Discussion 9 : Engulf the Trends!

Have you ever heard of this man named Munehisa Homma? Allow me to briefly introduce him to my readers in these opening few paragraphs of this Discussion.

If we study the history of Japanese revolutions, we would definitely come across writings relating to a 100 year which the revolutionists and historians call the "Sengoku Jidai", which literally means, "Age of Country at War". Unifications of over 60 provinces under one power (government) took place during that time (years 1500 - 1600).

After the "Sengoku Jidai", Japan is under the rule of Tokugawa Shogun. The country, at this time, is said to be in the Tokugawa era. With the centralization of feudal systems led by Tokugawa, Japan gained economic stability and had then resulted in growth of the agrarian economy, as well as improving ease of domestic trades. This introduction forms a national marketplace and, by the 17th century, replaced the conventional isolated and local marketplace concept.

As there was no currency standards in place at that time, rice became the de facto medium of exchange. The Dojima Rice Exchange was institutionalized in late 1600s in Osaka. The exchange deals with actual rice until 1710. After 1710, rice coupons were issued by rice warehouses. Since then, rice coupons were used as medium of transactions. Later, rice coupons were raised for crops that weren't even harvested yet! This, somehow, became the first kinds of "futures contracts" in the world!

In 1724, Homma was born to a wealthy family in Sakata, and inherited his family business in 1750. It was during that time that he developed a technique to trade in the local rice exchange, and subsequently amassed a huge fortune enough to trade "rice futures" in the Dojima Rice Exchange in Osaka. Using the same technique, he then moved on to conquer the regional exchange in Edo (now Tokyo). After making 100 consecutive successful trades, he retired and joined the government as a financial consultant. He was then later honoured with the title of 'samurai' before passing on his life in 1803.

The technique Homma used to achieve this huge financial success is none other than the Candlesticks that we use in Technical Analysis (TA) nowadays. Up to approximately 25 years ago, this technique was unknown to the western hemisphere until Steve Nison, the father of Candlesticks, wrote the book "Japanese Candlestick Charting Techniques".



ENGULFING SET
One of the candlestick patterns that I introduced to my readers in Discussion 4 (Part 2) is the Engulfing Set. As we know, the Engulfing Set consists of Bullish Engulfing and Bearish Engulfing. They are illustrated as one candle eclipses or engulfs the previous day's candle in opposite colour. Please see illustration (i).


Illustration (i) : Engulfing Patterns



PSYCHOLOGY
Consider the example below:

Illustration (ii) : Bearish Engulfing - John

John bought a stock at RM0.70. The price then went on an uptrend. On the 4th day, the price opened at RM0.90 and closed at RM0.95. On the 5th day, the stock price opened at RM1.10 (this is what we call a price Gap Up). Then, he sold his house and car and buy more into this stock, thinking that it is bullish. At the end of the day, the stock price closed at RM0.85. This completed the Bearish Engulfing Pattern.







Illustration (iii) : Bullish Engulfing - John

For the next 4 days, the price came tumbling down. On the 9th day, the price opened at RM0.60 and closed at RM0.55. On the 10th day, the price opened at RM0.40 (price Gap Down). John could no longer contain the fear inside him, and he sold off his entire holding at RM0.35 (bid price). He then jumped off the building on the same day at 5pm, after seeing the price closed at RM0.65. This completed the Bullish Engulfing Pattern.

(Note: Gaps are strong bullish or bearish signal, depending on the prevalent trend.)

Notice that in the event above, as the price rode up the trend, buyers were euphoric. The filling of the Gap Up, which subsequently went on to form the second black candle in Bearish Engulfing Pattern, tells us that the S&B Money considered the price was at the top, and that they greedily took profits. Seeing that the price moved so low to fully discount the profits earned on the first day, uncertainties strike investors.

(Note: "Filling of Gap" means the gap is closed by subsequent price movements during the day. For instance, the price closes on Monday at RM1.00 and opens at RM1.20 On Tuesday (Gap Up). During the day, the price then traded lower from RM1.20 back to RM1.00. The Gap is now filled.)

As the stock moved down, other investors started to sell in panic. As the price moved to a ridiculous low, even the most stubborn investors, such as John, began to feel defeated and started to sell in distress. The S&B Money then came back to grab at the low. This was signaled by a ridiculously high buying sentiment, moving the price higher to make up the previous day's losses (Bulling Engulfing Pattern).



ENGULFING - HOW TO USE
They are rather easily recognizable. One candle must eclipses or engulfs the candle of the previous day with an opposite colour.


What is the Trend?
Again, you must identify that the Engulfing Pattern in play is a Bullish or Bearish one. Remember that Bullish Engulfing appears only at the BOTTOM of a downtrend, while Bearish Engulfing appears only at the TOP of an uptrend.


Seek Confirmations
Most of the time, the second candle would have already acted as a signal confirmation. The first candle will most of the time be a single candlestick reversal pattern such as Hammer or Doji, or part of a three candles reversal pattern such as Three Black Crows or Three White Soldiers.

The question here is how strong the confirmation is. I usually look at three things : Volume, Support & Resistance, and Momentum Indicators (MIs).

Volume: Preferably high, but volume may not be high for Bearish Engulfing.
Support & Resistance: Engulfing Pattern should form at or near, Support or Resistance.
MIs: Prices should preferably be trading in overbought or oversold region.

What if the confirmations of the second candle aren't convincing? Wait for another day then!


Illustration (iv) : GAMUDA



Illustration (v) : SALCON



Illustration (vi) : MAYBANK

Illustration (iv) and (v) show recent movements in GAMUDA and SALCON that featured the Bearish Engulfing Pattern.

Illustration (vi) backdates MAYBANK to late May and mid August 2010 which showed a requirement for another day of confirmation due to the lack of strength of second candle.


Ignore Shadows in Recognition



Illustration (vii) : Western Bar vs Japanese Candles

Perhaps one of the most difficult recognition issues of Engulfing patterns is its shadows. Many Western traders recognize Engulfing when the body of the second candle engulfs the high and low of the previous day. This is due to the fact that this candlestick pattern is very similar to the "Outside Reversal Day" pattern in western bar charts that Western traders relied on prior to the introduction of Candlesticks some 25 years ago.

In Japanese Candlestick patterns, the requirement for it to qualify as an Engulfing pattern is the body of the second day engulfs the body of the first day. This makes most trend reversals to be identified quicker and timelier compared to the conventional "Outside Reversal Day" pattern. Study illustration (vii).


Gap Means Strength!


Illustration (viii) : Gap Engulfing

Some books write on Engulfing patterns to involve a Gap Up or Gap Down in price when the day opens. In my opinion, such gaps are essential to measure the reliability of a reversal signal. When a Gap occurs, it shows that the market sentiment is either very bullish or bearish, depending on the prevalent trend. When such gap is filled and then subsequently closed lower/higher than the previous day's close/open, it sends out an even stronger sentiment that trend reversal is now taking place with conviction.

However, this doesn't mean that a Gap is a must! An Engulfing Pattern is formed when the second candle fully eclipses or engulfs the body of the previous candle with opposite body colour. A Gap only strengthens the signal further!

(Note: We will cover more on Gap Analysis in future Discussions.)


Engulfing Support (ES) and Engulfing Resistance (ER)
Engulfing Patterns could give birth to a strong Support or Resistance, depending on the prevalent trend. The general rule is, the longer of the shadow or body (if the Engulfing Pattern doesn't have shadows) of the two candles would be the trend's Support or Resistance.


Illustration (ix) : MAYBANK - Support & Resistance



Illustration (x) : 1 minute FKLI

Illustration (ix) shows ES and ER that occured in MAYBANK that was backdated to late October and Early November of 2010.

Illustration (x) shows the FKLI futures 1 minute intra-day chart which took place this afternoon (11 February 2011).

Although this is commonly seen in the US market, ES and ER don't seem to work very well in KLSE. They are rarely tested and are rather easily broken by price surge. Having said so, traders should nonetheless be aware that Engulfing Patterns are extremely reliable in identifying trend reversals, although they defend their Support and Resistance levels poorly.



A smart trader would always trade when the stock price is trending. Therefore, knowing how to use reversal patterns would further enhance the chances of betting on the right animal. As the legendary trader Jesse Livermore says,

"There is only one side to the market... not the bull side nor the bear side, but the right side!"

My appreciations to my readers for your attentions. May the new Rabbit year leaps your wealth higher in the stock market!

Happy Charting!