Bearish Engulfing Pattern on EUR/CHF

A bearish engulfing pattern is a candlestick pattern that, like a its bullish counterpart, will appear frequently in any market. It is a bearish indicator and is particularly helpful when trying to time a trade to the downside during a downtrend or as a trigger at a resistance level. The engulfing pattern has two candles, the second candle should engulf with a higher or equal open price and a lower close price than the candle before. In order to meet that requirement the bearish engulfing pattern looks like the exact opposite of its bullish engulfing pattern counterpart with a smaller white candle followed by a larger black or red candle. As its name would indicate it is a signal that the market is likely to fall or continue falling. The pattern is defined as one day that the market is up (white or green candle) followed by a negative (black or red) candle that equals or exceeds the close from the previous day and definitely exceeds the open of the previous day. In the chart below you can see what this formation looks like 8/7 on the EUR/CHF. The up candle on 8/6 was "engulfed" by the next negative day on 8/7 which indicates that the market is likely to fall. A trader may decide to enter short on the open of the next candle on 8/8 anticipating profits to the downside. In the testing that I performed mechanically I required a downtrend to be in place however, as seen in chart #2, this time it is appearing at a level of resistance. Seeing a bearish candlestick pattern at resistance is a reasonable way to enhance this analysis to look for short term reversals. The story being told here is that market psychology has reversed. On 8/6 the bulls were in control and drove prices up, however, on 8/7 the bears had not only regained control but they had exceeded the price action of the previous day. That reversal of market psychology puts the momentum of the market in the hands of the bears and a decline is expected. There are a couple of adjustments you have to consider when evaluating this signal. First, if the charting package you use streams a continuous feed (no gaps) the first up day's close will never be exceeded by the engulfing day's open. In fact the up day's close will always be equal to the engulfing day's open. This is not a problem it is just a unique charting phenomenon in the forex; just make sure that the engulfing day's close exceeds the open of the previous up day. The second adjustment I made when testing the efficacy of this signal was to account for how common the pattern was. I have found that the more common a pattern is the less likely it is to return profits over time unless you add another technical filter. When tested all by itself, the pattern was very unprofitable, but when I applied a trend filter, performance jumped considerably. Chart #1 [IMG]http://www.pfxglobal.com/images/john/08072008eurchf.png[/IMG] Chart #2 [IMG]http://www.pfxglobal.com/images/john/08072008eurchf2.png[/IMG] [B]Method:[/B] I defined the candlestick pattern as above but added a condition that a short term moving average (10 period) had to be below a longer term (20 period) moving average indicating an downtrend. Once a trade was entered I applied a 25 pip trailing stop loss without a specific profit target. Since this is a momentum play I felt that this would be a good "acid test" for whether this pattern could be used profitably in the market. Whether a trade was profitable or not defined whether the pattern was successful for testing purposes. I think it is clear that if the pattern were refined or combined with a more rigorous support and resistance analysis it could outperform the mechanical parameters I applied for the test. To see the summary of findings - click here: [url]http://www.pfxglobal.com/pfx-forex-blog/bearish-engulfing-pattern-on-eur-chf.html[/url]