What is a Hammer Candlestick Pattern?

Candlestick patterns are one of the many reliable tools that traders use to predict price movements in an asset. When certain patterns appear on candlestick charts, they are often viewed as an indicator of specific price movements. For instance, the appearance of a particular pattern may signify the continuation of an existing trend, whereas the appearance of another pattern may indicate potential trend reversals. 

As a trader, you must look out for these candlestick patterns on price charts since they can help you identify and interpret market sentiment. One of the most popular patterns that traders widely encounter is the hammer candlestick. 

In this comprehensive guide on the hammer candlestick pattern, we are going to explore the intricacies of the pattern, decode its appearance, and interpret the candle. Additionally, we will also be delving into the importance, limitations, and practical applications of the hammer candle in trading strategies.   

What is a Hammer Candlestick Pattern? 

The hammer candlestick pattern is a single-candle bullish reversal pattern that usually forms at the bottom of a downtrend. The name is derived from the candle’s shape, which resembles a hammer. 

Spotting the hammer in a candlestick chart is easy. It has a short body on the top, with a long lower shadow that is at least twice as long as the body. Some variants of the hammer candle have a short upper wick, whereas others may not have an upper wick at all.  

Decoding the Appearance of the Hammer Candlestick 

Now that you know how to spot a hammer in a candlestick chart, let us understand the logic behind its unique visual appearance.

• The Body

The body of the hammer candle represents the difference between the opening and closing price of the asset. In a typical hammer pattern, this body is usually small, indicating a minor difference between the open and closing prices. 

If the price of the asset closes higher than its opening price, the body of the hammer will be coloured green or white. On the other hand, if the price of the asset closes lower than its opening price, the body of the hammer will be coloured red or black. That said, traders often do not pay much attention to the colour of the hammer. Instead, they focus on its position and the length of its lower wick. 

• The Upper Wick 

As you have already seen, a hammer candlestick may or may not have an upper wick. If the candle has an upper wick, it suggests that the buyers attempted to push the prices higher but were met with significant selling pressure, leading to the price closing lower than the day’s high.    

Meanwhile, if the candle does not have an upper wick, it suggests that the buyers’ attempts to push the prices higher were successful, leading to the asset closing the day on a high. Or, in the case of a red hammer candle, it could mean that the price opened at the day’s high and did not go past this mark throughout the session.    

• The Lower Wick 

The lower wick of the hammer is often considered to be the most important part of the candle. A long lower wick suggests that the sellers attempted to push the price to fall, in line with the current downtrend, but failed due to the sudden influx of a large number of buyers. The increase in buying pressure on the asset pushes the price upward, leading it to close slightly below or slightly above the opening price of the asset. 

Usually, the lower wick of the hammer candlestick must be at least twice the length of the body. However, the longer the lower wick, the stronger the bullish reversal signal is said to be. 

Interpreting the Hammer Candle

As a trader, knowing how to interpret the hammer candle is crucial to making well-informed trading decisions. Here is what the appearance of the candle signifies: 

The hammer pattern is a bullish reversal pattern that appears during a downtrend, typically at the end. After a sustained downward spiral in the asset price, the appearance of the hammer indicates the complex relationship between buyers and sellers, with the buyers ultimately prevailing. 

The long lower shadow of the hammer candle indicates that sellers initially dominated, pushing the price down significantly. However, despite the initial selling pressure, strong buying support emerges, pushing the price back up before the close of the trading period. 

The ability of the buyers to overcome immense selling pressure suggests that the downtrend may be losing momentum and that it could potentially lead to a reversal in the trend from bearish to bullish. 

However, although the hammer candlestick pattern is a signal for a bullish reversal, the reversal may not always happen. That is why many traders wait for confirmation of the reversal in the form of a strong bullish candle or increased trading volume in the period following the appearance of the hammer before entering into a long position.                      

The Importance of the Hammer Candlestick Pattern

The hammer candlestick pattern holds significant importance in technical analysis. Here are some reasons why it is regarded as one of the most crucial price patterns. 

• Signals Trend Reversals

The hammer pattern is one of the most reliable indicators of a potential trend reversal, especially if it appears at the bottom of a downtrend. The appearance of the pattern is usually followed by a new uptrend.  

• Provides Insights into Market Psychology

The pattern is a good indicator of market psychology and clearly shows the shift from bearish market sentiment to bullish market sentiment. 

• Useful as a Risk Management Tool

The hammer pattern can be used to identify potential entry points and set stop-loss levels, making it a good tool for managing the risk associated with a trade.  

• Works Well with Other Technical Indicators

When used in combination with other technical analysis tools and indicators, the hammer pattern can produce highly accurate trading signals. 

The Limitations of the Hammer Candlestick Pattern

While the hammer candlestick pattern is a powerful tool, it is important to understand its limitations. Here is a quick overview of some of its key drawbacks:

• Might Generate False Signals

Like all other technical indicators and candlestick patterns, the hammer candle is also prone to generating false signals. This is especially true in the case of volatile markets and rangebound markets where there is no clear trend.   

• Requires Confirmation

Since the hammer is a single candlestick pattern, the signals it generates may not always be very strong. This requires traders to obtain confirmation from subsequent price action or from other technical indicators before entering a position.   

• Dependent on the Market Context 

The effectiveness of the hammer candlestick pattern in providing accurate trading signals can vary depending on the overall market context and trend. 

Trading the Hammer Candlestick

Although the hammer pattern provides valuable insights into potential market reversals, you must consider various factors when incorporating it into your trading strategy. These factors include proper entry, stop-loss, and exit points. Here is a quick guide that can help you trade the pattern: 

• When to Enter the Market?

Entering a trade based on a hammer candlestick pattern requires careful consideration and confirmation. The first step is to wait for confirmation of the bullish reversal. If the candle succeeding the hammer is a bullish candle, the reversal is said to be confirmed. 

The ideal point of entry is when the price of the succeeding candle moves above the highest point of the hammer candle. Before placing an order, look for increased trading volume to get a second level of confirmation.    

• How to Set a Stop-Loss?

Setting an appropriate stop-loss is as crucial as timing the entry trade. With the stop-loss at the right point, you can effectively manage risk when trading the hammer candle. The ideal stop-loss point would be just below the bottom of the hammer’s lower wick. This level represents the point at which the pattern would be invalidated. If the market is too volatile, you could consider placing the stop-loss at an even lower point to prevent it from being triggered prematurely due to wild price swings.   

• When to Exit the Market?

Deciding when to exit a trade is very important for success. When setting a profit target, it is important to be realistic. You can consider using nearby resistance levels as take-profit points or use technical indicators like Fibonacci retracements. 

As the price moves towards your intended target, it is advisable to set trailing stops. This way, you can lock in profits and prevent sudden adverse movements from reducing your returns from the trade. Meanwhile, if you spot any new bearish reversal patterns or potential bearish signals, consider exiting the trade immediately.    

Key Technical Indicators to Use with the Hammer Candlestick Pattern

As you have already seen, combining the hammer pattern with other technical indicators could potentially increase the accuracy of the trading signal. Let us look at some of the key technical indicators that you can use along with the hammer.   

• Relative Strength Index (RSI)

If a hammer candlestick pattern forms in an asset and the Relative Strength Index is in oversold territory (below 30), a strong reversal signal is generated. At this point, you can consider entering into a long position once you spot the bullish confirmation candle.  

• Exponential Moving Averages (EMA)

A hammer pattern appearing near a key exponential moving average such as the 50-day or 200-day EMA could be a significant sign of a potential reversal. 

• Fibonacci Retracements

If a hammer candle forms near a key Fibonacci retracement level, it may indicate a stronger support level and a potential reversal point.

• Stochastic Oscillator

A bullish crossover in the Stochastic Oscillator coinciding with a hammer in a candlestick chart can provide additional confirmation of a bullish trend reversal. 

Conclusion

The hammer candlestick pattern is a valuable tool, with the ability to signal potential trend reversals. However, like all technical indicators, it should not be used in isolation. The most effective approach is to combine the hammer pattern with other technical indicators. This way, you can make well-informed investment decisions. 

With the Research 360 platform, powered by Motilal Oswal, you can filter stocks based on candlestick patterns like hammers using the Screeners function. The tool will instantly display stocks with hammer candles on their price charts. Additionally, you can correlate the hammer pattern with technical indicators like RSI, moving averages, MACD, ADX, and ATR to make informed trading decisions. Sign up for Research 360 today to unlock all of these features and become a better trader.