The Bearish engulfing is a candlestick pattern that occurs when a bullish candle is immediately followed by a bearish candle that completely “engulfs” it. These candle patterns are very nice for short term traders as they typically signal a 2-3 day pullback in a stock. This pullback can be taken advantage of with an easy stop to control risk.
The image to the right illustrates the look of a bearish engulfing. Note the bullish nature of the stock before the bearish engulfing candle. The bearish candle is then represented by a morning gap higher followed by selling throughout the day. The stock eventually closes below the previous day’s low.
The bearish engulfing price action is typically followed by a pullback in the stock. The severity of the pullback varies from stock to stock but traders normally can capture 2-3 days worth of gains on short or put option position. In some cases driven by fundamental news events like earnings, a bearish engulfing can signal a much more significant top and the beginning of a new longer term downtrend.
Yesterday, the market opened a bit higher in the morning and closed slightly lower. This action helped to create bearish engulfings patterns in many stocks. In fact, 26 stocks in the S&P 500 exhibited these characteristics. While bears can use this action to establish downside positions, bulls can also use the price action to reevaluate their gains and look to take profits.
The trade on a bearish engulfing offers a very easy stopping point that can be used to control risk. If the stock closes above the engulfing day’s high, the trade is compromised and it is time to exit the short or put option position. Typically this type of stop represents relatively small risk compared to the potential gains achieved on a 2-3 day pullback.
There are 3 engulfing plays that I find interesting in the market today. All 3 can be played with stops on the engulfing candle’s day high. The gold miners etf (GDX) may be my favorite as it goes along with my bearish gold thesis. Caterpillar (CAT) and Yum Brands (YUM) represent stocks that have underperformed the market and are more likely to pullback severely if the market falls. Below are the 3 charts. Note that of the 3 stocks, there was only one bearish engulfing that did not work.
CAT had an engulfing on the last day of June that was followed by a rally. One sign that the engulfing was suspect was the gap up 2 days prior. A strong gap especially in a stock on a downtrend can signal that the engulfing may just be a bullish trap. Currently, all three stocks show nice bearish engulfing patterns after a 1 month rally and can be played lower with a stop on the engulfing high.
This morning’s market is set to move slightly lower as European stocks ticked down overnight. While the move lower is not a market game changer, it does present a day trade opportunity for the bears. Caterpillar (CAT) may be the best representative of a stock showing signs of a small 2-3% correction.
Lets start by taking a look at the daily candlestick chart of CAT below. There are several things to note.
- The 1st thing to note is the $87-$88 resistance level. While this level is not a major resistance level in the long term outlook of the stock, it does increase the odds of a short term pullback to come.
- The 2nd observation is the strong buying volume seen in the middle of July. This volume is typical of a declining stock that is putting in a major bottom. With the potential of a major bottom, we must keep in mind that any bearish trade is short term
- During the stock rally over the last 4 days, trading volumes have been on the decline. Declining volume is a typical sign of a short term pullback to come.
With short term trading, keying only off the daily chart can be dangerous. The addition of a short term chart is needed. My favorite is the 1 hour chart as seen below. When looking at the hourly chart, there are a few things to keep in mind.
- The final hourly candle of the trading day can give a strong clue into the next day’s stock direction.
- Closes below the 7 hour moving average are typically bearish while closes above the 7 hour moving average are typically bullish.
- Confirmation is needed to play the tendency of observation #2. This confirmation typically comes in the form of a gap the next day. A gap lower after a bearish close the previous day can be played lower as in the case of CAT below.
- Short term support must be located as well as a stopping point if the trade moves against us. This short term support is created by the gap higher earlier this month as well as the bottom band on the bollinger bands.
- Short Sell CAT on the open for 87.70-87.90. In the money options can be used for lower or no margin accounts.
- Stop out on a move above the 7 hour moving average. Risk of $0.70-$0.90.
- Take profit around $85.50 or today’s close. Reward potential of $2.20-$2.40
This trade setup gives us approximately a 3-1 reward to risk ratio. When reward is higher than risk at a 3-1 clip we know the trade is a solid setup as long as the technical outlook confirms the trade.