What is a Hammer Candlestick? Example and How to Trade It

As a trader, you might have encountered various candlestick patterns, but the hammer candlestick stands out. This pattern provides valuable insights into market sentiment, helping me make informed trading decisions. Understanding how to identify and interpret hammer candlesticks can significantly enhance my trading strategy. 

This blog will help you understand what hammer candlesticks are, the different types, how they appear, their advantages and drawbacks, and how to utilise the inverted hammer candlestick pattern in my trading analysis. 

What is Hammer Candlestick? 

The hammer candlestick is a specific type of candlestick pattern that signals potential market reversals. It usually appears at the bottom of a downtrend and implies that buyers are starting to gain strength.

Key features of the hammer candlestick include

• A small body, which can be red or green.
• A long lower shadow that is at least double the length of the body.
• Little to no upper shadow.

This pattern indicates that while sellers pushed the price down during the session, buyers stepped in, pushing the price back up before the close. Recognising this pattern can help traders make timely decisions.

Types of Hammer Candlesticks

There are two main types of hammer candlesticks: the regular hammer and the inverted hammer.

How Does the Hammer Candlestick Pattern Appear?

The hammer candlestick pattern usually shows up after a downtrend. Understanding how it forms can help traders identify potential market reversals.

1. Opening Price: The price opens lower, indicating that sellers are in control at the start of the trading session.
2. Price Drop: Following the opening, the price falls significantly. This drop creates a long, lower shadow, which reflects intense selling pressure during the session.

3. Price Recovery: As the trading period continues, buyers begin to enter the market. Their buying activity pushes the price back up, resulting in a small body located near the top of the trading range.

Also Read: What is ASM in Stock Market: ASM List and Framework

Advantages of Referring to the Hammer Candlestick Pattern

Using the hammer candlestick pattern in trading offers several advantages that enhance decision-making.

1. Reversal Indicator

• The hammer candlestick acts as a signal for potential market reversals. 
• This pattern helps identify the right time to enter a trade, increasing the chances of making profitable decisions.

2. Clear Entry Point

• This pattern provides a clear entry point for traders. It indicates where to place stop-loss orders, which can help limit losses in case the market doesn’t move as expected. 
• Knowing where to set these orders adds an extra layer of protection for investments.

3. Market Psychology Insight

• The hammer candlestick pattern reflects the psychology of market participants. By understanding how buyers and sellers interact, traders can develop better strategies. 
• Recognising shifts in sentiment can lead to more informed trading decisions.

Drawbacks of Employing Hammer Candlestick Patterns

While hammer candlestick patterns can be helpful, there are some drawbacks to consider when using them in trading.

1. False Signals

Hammer patterns may produce false signals. Sometimes, a hammer may appear, but the expected reversal does not happen. This can lead to entering a trade at the wrong time, resulting in potential losses.

2. Need for Confirmation

It is important to wait for confirmation before acting on a hammer pattern. Traders often look for additional indicators or patterns to confirm the reversal. Without this confirmation, the risk of making poor trading decisions increases.

3. Limited Context

The hammer pattern provides limited information on its own. It does not show the overall market trend or other factors influencing price movements. Relying only on this pattern may lead to an incomplete analysis.

4. Market Volatility

In highly volatile markets, hammer patterns’ effectiveness may diminish. Rapid price changes can distort the pattern, making it less reliable. Traders should be cautious when using hammer patterns in such conditions.

Related Chart Patterns to Hammer Candlestick

While the Hammer candlestick signals a potential reversal, traders also confirm their research using other chart patterns. One such powerful pattern is the Pennant chart pattern.

The Pennant chart pattern is a continuation pattern that generally forms after a large price move. While the Hammer suggests a reversal, the Pennant shows that momentum may continue after a quick consolidation. If a Hammer appears at the base of a Pennant’s flagpole, it may be an early sign of a potential breakout.

Traders often look for Hammer candlesticks to identify potential reversal points and then wait for Pennant formations to ensure trend continuation. Using both together improves confidence in trading.

How to Use Inverted Hammer Candlestick Pattern in Trading Analysis?

When an inverted hammer appears, there are several important steps to follow for practical trading analysis.

1. Look for Confirmation

After spotting an inverted hammer, waiting for the next candlestick is crucial. A confirming candlestick should ideally show bullish movement. This confirmation helps ensure that a reversal is likely.

2. Volume Analysis

Checking the volume during the appearance of the inverted hammer is essential. High volume can indicate stronger market interest and lend credibility to the reversal signal. If the volume is low, the signal may be less reliable.

3. Combine with Other Indicators

Relying solely on the inverted hammer may not provide a complete picture. It is beneficial to use other technical indicators alongside the hammer pattern. Indicators such as the Relative Strength Index (RSI)  can provide further confirmation and insights into market trends.

Example of Hammer Candlestick Pattern

Let’s say Mr. Ajay is tracking the price movements of XYZ stock. After studying the candlestick chart for the stock, he identified a bullish hammer in a downtrend after three bearish candlesticks. Thinking it indicates a trend reversal, Mr. Ajay buys 200 shares of XYZ at Rs. 150 per share. 

After placing the buy order, the stock’s price jumps due to the expected uptrend. He sells all the shares at Rs. 200 per share and makes a profit of Rs. 10,000. A hammer candlestick pattern appears in a downtrend when the price of a stock is facing an evident decline. This pattern suggests that the market is in a downtrend during a specific period and is expected to witness a pullback before closing. 

When a hammer forms after at least three bearish candles, it generally shows a bullish trend reversal. By determining such signals and entering and exiting the market at the right time, traders can take the correct position and leverage it. 

Trading Strategies Based on the Hammer Pattern

When responding to possible price reversals, a trader’s strategy may include the hammer pattern when making trading decisions. The following are a few tactics that traders often consider using: 

• Stop Loss: To lower possible losses if the market moves further against the trader, it would make sense to put a stop loss below the hammer’s bottom. 

• Profit Target: Profit targets can be set at the next resistance level or based on a risk-reward ratio from the entry point. 

• Entry Point: A trader can try to open a long position if the hammer pattern is confirmed. Generally, the next candle’s closure above the hammer’s high would suggest confirmation.

Conclusion

The hammer candlestick serves as a vital tool in trading strategies. Understanding how it forms and what it signifies can lead to better-informed decisions. Recognising its potential to indicate market reversals enhances overall trading strategies. However, relying solely on the hammer candlestick is not advisable. Combining this knowledge with other technical analysis tools and considering various market factors is essential for successful trading.