When prices move sharply up or down, diving headfirst into the market is tempting. However, trading based on emotions often ends poorly. Therefore, we have found a simple strategy that can help most day traders “keep a level head” – at the same time, allowing you to participate effectively in significant market movements.
The strategy is known as “bullish or bearish engulfing”, and is one of the most commonly utilized trading strategies. It is fairly simple to understand, as will be explained in this article.
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Engulfing strategy
The simpler, the better. That’s often the case with trading strategies. And this is exactly the type of strategy that can provide fantastic returns if you enter the market correctly.
Here’s what to do:
- Find a market that is in a trend, whether upward or downward. The direction doesn’t matter; the strategy works in both cases and in both short and long terms. In this example, we have chosen a 4-hour chart for gold.
- Add the indicators Moving Average, MA 20 (simple moving average), and Exponential Moving Average, EMA 8 (exponential moving average). In this example, the green line is MA 20, and the red line is EMA 8.
Here you can see that the gold market is trending upwards. This means that the price of gold is rising. When the market corrects – undergoes a pullback, as it’s said – in the area around the green line, then you can look for the occurrence of a bullish engulfing pattern.
This pattern indicates a trend reversal and that the markets potentially can continue upward. On the gold chart above, we have marked a bullish engulfing candle with an arrow.
Here you go long in the market – meaning you buy – IF the subsequent candle goes above the bullish engulfing candle. And in this case, it does. You set a stop-loss level (at which your position is automatically closed) just below the bullish engulfing candle.
Now you are in the market, and it continues to trend upwards.
When should you take your profit?
Taking your profit can be one of the hardest things in trading. Some sell their positions too early because they want a quick gain. Others hold on to their profit for too long, hoping that the market will continue upwards indefinitely, but to their dismay, the price falls.
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If you want to succeed as a trader, it’s crucial that you accept that you won’t be able to sell at the top every time, just as it won’t be possible to buy exactly at the bottom.
This is where the red line, EMA 8, comes into play. According to this strategy, you simply close your position when a candle closes below EMA 8, IF the subsequent candle goes below the candle that closed under EMA 8. This may indicate that a market reversal is imminent.
It can be reassuring, especially for a new trader, to have a mechanical signal that determines when to exit the market. Otherwise, the decision to close trades will be based on gut feelings. And that is not a sustainable strategy in the long run.
You can probably see several bullish engulfing candles in the example above. With the entry we chose, the risk-reward ratio – also called risk-reward – would be as much as 16 times (see the red circle). If you risked 1000 kroner on the trade, you would be able to make 16,000 kr. on such a trade.
A larger bullish engulfing candle indicates more strength, but at the same time gives a worse risk-reward. With a small engulfing candle, you get a better risk-reward, but less sign of strength and thus less certainty.
If you go short, that is, you short the market – and make money on falling prices – then the pattern is the opposite, and you should look for a bearish engulfing pattern, like the one in the picture below.
Many find that shorting the market can be more straightforward. This may be because markets generally fall faster than they rise, making it mentally easier to hold a “short position”. When the market rises, it often happens more slowly, which gives more time for doubt, which can lead to making overly drastic decisions.
When is the market trending?
There are several ways to identify trending markets. For instance, one can apply a moving average. On trading platforms, this will most often be called Moving Average 200, or MA 200.
One can then have the rule that one only takes positions when the market is above or below the MA 200, depending on whether one wants to go long or short. If the market is on one side of the MA 200 as well as MA 20 and 8, it is often a sign of a strong trend.
Below, you see an example of a declining market in the German DAX index on a 5-minute chart. MA 200 is the blue line, and according to our rule, we can only enter the market when the price is below this line.
Notice that here we enter the market when the price hits EMA 8 instead of MA 20. It works best if an engulfing pattern also occurs before you enter the trade.
In this example, the risk/reward of the trade was about 1:6, but you can certainly see other bearish engulfing patterns with a different risk-reward ratio. Sometimes the trades are profitable, other times not. However, if you manage to catch a larger move like the one above occasionally, you can afford to lose many trades, and overall, you will be able to come out ahead.
We recommend focusing on markets with a low spread. The spread is the difference between the buying and selling price and thus the price you pay to trade.
the trading platform Markets offers a low spread on the DAX, so if you like trading the German index, it makes sense to trade on this platform.
The reason why trading the German DAX index is popular among many Danish traders is that it opens from 9 am to 5:30 pm, making it possible to trade during the daytime. Some also choose to trade the American indexes, which are open from 3:30 pm to 10 pm, but that might not fit as well into the daily routine for those who want to make trading their livelihood.
Another good piece of advice is to be creative with this strategy. You can expand it in different ways to suit your trading style and risk profile.
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If you want to test this strategy completely risk-free, you can quickly and easily open a demo account with the trading platform Markets.