Hammer Candlestick

A hammer candlestick formation appears when financial assets, for example, stocks, trade notably below their opening price but surge to close near it by the time the trading period ends. Analysts view it as a potential bullish trend reversal indicator, mainly appearing at the end of a downtrend.

The candlestick shows significant selling pressure at the start of a period, which buyers absorbed and pushed the price up near the opening price within the timeframe. The body represents the difference between opening and closing price while the wicks show the low and high price. Hammer candlestick patterns are of two types – bullish and bearish.

• The hammer candlestick is a pattern formed when a financial asset trades significantly below its opening price but makes a recovery to close near it within a particular period.
• A hammer candlestick mainly appears when a downtrend is about to end.
• Only a hammer candle is not a strong enough sign of a bullish reversal. Therefore, one should look for three bearish candles preceding the hammer and the confirmation candlestick before taking a position. 
• A hanging man candle is similar to a hammer but indicates a bearish reversal. Moreover, unlike a hammer, it appears mainly at the end of an uptrend.

Hammer candlestick pattern refers to a candlestick pattern with the appearance of a hammer or the English alphabet’s ‘T.’ It helps traders identify potential bullish trend reversals. One may find it at the end of a downtrend.  

The lower wick or shadow of the candle is at least twice the size of a very short body with little or no upper shadow. It shows that the buyers overpowered the sellers in a particular trading period. In other words, the buying pressure controlled the asset’s final price action during a specific duration. The longer a hammer’s lower wick, the more the activity concerning an asset.

Hammer candlestick chart serves as effective indicators when they appear after a minimum of three declining candles. However, one must note that this candlestick pattern does not give a strong trend reversal signal until confirmation on the chart. Traders get confirmation when the candle right after the hammer closes higher than the latter’s closing price. Once the confirmation candle appears, traders exit their short position or take a long position. Individuals entering a long position can place a stop-loss order below the hammer’s low price.

Let us look at the different types of hammer candles.

#1 - Bullish Hammer

A bullish or green hammer candlestick is a stronger formation than bearish or red hammer candles as it shows that the buyers or bulls were able to overpower sellers or bears completely. Moreover, this candlestick shows that the bulls were able to drive up the security’s price above the opening price.

#2 - Bearish Hammer

Similar to the green hammer candlestick, the red or bearish hammer candlestick serves as a bullish signal. It shows that the buyers could absorb the selling pressure but could not drive up the asset’s price past the opening price.  

This pattern is a bullish reversal pattern in a chart that can be used to identify possible buying opportunities. The steps to trade using this hammer candlestick pattern are as follows:

• Identification of hammer – The first step is to be able to identify the red or green hammer candlestick as given in the description above. The color of the hammer green or red, indicating a bullish or bearish pattern.
• Confirmation – It should be identified with the context of the trend in prices. It is more significant or strong if it is appearing at the end of a downtrend. The preceeding price action and trend should be used for confirmation. However, if a bullish engulfing candle can strengthen the signal. Even a high volume can indicate that the buying pressure is strong and the price can go up. The support levels should also be checked to decide the possibility of reversal.
• Place The Trade – Once the trader is able to identify the hammer, they can fix the entry point which should be above the high of the hammer, set the stop loss below the hammer’s lowest point of the wick which will help to control the potential loss in case the reversal does not occur.
• Take Profit- Finally the trader can take the profit when the price reaches the specific targeted price level as per the trader’s decision. This entire process of technical analysis helps traders identify potential possibility of profits in different stocks based on their own level of risk tolerance and return expectation.

However, this is not a fullproof strategy because there are various other indicators that should be taken into consideration along with the proper financial analysis of the concerned company, in conjunction with the bullish and bearish hammer candlestick. There should be a discipline in the entire trading approach.

The concept of hammer is easy to understand from the TradingView chart given below. In the chart of Apple Inc. below, there are many hammers marked clearly. Some are green and some are red. After the green ones, there are instances of the market showing either a long or a short uptrend. But, after every red hammer, the market is showing a down trend.

Hammer is a good indicator to identify market trends, but for short term. To understand the long-term movement, it should be used in combination with other indicators.

Source

Let us look at some red or green hammer candlestick examples to understand the concept better:

Example #1

Suppose a trader, Mike, is tracking the price movements of XYZ stock. After looking at the security’s candlestick chart, he identifies a bullish hammer in a downtrend after four declining candlesticks. Hoping it is an indicator of a trend reversal, he buys 50 shares of XYZ stock at $5 per share. After Mike placed the buy order, the stock's price jumped as an uptrend materialized. He sold all the shares at $8 per share and made a profit of $150.

Example #2

West Texas Intermediate (WTI) crude oil price fell during the 3rd week of August 2022. However, the market swiftly recovered, showing some signs of life. The hammer candlestick suggests that traders might see some support at the $90 mark, and there is a possibility that the price can surge up to the $100 mark if we manage to break over the top of the candlestick. However, if the support level breaks, the price can plunge to $80. 

As noted above, a hammer appears in a downtrend, i.e., when the price of an asset is falling. It signals that the market is trying to find the bottom. This pattern indicates a lot of activity surrounding the asset during a particular period — the asset price dropped initially but closed near the opening price following a pullback.

The hammer’s position in the chart also bears crucial signals. A bullish reversal could be on the horizon when a hammer forms after at least three bearish candles, and the candlestick next to the hammer closes above the hammer's closing. Traders can identify the signals and take a suitable position in the market.

Both the above are candlestick forms that provide insight into market sentiments and possibility of price reversal. However, there are some differences between them as follows:

• The hammer candlestick chart and hanging man candlesticks are similar in appearance, and both patterns signal trend reversals. That said, one can find these two candles in different trends. The former appears after a downtrend whereas the latter appears after an uptrend.
• In case the formation of the pattern takes place in an uptrend, signaling a bearish reversal, it is the hanging man pattern. On the other hand, if this pattern appears in a downtrend, indicating a bullish reversal, it is a hammer.
• Traders look for other bullish signals for confirmation like high volume, bullish engulfing candle or support levels to confirm the former, whereas for the latter, the traders look for opposite confirmation like bearish engulfing candle, low volume or resistance levels.

Thus, both of them have similar structure but their implications are different based on where they are placed in the chart. Both of them are used in conjunction with other signals and patterns that are commonly used as technical analysis tools.

The above are again hammer candlesticks with different implication and interpretation as given below:

An inverted hammer candlestick is identical to a hammer, except it is upside down. Moreover, similar to the latter, the former serves as a bullish reversal indicator. An inverted hammer mainly appears at the end of a downtrend and signals the possibility of a new bull run.

This article has been a guide to Hammer Candlestick & its meaning. We explain its types & how to trade, differences with hanging man & examples. You can learn more about it from the following articles -

• Candlestick
• Technical Indicator
• Trade Signal