When trading on the Forex market, we make decisions based on price action. In order to open the appropriate order we look at the graph and search answer to the question – which direction the price will move. On the candlestick chart (Japanese candles), the price creates recurring formations that can help us find the answer.
Among the most important Price Action candlestick formations, are Inside and Outside Bars – signalling a change or continuation of the current trend. One of such is the so-called Bearish/Bullish Engulfing or in general – Outside Bar. This formation is created when the next candle with its range covers completely the preceding. When a candle is bearish we have a bearish engulfing, whereas a growth candle it is a bullish engulfing. Formations are most effective on daily charts (D1). At lower intervals such as H4, we need to be cautious because of the frequent false signals.
The bearish candle “2” in its range “includes” preceding the growing “1”. Such a formation may herald a change in the direction of the price movement from the bullish to bearish.
When is the signal strong?
There is an old saying… “all is not gold that glitters”… so not all formations of this type are equally effective or valid – their strength depends on the position on the entire graph. The strongest formations are formed on important levels or local peaks forming far from the previous one.
Formation A – the maximum of the candle forms a local high remote from the previous one – the downward movement that was initiated was dynamic and lasted nearly 600 pips.
Formation B – the maximum of the engulfing candle is not a local high and its effectiveness is small – the downward movement was only 120 pips.
Bollinger Bands as additional confirmation
For less orthodox Price Action traders, an additional indication that the formation is strong is the Bollinger Bands indicator. You can use the Bollinger Band and look for confirmation that the forming formation is on enough “high” level. If the maximum candle is above the band, then the formation is strong, and if the candle has its maximum inside the band it is weak and usually ineffective.
Check also description of a strategy based on Outside Bars and MACD