Engulfing Patterns

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An engulfing pattern is a candle that literally engulfs the entire day's previous candle. A bullish engulfing candle opens lower than the previous day and then proceeds to close higher. The pattern is usually at the bottom of a descending move and can mean that traders are heavily covering shorts in anticipation of a possible ascending move. The bearish engulfing pattern is very similar but is on the top of an ascending trend and has an open and close at more extreme points than the previous session. Engulfing patterns are also called "outside" days by Western chartists, but generally mean the same thing. Much like all charting, engulfing patterns are best used when confirmed with the following day's trading activity. The chart in Figure 4.7 displays both bullish and bearish engulfing patterns.

Now that we have covered a few candlestick patterns, let's see how -this knowledge can apply to pairs trading. If our statistics are indicating that we should buy Stock A and sell short Stock B, we may want to check other information available, just to see whether our statistics agree with technical analysis. Then, by examining the charts, we may see that Stock A has just formed a hammer bottom (with confirmation), while Stock B has

FIGURE 4.5 Shooting Star 1
FIGURE 4.6 Shooting Star 2

created a shooting star (with confirmation), and we may feel more confident about entering our pair. The key to being an effective directional or pairs trader is to get as many different indicators on our side as we can. If our statistics coincide with the fundamentals and the technical charts, we have more favorable aspects of the trade working for us rather than against us.

FIGURE 4.7 Bullish and Bearish Engulfing Patterns

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