The Hammer candlestick pattern is a bullish reversal pattern, characterized by a short body, little or no upper wick, and a long lower wick that is typically two times the length of the body, resembling a hammer.
Appearing after a downtrend, the Hammer candlestick pattern signals a potential market bottom, reflecting sellers’ failure to maintain lower prices and the buyers’ determination to drive the price back up, indicating a possible shift in momentum.
Structure of Hammer Candlestick Pattern
Identifying the Hammer candlestick pattern on a chart involves understanding its key characteristics:
- Prevailing Trend: The Hammer pattern is a bullish reversal pattern and thus should appear after a downtrend. It suggests the market may be bottoming out and a potential upward move could be on the way.
- Candlestick Shape: A Hammer candlestick has a small body, little or no upper wick, and a long lower wick. The lower wick should be at least twice as long as the body, giving it the appearance of a hammer.
- Color of the Body: The color of the Hammer candlestick body can be either red (bearish) or green (bullish), although a green (bullish) Hammer is usually a stronger bullish signal as it indicates the closing price was higher than the opening price.
- Position on the Chart: The Hammer should appear at the bottom of a downtrend. This positioning can suggest an impending shift in market sentiment from bearish to bullish.
Significance
The Hammer candlestick pattern holds significant meaning for traders, with its main significances and indications as follows:
- Bullish Reversal: The Hammer is primarily a bullish reversal pattern, indicating that a downtrend might be nearing its end. It suggests that the selling pressure of the market is diminishing and buyers are starting to take control.
- Market Psychology: The long lower wick represents a period during which sellers pushed the price down, but buyers were able to overcome this selling pressure and close near the opening price. This shift suggests a change in market sentiment and can signal a bullish reversal.
- Confirmation Required: Like all technical analysis patterns, a single Hammer candlestick isn’t sufficient for executing a trade decision. The bullish reversal is confirmed if the next candle closes above the high of the Hammer candle.
- Volume: The significance of a Hammer increases with higher trading volume on the day the Hammer forms. High volume indicates stronger participation in the price move and can validate the reversal signal.
Market Maker’s Behavior during formation of Hammer Candlestick
When a Hammer candlestick pattern forms, it often indicates certain actions and behaviors by large institutional traders that can be useful for retail traders to understand:
- Testing Lower Levels: The long lower wick of the Hammer represents a period during which big traders pushed the price significantly lower. However, if the price is pushed back up and the candle closes near its opening level, this indicates that lower prices were rejected, suggesting that the bears may be losing their grip.
- Potential Reversal: The Hammer pattern after a significant downtrend often suggests that big traders are starting to take profits from their short positions, leading to buying pressure that could signal the start of a bullish reversal.
- Wait and See Approach: Many big traders wait for additional confirmation following a Hammer pattern before initiating significant long positions. This confirmation could be in the form of a gap up or a long bullish candle.
- High Volume: If the Hammer candle is accompanied by high volume, this is an indication that a lot of big traders participated in this price movement, which could make the potential reversal more reliable.
Understanding these possible behaviors by large institutional traders can help retail traders better anticipate future price movements.
Confirmation Tools
Here’s a table of four potential confirmation tools that can help validate a Hammer candlestick pattern:
| Confirmation Tool | Description |
|---|---|
| Key Levels | A Hammer’s significance increases when it forms near significant support levels. It indicates a strong reaction to these price levels and a potential reversal. |
| Follow-through Bullish Candle | A strong bullish candle following a Hammer can act as a confirmation of a trend reversal. Ideally, this candle should close above the high of the Hammer. |
| High Volume | High trading volume on the Hammer candle can indicate a stronger reversal signal. It shows that the price rejection indicated by the Hammer involved significant market participants. |
Important Points to note
Best Timeframe: While the Hammer candlestick pattern can be identified in any timeframe, its reliability tends to increase on longer timeframes such as the 1-hour, 4-hour, or daily charts. These timeframes filter out a lot of market noise and provide a clearer picture of potential reversals.
Trading Session: The Hammer pattern can form in any trading session, but those appearing during high liquidity sessions, such as the overlap of London and New York sessions for forex trading, can provide stronger reversal signals due to increased volume and volatility.
Winning Ratio: As with any technical pattern, the winning ratio can significantly vary. When used properly with other technical analysis tools and confirmation signals, the Hammer pattern could yield a winning ratio in the range of 50% to 70%.
Trading strategy
- Identifying the Pattern and Confluence Zone: Seek a Hammer candlestick pattern that has formed near a well-established support level. The combination of these elements can enhance the probability of a successful trade.
- Entry Point: Once the Hammer pattern is identified at a key support level, wait for the next candle to close above the high of the Hammer, which acts as a bullish confirmation. This would serve as your entry point for a long trade.
- Stop Loss: Set the stop loss slightly below the low of the Hammer candlestick. This accounts for market volatility and minimizes potential losses if the price moves against your position.
- Take Profit: Your take profit level could be determined by the next significant resistance level or by applying a risk-reward ratio consistent with your overall trading strategy, like 1:2 or 1:3, for instance.
Conclusion
The Hammer candlestick pattern is a potentially powerful signal for identifying market reversals at support levels. As with any trading pattern, it is not foolproof and should be used alongside other indicators and technical analysis tools to confirm its validity. Moreover, a robust risk management strategy should always be in place to protect your capital.
