The hammer is a classic and easily identifiable candlestick charting formation that often foreshadows a bullish reversal. Like other candlestick patterns, it can be particularly useful in tracking short-term price action for the purpose of setting up trades.
Identifying The Hammer
To spot a hammer formation, traders will want to recall how candlestick charts are interpreted.
The candlestick price chart formation is traditionally composed of a body and two wicks. The square or rectangular-shaped bodies of the candles on the chart, often called the "real bodies," indicate the difference between the opening and closing prices of the period being charted. The lines extending above and below the body are known as the "wicks," or "shadows," and they represent the high and low prices for the trading period represented by the body.
Information At A Glance
The advantage of candlesticks is that they allow traders to instantly compare opening and closing prices and how much the market is willing to pay at highs and lows. The candle formations are frequently color-coded, with red indicating a declining price and another color, often blue or green, indicating a rising price. When the asset is gaining value, the bottom of the candle body represents the opening price and the top represents the closing price. When it loses value, the top represents the opening and the bottom represents the closing price. As such, traders will want to pay special attention to the coloring and positioning of each candle on the chart in relation to its neighboring candle, as each will denote a price movement.
The hammer formation will usually appear with a long, downward-thrusting wick that will resemble a handle, and often a shorter "real body" resembling the head of a hammer. The downward wick will usually be at least twice the length of the body in order for the formation to be considered a hammer. At times, it may also have a short wick at the top. A hammer formation can appear as an upward blue- or green-colored candle or a downward red candle. However, the bullish hammer will normally appear at the end of a downtrend.
Reading The Hammer Candle
The hammer formation as a whole tells traders that during the period covered by the candle, the price of the asset in question fell rapidly and then reversed beyond its initial opening price to close higher. The appearance of the hammer candle is generally understood by traders to be a sign that the market is going to make a strong move upward.
The hammer will often appear after the retracement an uptrend, signaling the market tested and discarded the possibility of a deeper decline and is ready to make further gains. When this happens, traders can see the possibility of gains three to four times the initial uptrend.
Trading On The Hammer
Traders will want to enter a long position once the candle is closed and the hammer formation has completed. A stop can be placed just below the low of the hammer's wick, which will serve as a floor to protect against the consequences of any unexpected reversal. Then, a profit target can be placed at a higher level—up to twice the distance from the stop-loss or higher—to increase the likelihood that a profit might be taken from a subsequent upward price move.
The uniqueness of the hammer is that differently from other patterns the signal for a reversal can be detected within the formation of one candlestick. However, traders may want to use other technical indicators, such as Fibonacci retracements and pivot points, to help confirm the strength of its signal.
The Hammer And The Hanging Man
Traders need to remember that the bullish hammer signaling an upward move can only appear in a downtrend, because it can easily be confused with the so-called "hanging man" formation. A hanging man candle appears identical to a hammer candle. However, the hanging man signal will appear during an uptrend. Also, unlike the hammer, it's a bearish signal indicating a downward reversal.
As its name coincidentally implies, the hammer candlestick formation is considered a way of nailing the detection of a bullish reversal in the midst of a downtrend. As with other patterns, traders will want to familiarise themselves with the formation of candlesticks before putting the hammer to use. However, once the formation has been identified, it can predict a strong uptrend.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…