Selectivity Is the Key to Trading Hammer Candlesticks

02/08/2016 9:00 am EST

Focus: CURRENCIES

While many forex traders focus on finding hammer candlesticks and trading them, they often find it difficult to achieve sufficient profitability using this method, so Adam Lemon of DailyForex.com suggests methods traders can use to only pick the best quality hammer candlesticks to trade.

Most forex traders know about hammer candlesticks. They are also known as pin bars. They are generally believed to signify that a price reversal has just begun to take place, which obviously is very interesting as it would give traders the chance to enter a low risk, high reward probability trade and make some profit. Unfortunately, although a lot of traders focus on finding these hammer candlesticks and trading them, they still find it difficult to achieve sufficient profitability using this method. In this article I will examine why this happens and suggest methods that traders can use to only pick the best quality hammer candlesticks to trade.

No Edge in a Single Candlestick

Our starting point should be in acknowledging a brutal truth: candlesticks taken on their own have no predictive power regarding what their price is going to do next, with the exception of very long time frames. For example, if the price is higher than it was a few months ago, the price now is more likely to go up than down. In any case, when we are looking at more typical time frames such as five minutes, one hour, or one day, studies of individual candlesticks (such as hammers) on these time frames show they have no statistically valid predictive power.

This means that we have to add some filters and examine whether certain conditions are present when a hammer candlestick appears, in order to decide whether they are worth trading or not. There are several filters that can be applied that have been proven to signify when a positive edge is likely to be present. I will run through them in order of their effectiveness.

Trade in the Direction of the Trend

It is tempting to trade hammer candlesticks as they form whether they are pointing up or down. While some of the countertrend trades will work, you will get better results overall if you focus on the hammers that form that point in the direction of the trend over many weeks/several months. Trading in the direction of the long-term trend is usually the best favor most traders can do for themselves.

Lowest/Highest Wick of Last Several Candles

If the hammer candlestick is bullish, for example, it helps if it has the lowest candle wick of the past five or so candles. Similarly, if the hammer candle is a Flying Buddha candlestick, that is also a positive sign.

Bigger Than Last Several Candles

If the total range from the high to low of the hammer candlestick is greater than the range of any of the previous five or so candlesticks, then this also increases the quality of the candle, provided the range is not freakishly huge. Of course, time of day can be a factor here, if you are looking at the shorter time frames. There are times of the day where volatility tends to increase quite a lot, so a comparatively large candle right after a major session open like London or New York open might not be a very reliable indicator.

Confluence with Support or Resistance/Round Number/Key MA/Trend Line

It the wick of the hammer candlestick is poking through an area which is suspected to be support or resistance, this makes it a stronger signal. Round numbers, previous daily highs or lows, or key moving averages can all strengthen a hammer candlestick as indicating a price reversal. This is known as confluence. A good example of confluence is shown below in an hourly chart of the AUD/USD currency pair:

chart
Click to Enlarge

Note the hammer candlestick market by the downwards arrow. There were a few reasons to notice this candlestick as it formed as indicating a higher probability that the price would reverse. To read the entire article click here…

By Adam Lemon, Contributor, DailyForex.com

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