engulfing trading strategy has 274 trades and an average gain of 0.57% per trade. This is pretty good. The profit factor is 2.7 (what is a good profit factor?) and the max drawdown is about 16% (what is a good maximum drawdown?).

Is this a tradable strategy? Perhaps, if you make a few modifications.

Engulfing Trading Strategy – ending remarks

The backtests we did in this article show that the bearish engulfing strategy performs better than the bullish engulfing strategy. We are not surprised. The reason is simple: in the stock market you get paid to take on risk, thus it makes sense to buy on short-term weakness (what is mean reversion in trading?). For long-term strategies, though, it might not matter much.

However, keep in mind that we only backtested our strategy on stocks and no other assets. The results might be different in forex, for example.

Similar Posts