Using the bullish engulfing pattern for savvy trading

If you're vigilant and lucky enough to spot a bullish engulfing pattern, trading on it can yield some very appealing results. Figure 7-2 is a real-world example of the bullish engulfing pattern on a chart of the ETF that represents the members of the Dow Jones Industrial Average (DJIA), which is known as the Diamonds because its symbol is DIA. (An ETF or exchange traded fund is a security that trades like a stock, but represents a basket of stocks or an index.)

The DIA is a popular trading vehicle among short-term traders who try to profit from the direction of the Dow Jones Industrial Average from day to day and also among long-term investors who seek exposure to all DJIA stocks without having to buy all 30 of them individually.

Although it's not picture perfect, Figure 7-2 is a useful example of how the bullish engulfing pattern develops and how it can work out profitably. The bears dominate the setup day, leaving the close near the low. On the signal day, the DIA opens lower than the previous close and appears to trade lower — bad news for the bulls. But at some point during the day, the bulls rally with some strong buying and push the DIA much higher, to the point where the close of the day is higher than the high of the setup day. The resulting price action includes several days where the bulls are firmly in the driver's seat.

Figure 7-2:

A bullish engulfing pattern developing on a chart of the DIA ETF.

Figure 7-2:

A bullish engulfing pattern developing on a chart of the DIA ETF.

That leads me to an important question: How do you know when the bullish engulfing pattern's signal is no longer valid? My rule of thumb is if the low of the setup day is violated, then the signal is no longer good. To work this rule into your trading strategy, place a sell stop on the low of the setup day, not the signal day. Other traders may suggest that the sell stop be placed on the closing price of the setup day or even the opening price of the signal day, and you may want to consider those options as you get comfortable trading on the bullish engulfing pattern. Keep in mind, though, that things can get pretty miserable if you hold onto this trade for too long.

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