What is a Hammer
A hammer is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening, but rallies later in the day to close either above or near its opening price. This pattern forms a hammer-shaped candlestick, in which the body is at least half the size of the tail or wick.
BREAKING DOWN Hammer
A hammer occurs after a security has been declining, possibly suggesting the market is attempting to determine a bottom. The signal does not mean bullish investors have taken full control of a security, but simply indicates that the bulls are strengthening.
Psychology of Hammers
Hammers signal a capitulation by sellers to form a bottom, accompanied by a price rise to indicate a potential reversal in price direction. Hammers are most effective when they are preceded by at least three or more consecutive declining candles. Declining candles are indicated with lower low tails. This means prices reach a lower price than the low of the prior candle period. This illustrates the continuation of fear and selling pressure by participants feeling the pain of declining prices. Eventually, the pain becomes too great and forces the remaining sellers to panic out of their positions in a final selling frenzy, indicated by the lowest price being reached, followed by a quick rebound from the lowest price to close the candlestick with a small body. The tail should be at least twice the size of the candlestick body. It should look similar to a capital 'T'. This indicates the potential for a hammer candle. Note the term "potential."
The true confirmation of the hammer candle can only be made when the very next proceeding candle closes with a higher low than the hammer candle. This confirms the capitulation from sellers, as buyers have determined the price is too attractive to pass up and quickly buy into the position. When the proceeding candles continue to consecutively form higher lows, it indicates that the buyers are now supporting the pullbacks and bidding up shares. As the price rises higher, it can also cause earlier sellers to reconsider and buy back into the stock or other financial instrument. One thing to remember is that the buyers may not actually be bullish on the stock.
In fact, early buyers can often be composed of short-sellers who must actually buy shares in order to cover their short positions and lock in profits when a hammer candle forms. As the price continues to recover, it can also cause late short-sellers to re-evaluate their short positions as earlier profits turn into losses. Hammers can be measured on any time frame candlestick chart. The larger the time frame chart, the more thorough the hammer candlestick will be, due to the more participants involved.