What is a Hammer Candlestick Formation? Hammer in Trading

Candlestick chart patterns are great because they give you a single, clear picture of the struggles in market psychology that are going on within a trading session. Indeed, there’s an ongoing struggle in the minds of all the traders monitoring a security’s price action on a given day. Success depends on understanding price trends and going with them at just the right moment. Powerful emotions cloud your vision, though, and it’s hard to get an unbiased view of the facts. There aren’t many people who feel indifferent to the prospect of missing out on earning a large sum of money.

For those of us who are interested in overcoming the pull and push of emotion, and who are serious about basing their trading decisions on professional criteria, it’s crucial to develop a strategy. Candlestick charts can imbue your strategy with a lot more power because they finetune your expertise in the crucial factor behind price movements: human psychology. The colors and shapes on candlestick charts give you an idea of some of the emotional journeys people experienced during a trading session. And we are interested in these experiences for one simple reason: they could make a big difference to what traders will do next.

Once you realize this, it’ll be clear why each candlestick pattern must be viewed in the context of the price history. You may identify a chart pattern that looks exactly like a Hammer but, if it’s located in the middle of an uptrend, this is no Hammer. A Hammer in trading occurs in the middle of a pronounced downtrend, and it tells us that, possibly, the bearish selling action is about to peter out. If we are correct in our diagnosis, the Hammer will be followed by at least two long white bullish candles, when the forces of buying take control. Getting a hint of this beforehand gives us a chance to open a buy deal on the security and benefiting from that upward price action.

We are not robotic in our devotion to candlestick patterns. We are more like detectives trying to build a case for what future price action will look like. With diligent practice, you can gain a finer feeling for which candlesticks on your charts are the key ones to be watching at the moment. You’ll also get used to consulting other indicators to further strengthen your convictions. While it’s very important to be correct and precise when identifying candlestick chart patterns, bear in mind what they are actually telling you: a limited piece of information about price action in a fixed time period. Remember to introduce context to your candlestick chart analysis. The traffic light you find yourself looking at, when you’re sitting in your car this afternoon, may appear green, but if there’s a huge sixteen-wheeler truck careening across your path, you would be well advised to pause before applying the accelerator.

Hammer candlestick patterns have a solid reputation as bullish indicators. They are also relatively easy to recognize, consisting of only a single bar. While the colours of the previous bars matter, the Hammer itself can be either black or white (or green or red, depending on the colour system you’re using). As we’ll see, it gives us good reason to believe that the downward price momentum we’ve been seeing until now is about to slow down.

Capitulation- Understanding Hammer Candlesticks

When you’re looking at a Hammer candlestick pattern, what are you actually seeing? Take a look at this Hammer pattern below, which appears in the third of a series of five sessions. Remember that, when you see it on your charts, you won’t yet be able to see the fifth candle or even, maybe, the latter part of the fourth.

Firstly, you have to view it in the context of what came before. As you see in our picture above, the preceding two candles are long black ones, which means the selling pressure exerted by the bears won the sessions over. In the third session, the bears made another spirited effort to drive prices down, as is evident from the long lower shadow of the Hammer candlestick, but, this time, they were fended off by the bulls. Prices were driven well above the session low (indicated by the lower tip of the shadow) to the top of the Hammer’s short real body. The white colour shows prices closed at the top of the real body, which was not the case in the previous two sessions.

In other words, the Hammer candlestick records a standoff when the bulls finally told the bears, “Enough is enough!” Still, before candles four and five appear, we don’t know for sure that prices will keep going up. It’s possible, in fact, that they won’t. But the Hammer gives us a workable probability that the bullishness will continue, especially once we see prices surge up in candle number four. What’s the basis, however, for believing this? After all, candlestick patterns are not mystical oracles but records of real people’s trading activity.

The answer is that what we really see behind this pattern is a capitulation of the bears to the bulls. This doesn’t mean the bullish traders wrestled the bearish ones to the ground and forced them to stop trading. It means that, once the bears were overpowered by the bulls in session three, it’s likely they will go along with rising prices in the following sessions. They’ll accept the fact that a temporary bottom has been established and, because they know what’s good for them, they won’t resist the rising tide. Indeed, it’s often the case that, once prices set off in a certain direction, they keep going for some time before re-adjusting. Traders around the globe who are trying to figure out what will happen to prices next will take a cue from what they’re already doing. Add to this the fact that they won’t want to miss out on a new buying opportunity.

Importance of Confirmation in Hammer Candlesticks

Usually, traders will wait until the uptrend is confirmed before opening a buy position. A cautious approach would be to wait until candle number four closes above the Hammer’s closing price. If you’re less cautious, you could open your deal in the middle of session four, when the uptrend is already clear to be seen. Once it is, you have strong reason to believe that the bulls’ time in the sun has arrived. A stop loss would commonly be placed just below the Hammer’s shadow, in case things don’t go according to plan.

It's a good idea to look for other forms of confirmation too before committing. Many traders will consult other forms of technical analysis to confirm the bullish momentum is building. For instance, they may check to see if trading volume is on the rise during the Hammer candlestick. If it is, then we have more reason to believe a capitulation to the bulls is occurring. Momentum indicators would be another good confirmation to seek out before acting. Hammer candlesticks, like any other candlesticks, should be understood as hints of potential future price action, not as traffic lights that tell you exactly when to open deals and when to close them. The skilled trader incorporates them into his trading strategy, rather than following them blindly.

Support Levels

Another factor that adds to the power of Hammer candlesticks is the fact that traders all around the world who see the pattern are likely to identify it as a price bottom. Just the fact that lots of people view the Hammer as a turnaround point acts, in the way of a self-fulfilling prophecy, to actually make it into one when the buying activity starts. This is like a known support level where prices have repeatedly refused to continue dropping. Whenever prices fall to this point, market participants expect them to rebound. Therefore, they will tend to close any short positions they may have open or add to their long positions. The result is that the support level is confirmed for all participants when prices indeed bounce off this point.

Summing Up Hammer in Trading

A Hammer candlestick can be of help to traders when, in combination with other factors, it signals a bullish reversal is about to happen. Once you have confirmation of the trend change from the following candle, you have sufficient basis to open a buy deal. Remember to check out your pattern thoroughly to make sure it is indeed a Hammer before acting on it. And, as we have mentioned, it’ll be to your benefit to steadily expand your ability to take other indicators into account. After all, we all know the expression: “If the only tool you have is a hammer, you tend to see every problem as a nail”.