Real sit third in La Liga, five points adrift of leading duo Atletico and Barcelona, who face-off at the Vicente Calderon on Saturday.
And Ancelotti is well aware of the challenges that lie ahead as the Bernabeu outfit attempt to play catch-up in the title race, starting with their trip to Espanyol on Sunday.
"We have to compete with two very strong teams to win the league," he said. "Atletico Madrid have been a surprise for everyone.
"Tomorrow's match is an important one. We want to end the first part of the season with a victory but we know they are tough.
"It will be a tough match but we have to do our best to win."
Midfielder Xabi Alonso signed a new two-year contract at Real this week, ending talk of a move away from the Spanish capital, and Ancelotti revealed some details of his conversations with the former Liverpool man.
"I told Xabi that he was important for the club and everyone had faith in him," he continued.
"He is in the squad list (for Sunday). We will see if he starts. I'm going to decide the line-up tomorrow morning."
Meanwhile, the Italian coach has offered his backing to Cristiano Ronaldo, who will discover on Monday whether he has beaten Franck Ribery and Lionel Messi to the Ballon d'Or.
"Cristiano has played better than anyone else this season and that's why he deserves the Ballon d'Or," he added. "He is a unique player."
