Predicting market movements is tough. Yet technical analysis offers some help as it tries to make sense of stock market moves by creating and interpreting charts. Essentially, stock market participants come in two types: traders and investors. A trader places trades for a short period, sometimes even for a few hours, while an investor buys a stock or security and holds it longer. In this blog post, we will discuss the hammer candlestick pattern, a chart tool traders use to interpret the price movement of stocks.
To elaborate, traders will place a trade in the stock to benefit from the price movement once they identify this pattern. We will explain what a hammer candlestick pattern is, how you can identify it as a trader, and how you can use it to make a trade that could be beneficial. Read on to learn more about the hammer candlestick pattern.
What is a hammer candlestick?
Chartists extensively use candlestick charts for technical analysis as they factor in the emotions of traders. How can a chart depict emotions?
The candlestick charts visually depict emotions wherein the candle’s size and color signify the price moves and the magnitude of the price movements.
The hammer candlestick pattern is formed when the stock opens at a higher price and then it gives up gains to trade at a price that is significantly lower than the opening price. However, owing to the buying pressure, the stock starts rallying within one trading period to close near its opening price.
This price movement forms a hammer-shaped candlestick. Here, the lower shadow of the candle will be at least twice the size of the body. The body of the candlestick represents the difference between the opening and closing price, while the wick-like shadows on either end depict the high and low prices for the period.
The hammer candlestick pattern looks similar to the letter ‘T’. The hammer pattern does not indicate a price reversal to the upside until it is confirmed.
It is important to note that the hammer candlestick pattern helps with short-term and intra-day trading decisions. It might not be useful for long-term investment decisions.
The meaning behind hammer candlestick patterns
The hammer candlestick pattern can be indicative of a bullish price reversal. But the formation on the hammer is simply not enough, and there needs to be reversal price action in the security to create a bullish trend.
The hammer candlestick chart given below will help you understand the concept better:
The hammer candlestick pattern like the one above is formed when the stock opens in green but gives up the gains as the selling pressure increases. The lower price attracts buyers, driving the stock’s price back up to near its opening price. The buying pressure can sometimes be so intense that the closing price might be higher than the opening price.
Identifying hammer candlestick patterns
The above chart shows what a hammer candlestick pattern looks like. The candles show a price decline followed by the hammer formation shadow being more than double in length compared to the hammer body.
The green candles post the hammer formation denote confirmation of price reversal to the upside. The chart also indicates that buyers can absorb the selling pressure with the closing price ending above the opening price.
Traders usually place a trade after the confirmation candle. To limit the downside if the price reversal does not happen, the traders place a stop loss below the low of the hammer or the body if the price moves aggressively higher during the confirmation candle.
The hammer candlestick as shown above is a bullish reversal pattern that signals a potential price bottom followed by an upward move. Typically, it will have the following characteristics:
- A small body at the upper end of the trading range.
- A long lower shadow, typically two times or more the length of the body.
- Little to no upper shadow.
A green or bullish hammer candlestick pattern is a stronger formation than a red or bearish pattern. This is because the green pattern shows that buyers or bulls could overshadow sellers. It also shows that bulls can drive the prices above the opening price.
Interestingly, a red or bearish candlestick pattern is also a bullish sign. It shows that buyers were able to absorb the selling pressure but could not drive the price above the opening price.
Types of hammer candlestick patterns
Not all hammer candlestick patterns denote the same thing. Here are some of the different patterns and what they indicate.
- Bullish candlestick hammer
The bullish candlestick pattern is formed when the closing price is higher than the opening price, indicating that the bulls overpowered the bears before market close.
- Bullish inverted hammer
When the opening price goes below the closing price, it is an inverted hammer. The inverted hammer indicates a bullish reversal that appears after a downtrend. The pattern indicates a reduction in buying pressure just before market closing.
- Bearish candlestick hammer
The bearish candlestick hammer, also known as the hanging man pattern, occurs when the opening price is higher than the closing price, creating a red candle. This happens because the market is experiencing selling pressure. Essentially, this indicates a potential negative trend reversal.
- Bearish inverted hammer
Popularly known as the shooting star candlestick pattern, it just looks like a regular inverted candlestick pattern, but it signals changes of a bearish trend reversal instead of a bullish one. You can notice this pattern when the stock’s opening price goes above the closing price.
Example of hammer candlestick in trading
Hammer candlestick patterns can happen in any stock, currency, or commodity. Irrespective of the underlying security, the significance of the hammer formation remains the same. While the chart above depicts the price movement of a stock, let’s understand the hammer pattern formation price movement with the help of an example.
Mr. Raj is tracking the price changes of XYZ stock. His preferred method of stock analysis for trading is to study the candlestick charts. While going through the candlestick chart of XYZ stock, he comes across a bullish hammer in a downtrend after three bearish candles.
Mr Raj interprets the pattern as an indicator of price reversal and he buys 1,000 shares of XYZ at Rs 150 apiece.
After he placed the trade, the stock price jumped to Rs. 170 a share, netting him a profit of Rs. 20,000.
As Mr. Raj observed above, a hammer candlestick pattern indicates the stock is in a downtrend but is expected to pull back before the market closes. The bullish pullback is depicted by the three bearish candles.
Traders who have experience with the candlestick charts can leverage profitable opportunities by identifying such signals and entering and exiting the market at the right time.
How to incorporate hammer patterns into your trading strategy
Here are some steps to identify and incorporate hammer candlestick patterns in trade.
- Identify a hammer
First, you need to identify the hammer candlestick pattern. Ascertain whether it is a green or red hammer to identify if it is a bullish or bearish pattern. We have discussed the bullish and bearish patterns above.
- Confirmation
A hammer candlestick pattern isn’t confirmed until subsequent price action confirms a trend reversal. In other words, the candlestick formed immediately after the hammer signal should confirm the upward price movement.
Traders looking to profit from a hammer signal often place a trade during the formation of the upward confirmation candle.
- Place the Trade
Once the traders identify the hammer on the candlestick chart, they can decide on the entry point which should be above the high point of the hammer. They can set the stop loss below the hammer’s lowest point of the wick which will help control the potential loss in case the reversal does not occur.
- Book Profit
Finally, the trader can book a profit when the price reaches the targeted price. Technical analysis helps traders identify potential profits in different stocks based on their risk tolerance and return expectations.
Common mistakes to avoid
No single strategy is foolproof and this holds when you base your trading decisions solely on hammer candlestick patterns. When using charts for trading, the skill lies in the trader’s ability to read the charts accurately, leaving no room for misinterpretation.
Another common mistake traders make is to use the candlestick chart data in isolation. One should always read the charts in combination with other indicators such as the broader market momentum, market volatility, and financial analysis of the company.
Furthermore, hammer patterns don’t provide a price target, so figuring out the exit price for a hammer trade is difficult. Hence, traders should take risks only after gaining some experience. Exits need to be based on other types of candlestick patterns or analysis. Furthermore, traders should be disciplined in their trading approach while keeping greed in check.
Conclusion
Hammer candlestick pattern has its pros and cons like other chart-based patterns and trading techniques. The most significant drawback of this classic chart pattern is that the exit price has to be determined by the trader which can lead to errors. A safe approach would be to look at a broad range of technical analysis tools before executing a trade.
FAQs
Is a hammer bullish or bearish?
The hammer candlestick is a bullish trading pattern. The formation suggests that a stock, currency, or commodity has found its bottom and is poised for a trend reversal.
What is the hammer candlestick used for?
A hammer candlestick helps traders predict stock price movement during a trading session.
Is the red hammer candle bullish?
A red or bearish candlestick pattern is a bullish sign. It shows that buyers could absorb the selling pressure, but were unable to drive the price above the opening price.
What is the difference between a red hammer and a green hammer?
A green or bullish hammer candlestick pattern is a stronger formation than a red or bearish pattern. This is because the green pattern shows that bulls can overpower the bears. It also shows bulls could drive the prices above the opening price.
