The candlestick patterns that many traders rely on for clues about the market can have very colorful names. Perhaps none is more descriptive, however, than the “hanging man.”
The hanging man is a type of candlestick - a chart that displays the high, low, opening and closing prices for a security for a single day. Candlesticks reflect the impact of investors' emotions on security prices and are used by technical analysts to determine when to enter and exit trades.
Candlestick charting is based on a technique developed in Japan in the 1700s for tracking the price of rice. (In addition to the hanging man, there are many short-term trading strategies based upon candlestick patterns, such as the engulfing pattern, harami, harami cross and evening star.)
The term "hanging man" not only expresses the candlestick’s ominous shape, which looks like a head atop a dangling body, but also the unfortunate fate of a stock, currency or other asset that had earlier experienced an upswing.
While basing a purchase or sale solely on a hanging man pattern can be a risky proposition, many believe it’s a key piece of evidence that market sentiment is beginning to turn against the investment vehicle.
The Hanging Man Explained
As with other candlestick formations, the hanging man uses visual representations of the stock’s opening and closing price in a given day, as well as its high and low. The hanging man occurs when two main criteria are present: First, the asset has been on an uptrend; second, in graphical terms, the candle takes the shape of a fairly short box (the “real body”) atop a long stick (the “lower shadow”). A small upper shadow may or may not appear above the body.
What does this mean, exactly? While demand has been pushing the stock price higher for at least a few days, it suddenly opened with a significant sell-off. Buyers then managed to bring the price back near its original level before the closing bell. While the stock didn’t end the day much lower than where it opened (or perhaps even slightly higher), the initial sell-off is an indication that a growing number of investors think the price has peaked. For believers in candlestick trading, this is a good time to short their position ahead of a downturn.
The hanging man is characterized by a small “body” on top of a long lower shadow. The shadow underneath should be at least twice the length of the body.
The chart below shows a hanging man pattern that’s confirmed by the presence of a long red (or black) candle the following day.
Keep in mind that, even though traders often count on candlestick formations to detect the movement of individual stocks, it has a much wider application. It is just as appropriate to use the tool when looking at a market index like the S&P 500 or Dow Jones Industrial Average, for example.
The hanging man, along with other candlestick formations, is also a way to scrutinize volatile assets other than stocks. On the forex market, for example, some investors depend on this form of technical analysis to help predict the direction of world currencies.
What can look like a particular candlestick shape from a distance often doesn’t measure up when taking a closer look. More advanced traders will usually look for specific details of the pattern to help substantiate a true hanging man.
One of the most important indicators is the length of the lower shadow. If it’s an actual hanging man pattern, this thin vertical line will be at least two times as long as the body. In other words, there has to be a significant sell-off followed by a late-day surge that brings the price close to its opening mark.
Thomas Bulkowski’s "Encyclopedia of Candlestick Charts" suggests that the longer the lower shadow, the more meaningful the pattern becomes. Using historical market data, he studied some 20,000 hanging man shapes. In most cases, those with elongated shadows outperformed those with shorter ones.
Some traders will also look for strong trading volume during the breakout period early in the day; Bulkowski’s research likewise supports this view. Of the many candlesticks he analyzed, those with heavier trading volume were better predictors than those with light trading.
Perhaps just as important as the above, is the presence of a confirmation candle the day after a hanging man appears, which can manifest itself in a few different ways. One way is to look for a “gap opening,” when the asset starts the next trading day lower than its previous close. Another way is to look at the closing price the day after the hanging man formation appears. If the stock or other tradable asset closes lower, traders who use technical analysis tend to be more confident in a downturn ahead. According to Bulkowski, such occurrences foreshadow a pricing reversal as often as 70% of the time.
It’s worth noting that the color of the hanging man itself doesn’t matter to many of its adherents. Some believe a black box (or a red one, depending on the software being used) adds to the candlestick’s predictive power slightly, while others argue that it's a virtual non-factor.
A Question of Reliability
The hanging man is one of the most commonly used candlestick patterns in the investment world, so it clearly has its supporters. This doesn't necessarily make it a reliable indicator of a pricing turnaround, however; the consensus would suggest that it's a mild-to-fair predictor, at best.
Bulkowski is among those who feel the hanging man formation is, in and of itself, undependable. According to his analysis, the upward price trend actually continues a slight majority of the time when the hanging man appears on a candlestick chart.
There is an important caveat here: When the lower shadow is exaggerated, or if there’s a confirmation candle, it becomes a much more useful tool. If you’re patient and look for a lower opening or closing price the day after, the chances of a price reversal seem to increase significantly.
The Bottom Line
The presence of a hanging man pattern is one of the most well-known and commonly used candlestick patterns around. Yet the shape in and of itself is a relatively weak indicator that the upward trend is about to end. When investors wait for a confirmation candle the day after, the chances are much greater that a downturn is in fact taking hold.
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