The hammer candlestick pattern is a significant formation in technical analysis, which offers insights into potential market reversals. It is especially relevant in the Indian financial markets, where traders and investors actively use technical charts to navigate the stock market's volatility.
What is the hammer candlestick pattern
The hammer candlestick pattern is a unique chart formation that signals a potential reversal of a downward trend. It typically indicates a shift towards a bullish sentiment in the market. The pattern is characterised by a small green body and a long lower wick, reflecting the rejection of lower prices by the market. This rejection demonstrates that buyers managed to push the price back up after an initial period of selling pressure.
While the Bullish Hammer is widely recognised and signals a positive trend reversal, traders also observe a related pattern known as the Inverted Hammer, which has a similar reversal implication but with an upward wick.
The hammer candlestick appears specifically in a downtrend and suggests a possible bullish reversal. It gets its name due to its resemblance to a hammer, featuring a small body at the top and an extended lower wick. The green colour of the candle sets it apart from the preceding red candles in a downtrend, with the closing price exceeding the opening price. The extended lower shadow reflects the sellers' initial control, but their inability to sustain the lower price, as buyers ultimately regain control and drive the price upwards, showcasing renewed bullish momentum.
Importance of hammer candlestick patterns
Now that you know what a hammer candlestick pattern is, let us understand its significance for traders. Hammer candlestick pattern can be used in the following ways:
- A hammer candlestick can be a potential leading indicator in intraday trading, signalling a reversal of a bearish trend.
- It can be used to verify or refute a trend’s significant lows or highs. Before closing near the opening price, the price moves up or down, forming a top or bottom. This ‘hammering’ action highlights the importance of hammer candlestick patterns in identifying key market reversals.
- Special attention should be given to the length and duration of the shadow. Typically, the shadow is two or three times the body’s size.
- Hammer candlestick is also studied and relied on in conjunction with other reliable indicators of price reversals, as it lends weight to their insights.
- With all the uses of a hammer candlestick, you should also know when it fails. A hammer candlestick fails in a situation where the subsequent candle forms a new high. On the other hand, a hammer bottom candle can be regarded as a failure when the subsequent candle forms a new low.
Formation and interpretation
A hammer is formed when the market price experiences a significant sell-off after opening. However, before the period closes, the market recovers all or most of the losses to close either above or near the opening price. This action creates a candlestick with a small body and a long lower shadow.
The key to interpreting the hammer pattern lies in subsequent price action. For the pattern to be considered a true bullish reversal, the following candlestick must close above the hammer's closing price, confirming the reversal. They are also known as bullish hammer candlesticks.
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Types of hammer candlestick patterns
There are mainly two variations of the hammer pattern:
1. Hammer candle The classic hammer candle indicates a bullish price reversal. With the closing price higher than the opening, the candle reflects a rising control of buyers in the market. The hammer candlestick has a small body at the upper range of the trading period and a long lower shadow.
2. Inverted hammer candlestick Much like the regular hammer candle, the inverted hammer candlestick is a bullish reversal indicator. However, it is less bullish compared to the regular hammer candlestick. The inverted hammer candlestick signifies that the opening price is less than the closing price, with a long wick at the top. The wick indicates that buyers were increasing the pressure to increase the price. However, it was eventually dragged down before closing.
Additional read: What is fear and greed index
Trading strategies based on the hammer pattern
The hammer pattern can be part of a trader's overall strategy when it comes to acting on potential price reversals. Here are a few strategies that traders often look to use:
- Entry point: A trader may look to enter a long position upon confirmation of the hammer pattern. Typically, the confirmation would be the closing of the following candle above the hammer's high.
- Stop loss: A logical place for a stop loss would be below the low of the hammer to minimise potential losses should the market continue to move against the trader.
- Profit target: The profit targets can be set based on a risk-to-reward ratio or at the next resistance level from the point of entry.
How to trade
A hammer candlestick can be a good indicator for traders to enter the market as it is a sign of a bullish price reversal. Go through the following steps to understand the trend and make smart investments:
1. Identification
The first step in making a smart investment is identifying the candlestick pattern and what it signals. Make sure you consider all the aspects of the candle, including the colour, to better understand and predict the price movement.
2. Confirm the reading
The signal of a hammer candlestick should also be confirmed by the preceding and succeeding candles. For instance, a hammer candle is a stronger indicator when it appears at the end of a negative price movement. Also, a bullish engulfing candlestick strengthens the hammer candle. Before entering the market, you should also check a stock’s support levels.
3. Market entry
Once you have confidence in your reading of the trend and prediction, decide on a point where you will enter the market. The entry point is typically above the hammer’s high point, and the stop loss level is set below the wick’s lowest level. This can help mitigate losses in case the prediction of a price reversal does not come true.
4. Book your profit
Finally, when the stock price reaches the take profit level, you can book your profits. Understanding the basics of technical analysis will help you identify possible market entry points and make profits based on your risk appetite and financial goals.
It must be made clear at this point that the hammer candlestick may be a necessary but not sufficient condition to determine market entry. It can be a good indicator for understanding short-term market trends. For long-term trends, it should be analysed along with other metrics and indicators. Many other facets of technical analysis must be studied along with it to make a well-informed decision.
Examples
Let us now understand the hammer candle and its significance through a couple of examples:
- Example 1
Let us take the example of person ‘A’ who wants to invest in company ‘Y’. Presently, the stock of Y is trading at Rs. 10. So, the trader waits until a downtrend and they spot a bullish hammer candlestick after 5 consecutive declining candles. With the confidence that there will be a price reversal soon, they buy 100 shares at Rs. 8/share. After this, there is indeed a price reversal, and the stock jumps to Rs. 12/share, at which the trader exits the market, booking a profit of Rs. 400. - Example 2
Let us assume that the stock of company ‘S’ is priced at Rs. 92. The stock has recently recovered after experiencing a continued price decline. The hammer candle for this stock indicates that there is a support level at Rs. 90, along with the possibility of an upward price movement, getting the price up to Rs. 100. At the same time, if the support level breaks, the stock may fall to Rs. 80.
Limitations and considerations
While the hammer pattern is a powerful tool, it is not entirely foolproof. Traders should be aware of the limitations of the hammer pattern and consider the following:
- Confirmation: Always wait for confirmation before acting on a hammer pattern.
- Market context: Analyse the overall market context, as the hammer pattern does not guarantee a reversal.
- Complementary indicators: Use the hammer candles in conjunction with other technical indicators for a more robust analysis.
Difference between hammer candlestick and doji
The significant differences between a hammer candle and a Doji can be examined in the table below:
Feature |
Doji |
Hammer |
Appearance |
Small body with long lower and upper wicks |
Small body with a long lower wick (or long top shadow in case of an inverted hammer) |
Indicator |
This indicates the continuation of a trend or a reversal |
Indicates a positive price reversal |
Hammer Vs hanging man
The hammer candle and the hanging man pattern are similar in appearance. Both these candles have a similar structure and are used along with other candles to get market insights. However, they do have some key differences. Here are the differences between a hammer candlestick and the hanging man pattern:
Feature |
Hammer |
Hanging man |
When does it appear |
The hammer candle appears after a downtrend |
The hanging man pattern appears after an uptrend |
Indicator |
It indicates a bullish price reversal |
It indicates a bearish price reversal |
Trend confirmation |
To confirm a bullish trend, along with a hammer candle, traders study signs like support levels, bullish engulfing candles, and high volumes. |
To confirm the bearish trend, signs like resistance levels, bearish engulfing candles, and low volumes are sought. |
While the hammer candle and the hanging man candle look similar, they have completely different indications depending on where they appear.
Hammer vs inverted hammer candlestick
The hammer and inverted hammer candlesticks are both types of hammer candles. They are similar with one difference—the inverted hammer is the exact opposite of the hammer with a short body and a long top wick. Both the candles can be bullish price reversal signs when they appear at the end of a negative price movement.
Conclusion
The hammer candlestick pattern is an important indicator for traders interested in detecting potential trend reversals in share prices on offer. It is recommended that you use it cautiously and only with other technical analysis tools. Your decision-making process in the Indian stock market will be enhanced by gaining a good grip on the hammer pattern and using it judiciously.
