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Hammer Candlestick: What It Is and How Investors Use It

Sebencapital

Published
02/10/23
Hammer Candlestick: What It Is and How Investors Use It

What Is a Hammer Candlestick?

A hammer is a candlestick pattern used in chart analysis. It appears when a security opens at a certain price, then drops significantly during the trading period, only to recover and close near the opening price. The resulting candlestick looks like a hammer, with a long descending shadow that is at least twice the size of the actual body of the candlestick.

The candlestick's body signifies the difference between the opening and closing prices, while the shadow reflects the highest and lowest prices observed during the trading period.

Key Takeaways

  • Hammer candlesticks are typically seen after a price drop. They are characterized by having a small real body and a long lower shadow.
  • These candlesticks appear when, during a price decline, sellers become active in the market. However, buyers step in by the end of the trading period, absorbing the selling pressure and bringing the market price close to the opening level.
  • The closing price can be either above or below the opening price, but for the real body of the candlestick to stay small, the closing price should be near the opening price.
  • The lower shadow of the hammer candlestick must be at least twice the height of the real body.
  • Hammer candlesticks are a potential signal for a price reversal to the upside. To confirm this, the price should start moving upward following the appearance of the hammer.
Hammer Candlestick

Understanding Hammer Candlesticks

A hammer candlestick pattern emerges when the price of a security has been in a downtrend, indicating that the market is searching for a potential bottom.

Hammers conveys that sellers may be reaching a point of exhaustion, potentially signaling a trend reversal with a move to the upside. This entire scenario occurs within a single trading period, during which the price starts below the opening level but then manages to close near the opening price.

A hammer-shaped candlestick pattern should resemble the letter "T," which is the characteristic shape of a hammer candle. However, it's crucial to understand that a hammer doesn't confirm a price reversal.

Confirmation is necessary, and it happens when the candle following the hammer closes above the hammer's closing price. It's even more convincing if the confirmation candle shows strong buying activity.

Typically, candlestick traders consider entering long positions or exiting short positions during or after the confirmation candle. For those taking new long positions, placing a stop loss order below the low of the hammer's lower shadow is common.

Hammers are seldom used in isolation. Traders often combine them with other forms of analysis, such as price or trend analysis and technical indicators, to strengthen their trading decisions.

It's also important to note that hammers can be observed on various timeframes, including one-minute, daily, and weekly graphs.

Example of How to Use a Hammer Candlestick

Hammer Candlestick

In the chart, we can see a price decline followed by the formation of a hammer pattern. This hammer displayed a distinct characteristic with a long lower shadow, several times longer than the candle's real body. The presence of the hammer suggested a potential reversal in price direction, signaling a move to the upside.

The confirmation of this potential reversal occurred on the next candle. It opened with a gap higher and saw strong buying activity that drove the price significantly above the closing price of the hammer.

Traders often seize the opportunity to enter buying positions during this confirmation candle, taking advantage of the upward momentum. To manage risk, a common practice is placing a stop loss order below the hammer's low.

In some cases, traders may place the stop loss just below the real body of the hammer if the price is surging strongly during the confirmation candle.

This strategy aims to maximize gains while minimizing potential losses, a key principle in trading and investing.

A Difference Between a Hammer Candlestick and the Doji

A doji is a distinct candlestick characterized by a small real body. What sets a doji apart is that it possesses both an upper and a lower shadow, indicating a state of indecision in the market. Depending on the following confirmation, dojis can suggest either a potential price reversal or a continuation of the existing trend.

It's important to note the difference between a doji and a hammer. A hammer typically emerges after a price decline, hinting at a potential reversal to the upside (provided it's followed by confirmation). Hammers are recognized by their unique feature of a long lower shadow.

In contrast, dojis showcase a balance of power between buyers and sellers, signifying a moment of uncertainty in the market. Subsequent price action and confirmation are crucial for determining whether a doji marks a trend reversal or continuation.

Limitations of Using Hammer Candlesticks

While a hammer pattern, especially one with a long lower shadow and a robust confirmation candle, can lead to a significant price increase over a short period, it doesn't guarantee continued upward movement. In some cases, prices may surge quickly within two periods following a hammer pattern and confirmation.

However, this might not be the most opportune moment to initiate a trade because the required stop loss could be far from the entry point. Such a wide stop loss could expose the trader to an unwarranted level of risk that doesn't align with the potential reward.

It's essential to recognize that hammers don't provide a specific price target for traders. Determining the potential reward for a hammer trade can be challenging. Traders may need to rely on other candlestick patterns or various forms of technical analysis to determine their exit points from the trade.

Psychology of the Hammer

An actionable hammer pattern typically appears within a downtrend, where the price chart exhibits a series of lower highs and lower lows. When a hammer pattern emerges, more bullish investors are entering the market, which could reverse the prevailing downward price trend.

The long lower shadow seen in the hammer candlestick illustrates an attempt by sellers to push the price lower. Still, the higher closing price indicated by the real body reveals that these sellers ultimately failed to maintain the price at its intraday low.

The price's recovery from the session's low to a higher closing point suggests that a more optimistic sentiment prevailed, setting the stage for a potential price reversal to the upside.

Practical Application

When you've identified a hammer candlestick on a price chart, you might be enthusiastic about initiating a trade to capitalize on the anticipated price movement.

However, before placing your order, it's important to consider some practical factors that can enhance the effectiveness of your trade based on the hammer pattern.

  • The Hammer Signal

The first step in trading based on a hammer pattern is to confirm that the candlestick pattern you observe matches a hammer's characteristics.

To be a valid hammer signal indicating a potential upward reversal, it should appear in a downtrend, where the price has been consistently declining with lower highs and lower lows.

In this scenario, you should look for a hammer-shaped candlestick with a lower shadow at least twice the length of its real body. The closing price can be slightly above or below the opening price, but the close needs to be close to the open, resulting in a small real body for the candlestick.

  • Looking for Confirmation

Confirmation of a hammer signal happens when the following price action aligns with the anticipated trend reversal. This means that the candlestick immediately following the hammer should validate the expected upward price movement.

Traders who seek to capitalize on a hammer signal typically enter their buy positions while forming this confirming upward candlestick.

  • Placing Stops and Taking Profits

As with any trade, it's advisable to use stop-loss orders to protect your position if the hammer signal doesn't play out as expected. The placement of your stop-loss order should be determined by your confidence in the trade and your risk tolerance.

Setting a stop loss below the low of the hammer pattern can be useful, as it protects in case the market experiences a renewed downward move and the anticipated upward price movement fails to materialize.

On the other hand, when the price begins to rise and validates your recognition of the hammer signal, you'll need to decide on an optimal level to exit the trade and secure your profits. The hammer signal doesn't offer specific guidance on where to place your take-profit order.

To determine an appropriate exit point, consider other factors, such as nearby support or resistance levels, including recent swing lows.

What is a hammer candlestick?

A hammer candlestick is a technological trading pattern resembling a "T." It occurs when the security price opens and falls below its opening price, creating a long lower shadow. Subsequently, it reverses and closes near its opening price. Hammer candlestick patterns typically emerge after a downtrend and are often seen as signals for a potential reversal in the price pattern.

Is a hammer candlestick pattern bullish?

The hammer candlestick is a bullish trading design that suggests a stock has potentially reached its lowest point and is poised for a trend reversal. This pattern indicates that initially, sellers were active in the market, causing the price to decline.

However, buyers eventually took control, driving the asset's price higher. It's crucial to note that the bullish reversal signaled by the hammer must be confirmed by the next candle, which should close above the hammer's earlier closing price.

What is the difference between the hammer candlestick and the shooting star?

A shooting star candlestick pattern suggests a bearish reversal, the opposite of a hammer's bullish reversal. Shooting star patterns appear after an uptrend in a stock's price.

A long upper shadow characterizes them, and they typically open higher but close near the opening price. The shooting star pattern indicates a potential reversal in the price trend, marking the top of the trend.

The Bottom Line

A hammer candlestick pattern forms when a security opens at a certain price, experiences a significant decline during the trading period, but then manages to rally and close near its opening price. The candlestick in this pattern has a distinct hammer shape with a lower shadow at least twice the size of its real body.

This pattern suggests that sellers initially pushed the price lower, but eventually, buyers stepped in, regained control, and brought the price back near its opening level. The hammer pattern serves as a potential indication of a forthcoming price reversal to the upside.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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