A Hammer Candlestick, in reference to technical analysis of Forex markets, is a price pattern during a trading period that can provide significant information on the weakening strength of a current downtrend.
When undertaking technical analysis there are a variety of sophisticated tools and techniques that can be used to help determine future price movements of a currency pair or index. Often overlooked is the information provided by a single candlestick, information contained within can be so useful, that some traders incorporate them within their trading strategies as trading signals.
There are a range of significant candlestick formations that can be used as trading signals, but this article will focus on learning how to identify a hammer candlestick, understand what information is contained within, and how to use it as a trading signal.
In This Article:
- What Is A Hammer Candlestick
- Understanding Market Psychology
- Hammer Versus Doji
- Protect Your Position
- Summary
What Is A Hammer Candlestick
A hammer candlestick is a single trading period, within which, prices will have traded much lower than the period opening price, but close significantly higher than its lowest point.
Hammer candlesticks are considered significant trading signals that a previous downtrend may have ended, as they signal when selling pressure has weakened. During a hammer candlestick trading period, a "bottom" will be formed where selling pressure capitulates to buying pressure. A long wick is formed where the bottom is reversed by buying pressure taking the price close to the period opening.
On the above EUR/USD 1hour technical chart, a typical hammer candlestick has been highlighted to demonstrate the initial downward price movement followed by a reversal that takes prices close to the opening price. The long downward wick is evident, and the hammer name becomes clear.
Hammer candlestick formations can be further relied upon to indicate the end of a downtrend when it is preceded by a succession of down candles, as shown above. This may seem pretty straight forward, but there are a couple of points to remember:
Look For Confirmation - A hammer candle can only be confirmed if the following candle's price closes above the hammer candlestick. At this point there should be strong buying volume and you could enter a long position. As with any form of technical analysis hammer candlesticks are indicators, they are not an exact science and traders are recommended to place a stop loss order, usually just beneath the hammer candlestick's bottom.
Combine Indicators - While a hammer candlestick is a reasonably reliable signal, more risk adverse traders should always cross reference with other indicators. The Relative Strength Indicator (RSI) is frequently used as it provides the trader with a simple measurement between zero and 100. It states that a currency pair is oversold when it has a reading below 30. If you identify a hammer candlestick that is reinforced with a low RSI reading, entering a long position would potentially be a higher probability trade.
Understanding Market Psychology
There is a lot happening during the formation of a hammer candlestick in terms of relationship between buying and selling pressure. Following the start of the new period and its opening price, selling pressure will continue in line with the preceding longer term downtrend, pushing prices lower.
At some point, selling pressure will drive prices to its lowest point, known as the bottom. At this point buying pressure begins to overwhelm selling pressure as traders either begin to close their short positions and crystallise gains already made, or new buyers enter the market.
Once selling pressure has capitulated to the increased buying pressure, prices begin to rise and ultimately close near the period opening price.
This is significant to traders looking for trading signals, as the psychology of the marketplace within this period has pivoted from selling to buying and could represent a reversal in the longer term trend.
Hammer Versus Doji Candlestick
When analysing candlestick formations and looking for hammer candlesticks, it is important to not confuse with another common candlestick formation known as the Doji.
The Doji formation looks similar to the hammer candlestick. The Doji represents a period of indecision and consolidation within the market place, and also has a small body as the closing price finishes close to the opening price. The difference between the Doji and Hammer is that the Doji will not have had much price movement during the trading period, the hammer on the other hand has plenty of price action, initially down to a bottom, followed by buying volume.
The visual difference between the two candlesticks is that the hammer will have a large downward wick, generally twice the size of the body, a Doji however will not.
Protect Your Position
Although hammer candlesticks are considered strong indicators of a price reversal in the upward direction, they do have limitations that need to be considered.
The strength of the upward price movement that follows a hammer candlestick cannot be determined. It could be a move with lots of momentum that continues for severals subsequent periods, or it could be one or two periods following the confirmation.
When entering a position following the confirmation candle, a trader should consider their trading strategy and the level of risk to reward they are prepared to accept.
Generally a stop loss order will be placed a the bottom of the hammer candle, but if the confirmation candle was strong, your entry point may be a long way from your stop loss. There will need to be potential for a large pip gain to counter the risk of the distance of the stop loss for the trade to be considered viable.
To assist in calculating the potential of the bullish move, consideration to other indicators should be given. Fibonacci retracements are widely respected as a reliable indicator to help gauge the strength of a trend and should be considered in favour of entering a trade solely on the basis of a hammer candle being confirmed.
Summary
Hammer candlesticks can be used as a reliable indicator that a reversal into a bullish trend is imminent. It is important when entering a trade to use alternative technical tools like RSI or Fibonacci retracement to try and estimate the strength of the potential move, this will help with determining risk and reward and following your overall trading strategy.
