Hammer Candlestick: What It Is and How to Use It

What is a Hammer Candlestick?

If you are a trader, most likely, you have faced the importance of candlestick patterns in technical analysis. In that respect, the hammer candlestick pattern shouldn’t be an exception either, and it’s going to attract your attention with it. This single-candle formation gives a hint about the prospective trend reversal and should be an integral part of your trading toolkit.

At its most basic level, a hammer candlestick suggests a possible bullish reversal off a bottom. The shape of this pattern (the long lower shadow and short real body) indicates a change in the dynamics in the marketplace, and you will want to know about that change and how to profit from it.

Features of a Hammer Candlestick

Let’s first explore what structural attributes make up a hammer candlestick. This pattern can be identified by the following major features:

Long Lower Shadow

The long lower shadow or wick or tail of the hammer candlestick is the most prominent part. This should be at least twice as deep as the body of the candle. All this means a severe intraday price drop was seen before the bulls took over and turned prices in their favour.

Small Real Body

The body of the hammer candlestick, or the distance between the open and the close, is small in relation to the lower shadow. This small body indicates that the bulls and the bears were fighting hard, but the bears were winning for most of the day. However, the bulls then took control.

Little to No Upper Shadow

Hammer candlesticks do not usually have an upper shadow, or they may be very short. An absence of the upper wick means the bulls pushed the price back up to, or almost back to, the opening of the trading session before the session’s close.

Hammers vs Other Single-Candle Patterns

Hammer candlesticks are different from other single-candle patterns, such as doji patterns. Even though both of them have small real bodies, the doji candles are described by a lack of an open-close range which separates a distinct definition between opening and closing prices, hence appearing as straight horizontal lines. In contrast to dojis, hammer candlesticks will retain a small but measurable real body.

It also shares a close relationship with the hanging man and shooting star patterns. The difference only occurs in the context within which they occur. Hammers occur in downtrends and are a sign of a probable bullish reversal. The hanging man and shooting star patterns occur in uptrends and are a sign of a probable bearish reversal.

Bullish vs. Bearish Hammer Formations

Hammer candlesticks can also appear in both bullish and bearish contexts. A hammer arising after a downtrend is considered to be a bullish reversal pattern because this implies that the selling pressure has already been digested and the bulls are ready to seize control.

In a bullish context, the formation of a hammer could signal a continuation of the prevailing trend. However, when a hammer candlestick with an inverted appearance is formed in this context — the body of the hammer is at the lower end and a long shadow at the top. Here, this pattern would indicate that the bulls are facing some kind of resistance, and the bears may be gathering strength and momentum.

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The Psychology Behind Hammer Candlesticks

To understand hammer candlesticks, one needs some indispensable knowledge of the dynamics involved in the markets and even the change of sentiment.

Supply and Demand Dynamics

Hammer candlesticks form on the market decline as part of a specific interaction between supply and demand. Early on, the bears are in control and drive the price lower, which produces a long lower shadow. By the end of the trading session, however, the bulls have absorbed the selling, driving the price back up to, or near, the opening level.

This reversal in momentum means that the sellers have reached their wit’s end, which typically indicates that the selling pressure has become weak enough to allow the buyers to come in and cushion the stock in its price.

Sentiment Shifts Reflected in Hammer Patterns

The hammer candlestick would form when a probable formation of the shift in market sentiment occurs. Throughout a downtrend, the bears have been in control, forcing the price lower. It means that a hammer should show that the bulls are resuming some control, maybe that selling pressure is exhausted and a bullish reversal might be at hand.

This is a very significant shift in sentiment because it reflects the market’s perception of the underlying value. That the buyers could push the price back up to, or near, the opening level indicates that they believe the asset is undervalued and worthy of their support.

How to Identify Hammer Candlestick Patterns

When you scan your charts to find hammer candlestick formations, what are the key characteristics you want to look at? 

Visual Characteristics

• Length of Lower Shadow: It should be a minimum of twice as large as the real body, as discussed earlier. The long lower shadow is what classifies the pattern and also reflects the extreme selling pressure that the bulls were able to absorb.

• Size of Real Body: The real body of a hammer candlestick should be small, usually not more than one-quarter or one-third of the extent of the lower shadow. This small body represents the strong conflict between the bulls and bears, out of which the former comes out victorious over the latter.

• Presence or Absence of Upper Shadow: A hammer candlestick must have little or no upper shadow. That would mean that the bulls were able to push the price back up to, or at least near, the opening level by the end of the trading period.

Confirmation Criteria

These are the criteria to confirm that a hammer candlestick has provided a valid reversal signal:

• Relationship to Prior Trend: Because hammer candlesticks are a type of reversal pattern, they should occur after some type of downward price action. When the hammer occurs within an uptrend, it can more likely be read as a pause instead of a full reversal.

• Follow-Through on Next Candle: The candle immediately following the hammer should close above the close of the hammer for confirmation that the bulls are in control and are pushing the price upwards.

In doing so, you can make the hammer pattern more reliable and hence reduce the chances of being falsely signalled.

Incorporate Additional Technical Analysis

Additional factors that one may consider while analyzing the hammer patterns include:

• Support and Resistance Levels: Note where the hammer candlestick forms about established support and resistance levels. If the hammer is at an important support level, that could give a better possible signal for a bullish reversal.

• Trend Lines: Place the hammer candlestick in the context of the bigger trend. If the pattern forms at a point where the price tests an important trend line, that can give even more confirmation of a potential reversal.

• Momentum Indicators: You should then combine your study of the hammer candlestick with readings from momentum indicators like the Relative Strength Indicator or Stochastic Oscillator. Positive divergences between the indicator and price action can help to further confirm the bullish signal.

Strategies for Trading with Hammer Candlesticks

Entry Techniques

There are a couple of ways you could enter trades based on hammer candlestick patterns, including the following:

• Buying on Hammer Confirmation: The most basic and conservative way of entering the trade would be going long on the close of the candle that directly follows the hammer candlestick. It confirms the fact that the bulls have gained control and the price is now being driven higher.

• Wait for Additional Confirmation: Some traders like to get more confirmation, therefore, would wait for one or two more candles to close above the height of the hammer, before taking a long position. That is a more conservative way to trade; it would lower the number of false signals but also has some disadvantages since it could take away part of the price move.

Stop-Loss Placement

A logical place to set your stop-loss when trading with hammer candlesticks is below the low of the hammer’s lower shadow. That level would be considered the point at which the bullish reversal pattern is invalidated and the bears have regained control. You can start adjusting your stop-loss to lock in profits or trailing it behind the price action. That will provide a tighter level of protection while allowing the trade to run.

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Target Selection and Profit-Taking

One of the downsides to using hammer candlestick patterns is that they do not naturally provide any type of price target. You would need to look to other resources available to you in your technical analysis to identify where your profit-taking levels are.

Some logical target selection methods include:

• Identifying key nearby levels of resistance from prior swing highs
• Measuring the height of the hammer pattern and projecting that as a potential upside target
• Using technical indicators, such as Fibonacci retracement levels, to establish reasonable levels of profit-taking

Your profit target levels should be balanced with your risk management principles so that the potential reward will be worth the risk that you are undertaking for the trade.

Managing Risk and Position Sizing

Like all trading systems or strategies, use hammer candlestick patterns with proper risk management. Some things to take note of include:

• Position Sizing: The position size should be based on the overall account size and risk tolerance. You will not want to over-leverage the trade in case the pattern does not play out as anticipated; that could result in substantial losses.

• Stop-Loss Placement: As briefly described earlier, stop-losses can be set below the low of the hammer. On the other hand, this level might have to be adjusted according to market conditions and your holistic risk management approach.

• Diversification: Enter hammer candlestick trades as part of a broader diversified trading plan and not exclusively dependent upon them. This can help reduce the impact of the result from any single trade on your bottom line.

Risks and Limitations of Hammer Candlestick Trading

Potential for False Signals

Like any other technical pattern, hammer candlesticks do at times emit false signals. This could lead to some not-so-profitable trades. It happens in those instances when the apparent reversal just fails to materialize and the market simply keeps right on going with its previous trend or takes a turn nobody expected. 

Challenges in Determining Reward-to-Risk Ratios

One of the major pitfalls of hammer candlestick patterns is that they do not, by nature, clearly determine price targets. This will make it hard to have an attractive reward-to-risk ratio on your trades because you will be looking to your other technical analysis tools for guidance on your profit level determination.

Risky to Rely on Hammers in Isolation

For one, trading with just a hammer candlestick pattern should not be considered. As much as it might give great insight, it has to be taken into consideration with other forms of technical and fundamental analysis so that your trading strategy can be more reliable.

All these disadvantages of trading hammer candlestick patterns can be reduced by recognizing your weaknesses and undertaking proper risk management practices, which will inadvertently improve your overall trading performance.

Conclusion

The hammer candlestick pattern is a powerful tool in technical analysis, through which probable trend reversals can be summarized. A trader needs to understand pattern anatomy, the behind-the-scenes market psychology, and the identification and trading nuances of hammer formations to make more fruitful and better trading decisions.