Used in the right context, the hammer candlestick can be a valuable signal that a turn-around is in the making. While the hammer can be used to signal a trend change on the long-term charts, I find it much more useful for finding swing trade candidates. In the latter case the hammer acts as a signal indicating that buying is likely to overtake selling for a few days to weeks, or until a profit target is reached.
A hammer is a candlestick that occurs after a period of declining price. It's created by the day opening, then declining sharply, but then rallying within the same day to a slightly higher close (relative to open). This creates the visual appearance of a small hammer at the bottom of a decline. Since I prefer not to fight the dominant trend, I look for this pattern in stocks where the overall trend is up, but a pullback is currently underway. The hammer marks a potential end to the pullback and a resumption of the uptrend. Typically it's prudent to see if there is any buying follow-through in the next session, following the hammer, before going long.
Helmerich and Payne (NYSE:HP) predominated ranges over the last two years, but has seen well-defined up and downtrends within the range during that time. The overall bias appears to be to the upside though, with progressively higher lows on the longer-term chart. July 2012 marks the start of the most recent uptrend, peaking in February 2013. The hammer candlestick on April 30 may indicate a short-term upswing in the two and a half month pullback, or even a longer-term turning point higher. For a swing trade, the stop can be placed near $57, with a target at $61.75, just beyond the recent high. If the price continues to push higher or pullbacks and stays above the stop price, it can turn into a longer-term trade, with a target of $69 to $71 (near the February high). If just looking at this trade from a long-term perspective, an alternative stop level is $55.50.
SEE: Technical Analysis: Support And Resistance
Ametek (NYSE:AME) has been performing great overall, nearing doubling in price since October 2011, but the stock has been in decline much of April. The April 30 hammer pattern signals a re-entry into what could be another bull move. Stepping higher since the April 19 low, the stock seems to have found some buying support, and the hammer presents a likely low-risk entry. Like Helmerich and Payne, this trade sets up both as a swing and longer-term trade. For the swing, I'm looking at a stop level near $40.25 with a target between $41.40 and $41.60. For the longer-term trade: a stop near $40.25 or $39.50 and a target near $43.75.
Flour (NYSE:FLR) formed an interesting candlestick on April 30, because it occurs just after a recent low (April 22 at $53.50) and the overall trend is up based on progressively higher major lows in June and November 2012, and now potentially April 2013. The strong selling in April has subsided and a potential long trade exists, but ideally I want to see the price move and preferably close, above $57.30. If that happens, I like the long. A stop loss order can be placed at $55.60, just below the hammer low, or at $53.50 for longer-term trades. Two targets are $59.50 and $61 for the swing trade and if the overall uptrend resumes here, $68 to $69 is the target longer term.
SEE: Interpreting Support And Resistance Zones
Market Vectors Gold Miners ETF (NYSE:GDX): Unlike the other three stocks, this one is in an overall downtrend, with the hammer pointing to a potential short-term reprieve from the selling. Since this is a counter-trend trade, I like it less, but it's still a valid signal. The long-term downtrend is entrenched, but selling escalated in the middle of April. The hammer on April 30 occurs at a point where the ETF has already rallied off the April 17 low at $27.27 and, therefore, the hammer represents a potential higher low for the ETF - a requirement for a potential trend change. The upside target, should the bear market rally commence, is between $31.50 and $34. At or before $34 I expect selling to resume. Given the risk of the trade I'd keep the stop level fairly tight, just below the hammer low at $28.
The Bottom Line
Hammers indicate a potential escalation in buying interest. Ideally, I like to the see the pattern occur in an overall uptrend after a pullback has occurred, but it can also be used to signal a rally in a falling stock. The nice thing about trading with the overall trend is that if the trend resumes, a small profit swing trade can turn into a potentially larger profit longer-term trade. When you fight the trend, you're not likely to get that sort of opportunity too often. Hammers aren't a perfect signal, though, and don't guarantee a turnaround. Always control the risk and ideally look for another price confirmation signal that the next move is likely to be higher.
Charts courtesy of stockcharts.com
At the time of writing, Cory Mitchell did not own any shares in any company mentioned in this article.