RSI Engulfing Candlestick Strategy

Introduction

The strategy to be discussed today is a combination of a candlestick pattern of high reliability with a momentum indicator. This is strictly a reversal strategy since the engulfing candlestick pattern is a candlestick reversal pattern. The RSI indicator is a momentum indicator which is capable of detecting oversold and overbought market conditions; precursors for an upward or a downward reversal respectively.

Indicators

The only indicator used here is the Relative Strength Index indicator. Other momentum indicators that we have discussed in our strategy articles can be used as substitutes for this indicator. However, the indicators must be capable of detecting overbought and oversold market conditions.

The Strategy

This strategy is hinged on the reversal. The candlestick pattern known as the engulfing pattern is a high reliability reversal candlestick pattern. It shows exactly what is going on in the market, which is that the traders who are opposing the primary trend have overpowered the traders pushing the trend.

For a bullish engulfing pattern, the first candle in the pattern is a bullish candle, while the second candle opens the trade higher than the day 1 close, but closes lower than the day 1 candle, showing that the momentum has changed. The move is confirmed by the RSI which is shown to have reached overbought territory (70 or above), but has turned down and is now <70.

For a bearish engulfing pattern, the first candle in the pattern is a bearish candle, while the second candle opens the trade lower than the day 1 close, but closes higher than the day 1 candle. This move is confirmed by the RSI which is shown to have reached oversold territory (30 or below), but has turned upwards and is now >30.

1) Long Trade

The long trade setup occurs when we have a bullish engulfing candlestick pattern occurring after the RSI has previously hit the oversold level and has started to turn up so that it is now above 30.

RSI_engulfing2

In this snapshot which is a daily chart for the AUDUSD, we see the previous trend which is a downtrend, followed by the bullish engulfing pattern. The day 1 candle’s body is quite small when compared with the size of the body of the day 2 candle. This is a sign that the selling action is now quite muted, while the bullish action is firmly strong. The trade entry is made at the open of the candlestick which follows the candlestick pattern.

When considering the bullish engulfing pattern, the shadows are not considered: only the bodies of the two candles, which is the part of the candlestick that shows the open and close, are considered in the trade setup. It is now about how high or low the candle was, but about how it started and ended.

Stop Loss and Take Profit Settings

The stop loss is set below the lowest price in the candlestick pattern, which is the day 2 low. The Take Profit is set at the trader’s discretion and several parameters can be used to dictate this. One parameter is to allow the RSI to get to overbought levels before closing. At other times, the appearance of a candlestick which will serve as another reversal signal.

2) Short Trade

The short trade setup occurs when we have a bearish engulfing candlestick pattern occurring after the RSI has previously hit the overbought level and has started to turn down so that it is now at a level that is <70.

RSI_engulfing1

In this snapshot which is a daily chart for the AUDUSD, we see the previous trend which is an uptrend, followed by the bearish engulfing pattern. The day 2 candle is a long one which shows that the selling pressure on the asset is strengthening. The trade entry is made at the open of the candlestick which follows the candlestick pattern.

Stop Loss and Take Profit Settings

The stop loss is set below the highest price in the candlestick pattern, which is the day 2 high price. The Take Profit is set at the trader’s discretion and several parameters can be used to dictate this. One parameter is to allow the RSI to get to oversold levels before closing the trade. At other times, the appearance of a candlestick which will serve as another reversal signal is used, or the trader can simply decide to set the Take Profit at two or three times the stop loss level.

Conclusion

The strategy works best when long term time frames are used. This allows for the true trend to be used in setting up the trade, and also allows the trader to earn a lot of pips from a profitable trade over the next few days or weeks, thus compensating for any inactivity or poor trade results obtained previously. The placement of the Stop Loss and Take Profit areas also shows that this trade setup has a good risk-reward ratio, which compensates for losses that may have been sustained earlier.

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