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Last Gasp Bullish Engulfing signal

 

 

Normally the formation of a Bullish Engulfing signal is associated with the reversal of a downtrend. The key in this statement is the fact that the signal is formed after a downtrend. Normally stochastics will indicate the stock to be in oversold condition. However, what do you do when you see a Bullish Engulfing signal in an overbought condition?

The implication of this signal is completely opposite in this case. Candlestick traders need to start watching for a sell signal to appear soon behind. The psychology here is as follows:
After an uptrend has moved stock prices well into the overbought region, there is profit taking. This leads to a dark candle. However, amateur investors think this pullback is a good buying opportunity. When prices open down the next day, they start loading up the stock. There is exuberance in the buying, closing the prices higher and creating an engulfing pattern. Usually, the exuberance will lead to lower prices soon. That is the reason, the candlestick traders need to wait for a sell signal before taking any action. Just observing a Bullish Engulfing signal in overbought condition should not lead you to liquidate your position or initiate any short position. 

The following chart shows a Bullish Engulfing signal in overbought conditions in POT Inc. Prices had steadily risen from end of March till mid May. When do most investors buy? Near the top! The candlestick trader knowing what should happen after witnessing a Bullish Engulfing signal has an advantage over bar chart or line chart readers. Notice a Bearish Harami being formed the next day. Ideal point to short would be on confirmation of the Harami.

Chart courtesy stockcharts.com