Hammer Candlestick Chart Trading Tutorial and Example
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The frequently occurring hammer candlestick pattern is closely watched by the market participants as it may lead to price reversal to upside when the pattern is formed on the ongoing downward pattern. The name of the candlestick emerges from the word 'hammer' which is a common tool used to hit or strike, and consists of a thick but small metallic body and a relatively long handle. The candlestick pattern represents a hammer tool held upwards, as if someone has raised it to strike, hence the name. The body of the hammer is formed by the open and close prices, while the handle is the part below the body till the lowest price of the candlestick period. On the price charts, a hammer appears as a single-line pattern - that is, it is made of only one candle which may be red or green - the color of the candle does not matter. When formed on a downtrend, it indicates a possibility of price reversal - that is, the prices may rise after the hammer pattern is formed on a downward price movement. Most of the active traders often wait for the next confirmation candle to form before taking a position on a hammer-based candlestick pattern. When formed on a downtrend, the confirmation candle should be green in color representing the price reversal to the up direction. Additionally, one must wait for a confirmation candle to form next, which is used to further ascertain if the price has actually reversed or not. This article explains the details of how the hammer candlestick is formed, what market conditions are indicated by its formation, how to trade the hammer candlestick, and the article also covers the most recent examples of the same. To understand the working and trading of the hammer candlestick, let's start by checking the factors needed for its formation.
Construction of the Hammer Candlestick Chart Pattern
Being a single line pattern, it may appear that only the formation of hammer shape is sufficient, but there's more to forming the hammer candlestick pattern. It is constructed on the price charts during the downtrend, and must have a lower long wick (shadow) which must be at least twice the size of the body. The body is constituted by the open and close prices, while the lower wick is the portion driven by the low price. To ensure longer size of the lower wick, the lower the value of the low price the better. Upper wick should not be there, or should be of relatively insignificant length. A gap that may exist at the opening and closing adds to the strength of the signal and bolsters the chances of price reversal. As for the confirmation candle, the bigger its body the stronger the reversal signal. The hammer candle can have any size and any color. The only exception is that it should not be the Four-priced Doji Candle which has all four of its prices (open, high, low and close) as same. The next requirement for a reliable hammer pattern is that it should form during an ongoing downward price move. Formation of a hammer candle pattern indicates that the price reversal is possible, and the ongoing trend of the red-colored candles is expected to come to a halt. Before entering a trade based on the emergence of the hammer pattern, many traders may like to wait for a confirmation candle to be formed. If a green-colored confirmation candle is formed, it further confirms the premise that the prices are set to go upwards in near future and the downtrend has ended. Its time to go long on the stock (buy), or cut the losses if already holding a short position. This is how a typical hammer candlestick appears:
Trading the Hammer Candlestick
The hammers form very regularly on the price charts of stocks, ETFs and market indexes - so one must be cautious to spot the right circumstances before jumping into a trade. Here are the dynamics of the market resulting in the construction of the hammers.
During a downtrend, the sellers (bears) are leading the race and pushing the stock prices down. After few such red-colored candles, the hammer appears which has a small body formed of open and close prices, but a very long lower wick. It indicates that the price went to pretty low value, but rebounded from there to near around the open price. It means that the buyers (bulls) are now able to match the sellers. This state indicates indecision that has developed amid ongoing downtrend, and hence there is a good possibility that prices may rebound to move upwards. The confirmation candle which should be green in color - that is, a bullish candle - will further support this premise, and longer this confirmation candle the better. It will mean that buyers are now taking charge of the market prices and outpacing the sellers. If following a downtrend, there is a hammer pattern formed and that is followed by a bullish green-colored candle, it indicates that the sellers are being outpaced by the buyers, and the chances of price reversal looks good in the near future. If either of the hammer and/or the confirmation candle is accompanied by a considerably huge volume, then it bumps up the chances of price reversal. The buyers have returned to the market in full swing with high buying demand, and hence they are getting stronger and are able to push up the prices. Therefore, its time to go long - that is, buy the security, or cut the losses if holding a short position.
The hammer candle pattern gains significance when formed during the downtrend. The formation establishes the base for a potential reversal in prices after the downward move. Traders enter the trade when the hammer is formed at the breakout of the lower Bollinger band, or at the breakout of the trend-line (like 200-day moving average), or at the breakouts of any other suitable ranges. The larger the breakout indicated by the length of the candlestick (mainly the lower wick of hammer), the stronger the reversal pattern. If the hammer is formed in the middle Bollinger band or far away from the trend-line (without breaching the trend-line), then the traders may not consider it as a strong reversal signal and they avoid the trade. When formed around the middle band or away from the breakout range, the hammer often leads to continuation of the existing trend instead of a reversal.
Trading Scenario for Hammer Candlestick Chart Pattern
The following are the general considerations and scenrio for trading the hammer candlestick.
▶ Trade Entry: Formation of hammer during a downtrend is taken as a sign of reversal, that is - the market prices are expected to go up in the near term. So traders try to take a long or buy position at or around the low price of the hammer candle. As a few traders may like to wait for the confirmation candle to form, their purchase price may be higher as the trend made the move which took the prices upwards. That's the tradeoff one needs to accept if waiting for a confirmation candle.
▶ Stop-loss Limit: The stop-loss varies from trader to trader based on their individual trade preferences, but usually while going long they set the stop-loss at 2-3 units below the low price of the hammer baby candle. Others who enter at a higher price should adjust the stop-loss proportionatly.
▶ Profit-levels: While active trading at short intervals, traders must follow a risk-reward ratio to determine the possible profit level from their hammer pattern trading. For instance, if the stop-loss limit is set at $1 (the maximum loss one is willing to take on a trade) and the risk-reward ratio one follows is 1/2, then one must take profits when it hits $2. If the risk-reward ratio being followed is 1/3, then one must aim for profits when the price hits a level that generated $3 for every $1 stop-loss set.
▶ Market Conditions: Along with the above mentioned hammer formation requirement, traders should ensure that their selected price range, bands or trend-line limits are getting breached with large moves of the second bearish (and subsequent) candle. This ensures higher success rate of profitability. Although one must note that trading on technical analysis like candlestick patterns has limited success rate, so following strict stop-loss, disciplined trading and efficient capital management is advised.
Example of Hammer Candlestick
The following chart shows an instance of hammer candlesticks and the uptrend that followed shortly after: As one can observe in the above chart, the formation of the hammer candle, where the candle has a considerably long lower wick, reversed the ongoing downtrend that preceded the first red candle, and led to an upward move indicated by the long green arrow. Additionally, there was a range breakout with large value which added to the possibility of the price reversal. Traders usually set their profit targets and stop-loss levels based on the risk-reward ratio of their choice as mentioned in the previous section.
Latest Hammer Formations
Now that you've learned the basics of trading the hammer candlestick patterns, its time to check for the latest formations of these candlestick patterns on the stock price charts. FKnol.com has a dedicated section on candlesticks where the list of stocks and indices forming the hammer candles is updated on a daily basis. We cover different stock markets around the globe for formation of hammer candlestick chart patterns. Please select the market from the following dropdown list to see the hammer candlestick chart patterns formed most recently:
The Bottom Line
Trading candlesticks like the hammer needs strict discipline and emotion-free trading. Candlestick trading is a part of technical analysis and success rate may vary depending upon the type of stock selected and the overall market conditions. Use of proper stop-loss, profit level and capital management is advised.