Hammer Candlestick: Formation and 6 Trading Strategies

What Is a Hammer Candlestick?

A hammer candlestick is a single candle pattern that forms at the bottom of a downtrend and signals a potential reversal.

Its shape resembles a hammer, hence its name, and is characterized by the following features:

• Small Real Body: The real body of the candle is small and located at the upper end of the trading range. This indicates that the opening and closing prices are close to each other.

• Long Lower Shadow: The lower shadow (or wick) is typically at least twice the length of the real body.
  This long lower shadow shows that prices were driven down significantly during the trading session, but strong buying pressure pushed the price back up.

• Little to No Upper Shadow: There is usually little to no upper shadow, indicating that the price did not move significantly above the opening and closing levels.

Identifying Hammer Candlestick

A hammer candlestick formation occurs during a downtrend. Here’s how it typically forms so you can identify on a chart:

1. Downtrend: The market is in a downtrend, with successive lower highs and lower lows.

2. Price Decline: During the trading session, sellers continue to drive the price down, extending the downtrend.

3. Buying Pressure: At some point, buyers start entering the market, creating significant buying pressure that pushes the price back towards the opening level.

4. Close Near Opening: The session ends with the price closing near or above the opening price, forming a small real body at the top of the candle and leaving a long lower shadow.

Significance of Hammer Candlestick

The significance of a hammer candlestick lies in its ability to signal a market trend reversal.

When this pattern appears at the bottom of a downtrend, it hints that selling pressure is easing off and buying pressure is starting to take over. This potential shift from a bearish to a bullish market is crucial for traders as it clearly indicates that the market trend is shifting.

The hammer candlestick also strengthens the importance of support levels. When it forms near these levels, it confirms that buyers are stepping in, stopping further price drops, and possibly pushing prices higher.

The significance of this pattern is even greater when there is high trading volume, which shows strong market interest and confirms the reversal signal.

Variants of the Hammer Candlestick

The hammer candlestick has several variants with unique characteristics and implications for traders.

Here are the most common hammer candlestick variants.

Bullish Hammer Candlestick

When we refer to the hammer candlestick in general, we are typically talking about the bullish hammer candlestick.

As we mentioned above, this pattern forms after a price decline and signals a potential reversal to the upside.

Moreover, the color of the body can be either green or red, but a green body is generally seen as more bullish because it shows that the price closed higher than it opened.

Inverted Hammer Candlestick

The inverted hammer candlestick also signals a potential bullish reversal but appears differently.

It forms at the bottom of a downtrend and has a small body at the lower end with a long upper shadow and little to no lower shadow.

This pattern suggests that buyers attempted to push the price higher during the session, but sellers brought it back down near the opening price.

Despite this, the buying pressure is strong enough to indicate a potential reversal. The inverted hammer is the opposite of the hammer candlestick.

While both candlestick patterns have a small body, the hammer has little to no upper shadow, whereas the inverted hammer has a long upper shadow.

Similarly, the inverted hammer has little to no low shadow, whereas the hammer has a long lower shadow.

Hammer Candlestick vs Doji

While both the hammer and doji indicate potential reversals, the hammer candlestick formation has a small body and a long lower shadow, whereas the doji has a very small body with shadows of nearly equal length on both sides.

The doji suggests indecision in the market, while the hammer indicates a stronger shift from selling to buying pressure.

Hammer vs Shooting Star

While not a variant of the hammer itself, the shooting star candlestick is worth mentioning due to its similarity to the inverted hammer but with a bearish implication.

Both have similar structures but appear in different contexts. The shooting star forms at the top of an uptrend. It has a small body at the bottom and a long upper shadow.

This pattern suggests that buyers tried to push the price higher but were overpowered by sellers, leading to a potential reversal to the downside.

Hammer vs Hanging Man

The hammer candlestick vs hanging man comparison is common. While they look identical, the context of their appearance differs.

A hammer appears at the bottom of a downtrend, suggesting a bullish reversal. However, a hanging man appears at the top of an uptrend, indicating a bearish reversal.

Both patterns have small bodies and long lower shadows, but their implications are opposite based on their location in the trend.

How to Trade a Hammer Candlestick

Trading the hammer candlestick involves recognizing the pattern and confirming the reversal signal. Here’s an example and some trading strategies.

Example of How to Use a Hammer Candlestick

Imagine you spot a hammer candlestick in forex at the end of a downtrend. You wait for the next candle to confirm the reversal by closing above the hammer's high. This confirmation gives you a buy signal.

Here’s a step-by-step guide based on an example of using the hammer candlestick to trade a currency pair.

1. Identify the Hammer: You're analyzing the EUR/USD currency pair and notice a hammer candlestick on the daily chart.
   The pair has been in a downtrend, but the hammer forms with a small body and a long lower shadow, signaling a potential reversal.

2. Confirm the Signal: The next day, you wait for the daily candle to close above the high of the hammer. This confirmation candle closes significantly higher, validating the bullish signal.

3. Enter the Trade: With confirmation in place, you open a long position on EUR/USD at the market price.

4. Set a Stop Loss: To manage your risk, you set a stop loss just below the low of the hammer candlestick. This placement ensures that your losses will be minimized if the market turns against you.

5. Monitor the Trade: As the price begins to rise, you monitor the market. The EUR/USD pair moves higher, and you adjust your stop loss upward to protect your profits.

You continue to monitor the trade, making adjustments as needed to maximize gains and minimize risk.

Hammer Candlestick Trading Strategies

Now that you know what a hammer candlestick is, how it forms, how to identify it, and a general trading example, let’s explore some practical trading strategies.

1. Pullbacks On Charts

When the market is on an uptrend, traders often watch for pullbacks. The hammer candlestick is an excellent pattern to look for during these pullbacks.

Simply wait for the price to dip, and then keep an eye out for the hammer. This pattern often signals the end of the pullback and the start of a new leg upwards.

Imagine a scenario where a stock is steadily rising but then starts to pull back. You spot a hammer candlestick forming.

This is your cue that the pullback might end and it’s time to prepare for the next upward movement.

2. Support Levels Hammer Trading Strategy

Support levels are key areas where price reversals are likely to occur. Combining the hammer candlestick with support levels can create great opportunities for going long.

1. Start by identifying and drawing support levels on your chart.

2. Be patient, wait for the price to decline, and reach one of these support levels.

3. Look for a hammer candlestick forming at the support level.

4. Once the price breaks above the high of the hammer, go long (buy).

5. Place your stop loss just below the low of the hammer to manage risk.

6. Establish your take-profit levels based on your trading plan.

For instance, if a stock is falling towards a clearly defined support level and a hammer candlestick appears at that point, it's a strong signal that the price might start to rise.

This setup allows you to enter a long position, anticipating an upward move.

3. Hammer with Pivot Points Trading Strategy

Pivot Points are automatic support and resistance levels calculated mathematically and are especially popular among day traders.

Here's how to trade the hammer candlestick using pivot points:

1. Turn on the Pivot Points indicator on your chart.

2. Look for Pivot Points below the current price, as these act as support levels.

3. While it's ideal for the price to be in an uptrend, it's not strictly necessary.

4. Be patient and wait for the price to drop to a Pivot Point level.

5. Look for a hammer candlestick forming at the Pivot Point.

6. Go long (buy) when the price breaks above the high of the hammer.

7. Place your stop loss just below the low of the hammer.

8. Plan your take profit level based on your trading strategy.

For example, imagine you're day trading, and the price of an asset drops to a daily Pivot Point. If a hammer candlestick forms at this level, it indicates that the Pivot Point is holding as support.

This suggests a potential upward move, providing a strong signal to enter a long position.

4. Hammer Candlestick with RSI Divergences Trading Strategy

This strategy takes a different approach by combining the hammer candlestick with RSI divergences to spot bullish reversals.

1. Look for a market that is clearly trending downward.

2. Note the lows that the price hits during each leg down.

3. Check these price lows against the RSI (Relative Strength Index) indicator.

4. You have a divergence when the price makes lower lows, but the RSI makes higher lows.

5. Look for a hammer candlestick to form at the price's lower low, which aligns with the RSI's higher low.

6. Go long (buy) when the price breaks above the high of the hammer.

7. Place your stop loss below the low of the hammer.

8. Set your take profit level according to your trading plan.

For example, imagine you're tracking a stock in a downtrend. You notice that the price is making lower lows, but the RSI is making higher lows. When a hammer candlestick forms at this point, it signals a potential bullish reversal.

This setup suggests that it's a good time to consider entering a long position, anticipating an upward move.

5. Hammer Candlestick with Moving Averages Trading Strategy

Moving averages are helpful technical indicators for identifying trends. This strategy involves trading pullbacks to the moving average within an uptrend.

Here’s how it works:

1. Identify an uptrend where the price is above a moving average.

2. Wait for the price to decline back towards the moving average.

3. Look for a hammer candlestick to form at the moving average.

4. Go long when the price breaks above the high of the hammer.

5. Set your stop loss below the low of the hammer and plan your take profit.

For example, let’s say the price of a currency pair is above its 50-day moving average but then dips. If a hammer forms as the price hits the moving average, this could be your signal to buy, anticipating the next leg up.

6. Trading The Hammer with Fibonacci Trading Strategy

Using the Fibonacci retracement tool, traders can identify key levels where price reversals often occur.

This strategy involves looking for hammer candlesticks at these levels. Here’s how:

1. Ensure the price is in an uptrend.

2. Wait for a price decline (retracement).

3. Use the Fibonacci tool to draw levels from the low to the high of the move.

4. Look for a hammer to form at a Fibonacci retracement level.

5. Enter a long position when the price breaks above the high of the hammer.

6. Set your stop loss below the low of the hammer and plan your take profit.

For instance, during an uptrend, a stock's price might pull back to the 38.2% Fibonacci retracement level.

If a hammer candlestick forms at this level, it could be a signal to go long, expecting the uptrend to resume.

Benefits of the Hammer Candlestick

Here are some of the benefits of the hammer candlestick:

• Provides a straightforward indication of a potential trend reversal from bearish to bullish.

• The pattern's distinctive shape makes it easy to spot on price charts.

• Can be applied across various financial markets, including stocks, forex, commodities, and cryptocurrencies.

• Works effectively with other technical analysis tools like moving averages, RSI, Fibonacci levels, and Pivot Points.

• Helps traders make informed decisions by providing a clear visual cue of market sentiment.

• When combined with support levels, it strengthens the reliability of reversal signals.

Limitations of the Hammer Candlestick

While the hammer candlestick is very helpful, here are some of its limitations:

• The hammer candlestick can sometimes give false reversal signals, especially in highly volatile markets.

• It often requires additional confirmation from other indicators or candlestick patterns to validate the reversal.

• The effectiveness of the hammer depends heavily on its context within the overall market trend.

• It is generally considered a short-term signal and may not provide long-term trend information.

• Relying solely on the hammer candlestick without considering other market factors can lead to incorrect trading decisions.

Conclusion

The hammer candlestick is a single-pattern candlestick used as an indicator when analyzing trades. It’s easy to identify on charts, but know its different variants to avoid confusion.

You can use some of the trading strategies mentioned above to trade this pattern, but make sure you thoroughly research and understand each strategy further in-depth.