Chart Patterns: The Hammer

The hammer is a classic and easily identifiable candlestick chart pattern that often foreshadows a bullish reversal. Like any other candlestick pattern, it can be particularly useful in tracking price action for the purpose of setting up trades. Trading strategies built upon the hammer candle are functional on any timeframe, beit on an intraday or daily chart. In addition, hammers work well when combined with other technical indicators such as the moving average or Fibonacci retracement.

Identifying The Hammer

To spot a hammer formation, traders will want to recall how candlestick charts are interpreted. Below are the key facets of candlestick chart reading:

• The candlestick price chart is traditionally composed of a series of individual "candles."
• Each candle consists 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." The wicks 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. Candles 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's "real 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 previous or next candle, as each will denote a price movement. In doing so, one is able to readily identify a single or multiple candlestick pattern. Five of the most popular single candle patterns are the doji, hanging man, hammer, inverted hammer and shooting star.

The hammer formation will usually appear with a long downward-thrusting wick (also referred to as "shadow") that will resemble a handle, and often a shorter, small body resembling the head of a hammer. The long lower shadow 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. The 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 or near the end of a downtrend or bearish trendline.^[1]

As a whole, the appearance of the hammer candlestick pattern is generally understood by traders to be a sign that the market is going to make a strong move upward. In addition, the hammer will often appear after a pullback or "retracement" of an uptrend. This signal is technically a bullish reversal pattern in that it tells us the market has tested the possibility of a bearish reversal and is ready to make further gains. When this happens, traders can see the possibility of gains three to four times the initial uptrend.

How Do You Trade On The Hammer?

Traders will want to enter a long position once the candle posts its closing price and the hammer formation has completed. A stop loss 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.

In addition to its bullish trend-following functionality, the hammer candle has several applications. For active equities, futures, CFD and forex traders, the following hammer-oriented strategies are frequently applied:

• Bearish Reversal: The hammer can function as a bearish reversal signal when it sets up as a hanging man or shooting star. In the case of the shooting star, the hammer consists of a long upper shadow, small body and a small or non-existent lower wick. It occurs during an uptrend and is often viewed as a precursor to a price reversal. To capitalise on the shooting star, the trader may open a new short position in the market and place a stop loss above the upper shadow. For instance, forex day traders engaging the USD Index may decide to sell the market the next day after the shooting star fully forms.
• Bullish Reversal: The hammer is a versatile technical tool and may function as both a trend following and reversal signal. As a bearish trend reversal indicator, the inverted hammer candlestick pattern typically forms at or near the bottom of a downtrend or new low. The inverted hammer is visually similar to the shooting star and suggests that a potential reversal of a prevailing bearish trend may be in the offing. When used in concert with other technical tools such as pivot points, the inverted hammer lends credence to an established support level. If this reversal pattern is spotted, traders may decide to go long and cash in on the bullish hammer.

In contrast to other multi-candle patterns that include the doji (morning/evening stars), the hammer is a single candle bullish or bearish reversal indicator. However, traders may want to use other technical indicators, such as Fibonacci retracements and pivot points, to help confirm the strength of the signal. It's important to remember that no form of technical analysis or trading strategy is infallible. When trading the hammer, one is well advised to evaluate price action in an unbiased fashion and respect the prevailing uptrend or downtrend.

The Hammer vs The Hanging Man

Traders need to remember that the bullish hammer candlestick pattern 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 the hammer candle. However, the hanging man signal will appear during an uptrend. Also, unlike the bullish hammer, it's a bearish signal indicating a downward reversal.

Summary

The hammer chart pattern is a single candlestick formation that is used to project bullish trends and identify potential reversals. As its name implies, the hammer candlestick formation is considered a viable way of following bullish trends or nailing the detection of a bullish reversal:

• Trend Extension: When a hammer forms within a market retracement, continuation of the prevailing uptrend may be in the offing. To capitalise on forthcoming price action, traders often open a new long position in the market.
• Bullish Reversal: In the event that a hammer develops within the context of a downtrend, it is possible that bidders may prompt a bullish reversal. In order to get in on the reversal, traders frequently buy into the market in anticipation of bullish price action.

As with other Japanese candlestick charting patterns, traders will want to familiarise themselves with candlestick chart basics before putting the hammer to use. This means being able to identify and evaluate each candle's real body, opening price, closing price, lower wick and upper wick. However, once the hammer candlestick pattern has been identified, it can predict a strong uptrend as well as the reversal of a pullback or downtrend.