The hanging man is a type of candlestick pattern. Candlesticks displays the high, low, opening and closing prices for a security for a specific time frame. Candlesticks reflect the impact of investor' emotions on security prices and are used by some technical traders to determine when to enter and exit trades. (To brush up on the basics of candlestick charting, check out: Candlestick Charting: What Is It?)
The term "hanging man" refers to the candle's shape, as well as what the appearance of this pattern infers. The hanging man represents a potential reversal in an uptrend. While selling an asset solely based on a hanging man pattern is a risky proposition, many believe it's a key piece of evidence that market sentiment is beginning to turn. The strength in the uptrend is no longer there.
The Hanging Man Explained
The hanging man occurs when two main criteria are present:
Given these two criteria, when a hanging man forms in an uptrend, it indicates that buyers have lost their strength. While demand has been pushing the stock price higher, on this day, there was significant selling. While buyers managed to bring the price back to near the open, the initial sell-off is an indication that a growing number of investors think the price has peaked. For believers in candlestick trading, the pattern provides an opportunity to sell existing long positions or even go short in anticipation of a price decline.
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 two hanging man patterns in Facebook, Inc. (FB) stock, both which led to at least short-term moves lower in the price. The long-term direction of the asset was unaffected, as hanging man patterns are only useful for gauging short-term momentum and price changes.
Even though traders often count on candlestick formations to detect the movement of individual stocks, it is also appropriate to look for candlestick patterns in indexes, such as the S&P 500 or Dow Jones Industrial Average. Candlesticks can be also be used to monitor momentum and price action in other asset classes, including currencies or futures. (For more, see: Advanced Candlestick Patterns.)
If it's an actual hanging man pattern, the lower shadow is at least two times as long as the body. In other words, traders want to see that long lower shadow to verify that sellers stepped in aggressively at some point during the formation of that candle.
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. Bulkowski's research supports this view. Of the many candlesticks he analyzed, those with heavier trading volume were better predictors of the price moving lower than those with lower volume.
Another distinguishing feature is the presence of a confirmation candle the day after a hanging man appears. Since the hanging man hints at a price drop, the signal should be confirmed by a price drop the next day. That may come by way of a gap lower or the price simply moving down the next day (lower close than the hanging man close). According to Bulkowski, such occurrences foreshadow a further pricing reversal up to 70% of the time.
It's worth noting that the color of the hanging man's real body isn't of concern. All that matters is that the real body is relatively small compared with the lower shadow.
Trading the Hanging Man
The hanging man patterns that have above average volume, long lower shadows and are followed by a selling day have the best chance of resulting in the price moving lower. Therefore, it follows that these are ideal patterns to trade off of.
Upon seeing such a pattern, consider initiating a short trade near the close of the down day following the hanging man. A more aggressive strategy is to take a trade near the closing price of the hanging man or near the open of the next candle. Place a stop-loss order above the high of the hanging man candle. The following chart shows the possible entries, as well as the stop loss location.
One of the problems with candlesticks is that they don't provide price targets. Therefore, stay in the trade while the downward momentum remains intact, but get out when the price starts to rise again. Hanging man patterns are only short-term reversal signals. (See also: Market Reversals and How to Spot Them.)
A Question of Reliability
If looking for any hanging man, the pattern is only a mild predictor of a reversal. Look for specific characteristics, and it becomes a much better predictor. 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 chart.
However, there are things to look for that increase the chances of the price falling after a hanging man. These include above average volume, longer lower shadows and selling on the following day. By looking for hanging man candlestick patterns with all these characteristics, it becomes a better predictor of the price moving lower. Stick to trading only these strong types of patterns.
Hanging Man Versus Shooting Stars and Hammers
There are two other similar candlestick patterns. This can lead to some confusion.
The hanging man appears near the top of an uptrend, and so do shooting stars. The difference is that the small real body of a hanging man is near the top of the entire candlestick, and it has a long lower shadow. A shooting star as a small real body near the bottom of the candlestick, with a long upper shadow. Basically, a shooting star is a hanging man flipped upside down. In both cases, the shadows should be at least two times the height of the real body. Both indicate a potential slide lower in price.
The hanging man and the hammer are both candlestick patterns that indicate trend reversal. The only difference between the two is the nature of the trend in which they appear. If the pattern appears in a chart with an upward trend indicating a bearish reversal, it is called the hanging man. If it appears in a downward trend indicating a bullish reversal, it is a hammer. Apart from this key difference, the patterns and their components are identical. (For more, see: The 5 Most Powerful Candlestick Patterns.)
The Bottom Line
Hanging men occur frequently. If you highlight them all on a chart, you will find that most are poor predictors of a price move lower. Look for increased volume, a sell-off the next day and longer lower shadows, and the pattern becomes more reliable. Utilize a stop loss above the hanging man high if you are going to trade it. (For additional reading, check out: Using Bullish Candlestick Patterns to Buy Stocks.)