Reading the Hammer Candle Pattern

07/29/2011 8:00 am EST

Focus: STRATEGIES

Hammer patterns on charts provide useful confirmation signals, and these textbook examples of bullish and bearish hammers show the formations and important trading considerations for each.

Among single-stick candles, a few have significance depending on the context. So a one-session indicator can be either bullish or bearish. The determining factor is the type of trend underway at the time.

One example is the inverted hammer. This is a version of the hammer, which is also called a “hanging man,” depending on whether it shows up after an uptrend or a downtrend. The inverted variety has a fairly small real body, and making this even more interesting, the body can be either white or black. If all of the other signal attributes are present, this is one of the few candlesticks in which the real body’s color can go either way.

When the inverted hammer shows up at the bottom of a downtrend, it is bullish. The small real body is accompanied by an upper shadow, but no lower shadow. Ideally, the upper shadow should be at least as long as the size of the real body.

As a reversal signal, you would also expect to see the downtrend characterized by mainly black candles, and then, after the inverted hammer, an uptrend characterized by mostly white-bodied candlesticks.

The figure below demonstrates the ideal bullish version of an inverted hammer. However, sessions before and after the inverted hammer can be of either color, while the overall trend should clearly precede with a downward movement and follow upwards.

Chart1

NEXT: The Bearish Hammer Pattern Explained

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The bearish version is also named the “shooting star.” Like its bullish counterpart, this single-session trading indicator has a small real body of either color and an upper shadow, but no lower shadow. The shadow should be the same size or larger than the real body. It shows up after an uptrend and signals a reversal.

So you would expect to see mostly white sessions prior to the shooting star, and then mostly black sessions moving in the opposite direction. The below illustration lays out this pattern.

Chart2

Caution is advised with the inverted hammer in either bullish or bearish versions. Although it is a useful signal, it is not among the strongest. Its value is in its confirmation properties.

If you see reversal signals in the form of tests of support or resistance, double bottoms or tops, head- and-shoulders patterns, or repetitive gapping movement, the inverted hammer gains value to the extent that it confirms what those other signals reveal. Augmenting value even more, when you see a turn in momentum oscillators such as Moving Average Convergence Divergence (MACD) or Relative Strength Index (RSI), the inverted hammer again becomes a strong form of confirmation.

Some analysts acknowledge the inverted hammer only if and when a gap is found between the preceding session and the inverted hammer’s session. The problem with this rule is that a gap may or may not exist depending on whether the inverted hammer session is white or black.

For example, in a bullish version, a lower-opening white inverted hammer clearly has a gap from the previous day’s close. In a bearish version, the same rule applies with a higher-opening black session, but it is possible that no gap would be found in a white real body. So analysts need to determine which guideline is more important, the placement of the session and extent of the upper shadow, or the existence of a price gap.

By Michael Thomsett

Michael C. Thomsett is an investment author with dozens of published books. His projects include the bestselling Getting Started in Options.This article first appeared on Minyanville.com.

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