The hammer pattern, also called the “takuri line,” is a commonly used candlestick pattern to trade assets. It is said to have a reliability of 64%, making it one of the more reliable candlestick patterns out there. But what does this mean for traders? What is a hammer pattern in candlestick trading?
A hammer pattern is a reversal candlestick pattern. The term describes a hammer-shaped candlestick that can be formed in trading, which has a lower shadow at least twice the size of the candlestick’s real body.
The hammer occurs when a security trades at a price point significantly lower than its opening price but “rallies” or makes a comeback during the period to the level of its opening price. The most common Hammer patterns are bullish reversal patterns that form after a downtrend.
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Table of Contents
How to Identify Hammer Pattern in Candlestick Trading?
Identifying a hammer pattern in candlestick trading goes beyond identifying the single line that makes up the hammer pattern itself.
Construction of Hammer Pattern
Described below are the two components that comprise a hammer pattern –
- Small Body – The opening price and closing price are both close to the price high of the period. This causes the hammer to have a small body compared to its wick, which is situated at the top of it.
- Long Wick – The lower shadow of the candle is long because the price low is far away from the other three price points that must be noted.
Characteristics of Hammer Pattern
Described below are the key characteristics that can further help with identifying the hammer pattern –
- Color – Hammers can appear on the chart as green or red. It can be a hammer candlestick pattern irrespective of the color, but the latter (green) is a stronger hammer since the closing price occurs at the top of the candle above the open price. This signals strong momentum.
- Downward Trend – A hammer pattern is formed at the low point of a preceding downtrend. This is such that the hammer ends up becoming an indication of a bullish reversal. This is also what sets this pattern apart from the hangman or the inverse hammer pattern (each forming at the top of an uptrend in contrast).
- Upper Shadow – The candlestick has little to no upper shadow or wick; this implies, as mentioned in the previous subsection, that the closing and opening prices are close together.
- Lower Shadow – Conversely, the lower shadow of the hammer is very long, indicating that there is an increasing level of buying pushing the price up, and the reversal signal many traders are seeking is defined by the length of this shadow.
How to Interpret the Hammer Pattern?
There are two main groups of traders to take into consideration here:
- Traders who believe the asset’s price will fall during the trade period and so are selling or short selling to make a profit. This group is often called the “bears.”
- Traders who believe the asset’s price should experience an increase or uptrend and so buy shares in anticipation of this event. This group is called the “bulls.”
The long wick of the hammer candlestick pattern indicates that there was more activity from bears than bulls during the middle of the period, pushing the rice downward.
But the fact that the candlestick closes back up as high as it started shows that the bullish transactions at a point exceeded bearish trades. (There were more buyers than sellers.) The momentum of the bullish pressure pushed the price back up for the close.
How to Improve the Reliability of Hammer Pattern in Candlestick Trading?
Traders regularly use price or trend analysis indicators in tandem with the hammer pattern to further confirm its reliability. Trend indicators such as moving averages, momentum indicators, trend lines, and chart patterns are all useful examples. The proper one to use, however, will be dependent on the timeline of the trade.
- Stochastic Indicator – The stochastic indicator is a measure of momentum which can be coupled with candlesticks to ensure that a trader does not make a purchasing transaction on a stock that is already appearing to be overbought and vice versa. If the indicator is above 70% shortly after a regular hammer candlestick pattern, the reversal may have already reached an upper limit and could be reversing again.
- Price Channels – As trend indicators, studying the direction of the upper and lower channels of price channels, can further confirm if a hammer pattern is indeed indicating a reversal. If the trendlines are sloping downward before the hammer and they indicate that the direction is reversing shortly after the candlestick, this is a good confirmation of the reversal.
- MACD – Another useful tool to have is “Moving Average Convergence Divergence,” which will be discussed in more detail in the next section.
How to Trade Hammer Pattern in Candlestick Trading?
One key strategy used when trading with the hammer pattern involves MACD. This trading strategy is meant for short term traders such as day traders who can benefit from temporary changes in price predicted by a single candlestick like the hammer pattern.
Market Environment
First, there must be a bearish trend in the market for this trade to work. That is to say, the price of the asset in the market must be experiencing a downtrend before the hammer pattern candlestick occurs.
On the MACD, look for its larger moving average to be moving below its shorter moving average, then identify a trade opportunity.
Identify and Confirm Trade Opportunity
A bullish hammer candlestick must form at the end of the downtrend before the trade can be identified. The hammer pattern must also have a strong shadow.
The candle’s color does not necessarily matter because the outcome is the same. However, a white or green hammer is ideal since it indicates that there is higher momentum in the bullish reversal. Some traders will wait to see a green or a white-colored confirmation to show there is momentum in the price uptrend.
Determine Trade Entry, Stop Loss and Take Profit Levels
- Trade Entry – Wait for a confirmation of the reversal before trading. You can find the confirmation in a couple of ways:
- Find a bullish candle that follows the hammer candlestick pattern, indicating that bullish momentum has occurred. This candle should appear green or white in the chart.
- Use a moving average indicator like the moving average convergence divergence (MACD) to confirm an uptrend is occurring. Look for the shorter moving average to be moving above the longer moving average.
- Stop-Loss – Place your stop-loss below the support level. You can use Fibonacci retracement levels to determine your support level based on the case you are dealing with.
- Take Profit – The take profit level you set will be dependent on the momentum of the market and the location of the trend on the chart. As a rule of thumb, aim to make a profit that will equal at least half the distance between the hammer’s high and low prices added to your point of entry.
Execute and Manage Trade
Keep in mind that trading on a hammer pattern is meant for short-term, high-speed trading such as day trading. The market could be indicating that a bullish reversal will occur, but it does not pull through on that.
Be wary of false signals, some of which can be identified by using complementary trading tools such as the MACD mentioned above. If the pattern fails to reverse and is a false signal, your best bet is to exit the trade first.
Advantages and Limitations of Trading Hammer Patterns
While the hammer pattern is considered quite reliable in candlestick trading, it does comes with its own set of advantages and disadvantages. To effectively trade this pattern, it is critical that you account for these pros and cons in your overall trading strategy.
Therefore, let us briefly discuss various strengths and weaknesses of the hammer pattern in the following sections.
Advantages of Trading Hammer Pattern
Listed below are the primary advantages of trading the hammer pattern –
- It is relatively easy to spot and trade using this pattern
- The appearance of this pattern is quite frequent, and it therefore provides enough trading opportunities
- It is ideal for short-term, fast-paced trading
Limitations of Trading Hammer Pattern
Listed below are the primary limitations of trading the hammer pattern –
- It does not guarantee a reversal in the price trend
- It is rarely sufficient as a standalone indicator
- It is known to produce false signals in a volatile trading environment
Candlestick Pattern Opposite to Hammer Pattern
There are other candlestick forms like the hammer, sometimes considered their own, other times considered types of hammers.
- For example, there is the hanging man, which shows a bullish reversal at the end of an uptrend.
- Then there is the inverted hammer, which is the inverse of the hammer (as its name implies) and is a signal of bearish reversal.
- A shooting star is also an inverted hammer at the end of an uptrend.
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Conclusion
There is a lot to decipher when it comes to the hammer candlestick pattern. Candlestick patterns are not like other indicators that can cover a larger area. This pattern, for example, is a single line on the chart. Whether it can genuinely predict future pricing trends, given that it does not give a large amount of information to work with, is one of the major questions traders have of its use.
All this being said, this pattern is beneficial for traders who are short-term and react quickly to changes in price to make a profit, especially when paired with MACD.
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