Jun 24, 2011
Written by:
Al Hill
The concealing baby swallow occurs at the end of downtrends and is a bullish reversal signal. The pattern consists of four candlesticks that are all black (red), and is an early sign that the downtrend is deteriorating.
The first two days of the concealing baby swallow pattern are two black marubozus. The third day gaps down on the open, but the price eats into the body of the second day prior to closing lower. The fourth candlestick completely engulfs the third day and closes near its low. The last day could also be a black marubozu as well, but this version of the formation is so rare, its not worth discussing. The reason the formation leads to reversals is due to the overly bearishness in the market as a result of consecutive black marubozus and finally the engulfing pattern on the fourth candlestick. This extreme bearishness over a short-term time frame in the concealing baby swallow formation, often leads to sharp counter reversals.
Like many other trading strategies discussed on the Tradingsim blog, we will cover three key elements for executing the trade: (1) entry, (2) stop loss and (3) profit targets.
The pattern occurs after the creation of the fourth candle – the engulfing candle; however, this is not enough to enter a trade. In order to buy a stock using the formation, you need to identify a close above the upper body of the engulfing candle (fourth candlestick).
It is not mandatory that the next candle close above the fourth candlestick, as it could take time for the breakout pattern to develop.
In the above image, we see the confirmation comes with the fifth candlestick.
Notice how the bullish candle closes above the body of the engulfing. This confirms the validity of the pattern.
This would be an opportunity for you to take a long position.
Although the concealing baby swallow is a very high probability trade, you should never place a trade without a stop loss order.
You should always place your stop loss order below the lowest point of the pattern. This is the area below the lower candlewick of the 4rd candle – the engulfing candle.
Above you see an example of how your stop loss should be positioned.
I know this sounds super simple, but one of the hardest things to do is commit to the risk in a trade. You may talk yourself out of placing the order because you don’t want the market makers to low tick you and then rally.
Or you just want to watch the action and manually sell if things get crazy.
Both of these stop loss entry approaches make sense on paper, but in reality your human emotions will likely prevent you from actually following through on a consistent basis.
For this reason, I again strongly urge you to enter your stop loss order and truly accept the risk.
The minimum profit target of the concealing baby swallow is equal to the size of the pattern.
To measure the size of the pattern, you need to take the distance between the first marubozu and the lower candlewick of the engulfing candle.
After you measure this distance, you need to apply it upwards starting from the lower point of the engulfing candle. When the price action breaks the upper body of the engulfing candle, we confirm the trade.
Then we should aim for a price target equal to the size of the pattern.
The first blue arrow shows you how to measure the size of the pattern. The second blue arrow shows you how to apply this distance as your minimum target of your trade.
As you can see from the image, we are applying the length of the pattern to the top of the fourth candlestick.
If you want to be more aggressive in calculating your price targets, you can apply the length of the pattern to the highest point of the concealing baby swallow formation.
Your risk tolerance will determine the preferable approach for your trading style.
If you hit the Concealing Baby Swallow pattern for the minimum target, you will usually get a win-loss ratio of slightly great than 1:1. This will sometimes be 1.2:1 and sometimes can go all the way to 2:1.
This time we have also applied the risk management measurements to the image. The big red arrow represents the risk we are taking in the trade. The green arrow with the same size represents the 1:1 win-loss ratio.
As you can see, the first green arrow represents a 1:1 win-loss ratio. However, this pattern has a little more profit potential, which is the second small green arrow.
Therefore, the risk reward on this trade example is 1.4:1.
If you want to further minimize your risk, you can find concealing baby swallow patterns which have smaller fourth engulfing candlestick.
This will naturally give you a tighter stop with a larger profit potential.
If you look hard enough, you can find concealing baby swallow patterns with 2:1 up to even 5:1 risk reward ratios.
Now we will apply our trading rules into a real concealing baby swallow trading example.
The chart above illustrates a real concealing baby swallow trading example, which is highlighted in the green rectangle.
As you can see, we have all five components of a valid concealing baby swallow pattern:
After we receive the confirmation candlestick, we go long.
The thing I like about this particular example is the relative small size of the engulfing candlestick. This gives us a great risk reward ratio on the trade.
Please note that we also placed our stop loss order to ensure we manage the trade effectively. Please and I repeat please, do not trade if you are unwilling to enter a stop loss order.
As you can see, this topic is near and dear to my heart.
The next thing we need to do is to measure the size of the pattern.
This is shown with the left blue arrow on the chart. As you see it takes the lowest and the highest points of the pattern for a distance. Then we need to apply this size starting from the upper body of the engulfing candle. The second blue arrow shows how to perform this step. The tip of this arrow is our minimum target.
Now we can monitor the trade in anticipation of a price target equal to the size of the pattern.
Seven periods later, the price action reaches the minimum target of our trade. See that there is a doji candle, which upper wick crosses our target line. This is when we need to close the trade and collect our profits.
Due to the large marubozu candlestick and small engulfing candle, we are able to achieve a 3:1 risk-reward ratio for this trade.
Remember, trading is a game of odds and the better you put them in your favor, the greater your chances of success.
Above you saw how to apply the trading rules of the concealing baby swallow based on a preset profit target.
What I have realized is that you make the most amount of money in the market, when you do not limit your gains and let a stock run as far as it wants to.
Therefore, another way to manage a concealing baby swallow trade is to let the price action dictate when you should exit the position.
To do this, you should use some basic price action instruments like support, resistance, trends, or chart patterns.
Let’s review how to combine the concealing baby swallow with price action.
We have another concealing baby swallow example, which is shown in the green rectangle. All the five components are present, so we can open a long trade with the confirmation candle.
The opening of the trade is shown on the image. We buy the stock when the price action breaks the upper level of the engulfing candle. Then we immediately place a stop loss order right below the lower wick of the engulfing candle.
The price action then starts crawling upwards. The first correction is a bit bigger, but our stop loss is well positioned and we stay in the trade. After another impulse and one more correction, the minimum target of the pattern is reached.
After the minimum price target is reached, there is a reaction, which we use to draw a bullish trend line through the bottoms of the price action (pink).
The trading plan is simple, stay in the trade until the stock closes below the pink line.
As you can see, there was an impulsive move higher that generated some serious profits.
This is just one example of how you can take the win loss ratio up to 7:1, which are great odds to have in your favor.
Tags: Candlesticks
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