What Is a Hammer Candlestick?
A hammer is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening, but rallies within the period to close near opening price. This pattern forms a hammer-shaped candlestick, in which the lower shadow is at least twice the size of the real body. The body of the candlestick represents the difference between the open and closing prices, while the shadow shows the high and low prices for the period.
- Hammers have a small real body and a long lower shadow.
- Hammers occur after a price decline.
- The hammer candlestick shows sellers came into the market during the period but by the close the selling had been absorbed and buyers had pushed the price back to near the open.
- The close can be above or below the open, although the close should be near the open in order for the real body to remain small.
- The lower shadow should be at least two times the height of the real body.
- Hammer candlesticks indicate a potential price reversal to the upside. The price must start moving up following the hammer; this is called confirmation.
What Does the Hammer Candlestick Tell You?
A hammer occurs after a security has been declining, suggesting the market is attempting to determine a bottom.
Hammers signal a potential capitulation by sellers to form a bottom, accompanied by a price rise to indicate a potential reversal in price direction. This happens all during the one period, where the price falls after the open but then regroups to close near the open.
Hammers are most effective when they are preceded by at least three or more declining candles. A declining candle is one which closes lower than the close of the candle before it.
A hammer should look similar to a "T". This indicates the potential for a hammer candle. A hammer candlestick does not indicate a price reversal to the upside until it is confirmed.
Confirmation occurs if the candle following the hammer closes above the closing price of the hammer. Ideally, this confirmation candle shows strong buying. Candlestick traders will typically look to enter long positions or exit short positions during or after the confirmation candle. For those taking new long positions, a stop loss can be placed below the low of the hammer's shadow.
Hammers occur on all time frames, including one-minute charts, daily charts, and weekly charts.
Example of How to Use a Hammer Candlestick
The chart shows a price decline followed by a hammer pattern. This pattern had a long lower shadow, several times longer than the real body. The hammer signaled a possible price reversal to the upside.
Confirmation came on the next candle, which gapped higher and then saw the price get bid up to a close well above the closing price of the hammer.
During the confirmation candle is when traders typically step in to buy. A stop loss is placed below the low of the hammer, or even potentially just below the hammer's real body if the price is moving aggressively higher during the confirmation candle.
The Difference Between a Hammer Candlestick and a Doji
A doji is another type of candlestick with a small real body. A doji signifies indecision because it is has both an upper and lower shadow. Dojis may signal a price reversal or trend continuation, depending on the confirmation that follows This differs from the hammer which occurs after a price decline, signals a potential upside reversal (if followed by confirmation), and only has a long lower shadow.
Limitations of Using Hammer Candlesticks
There is no assurance the price will continue to move to the upside following the confirmation candle. A long-shadowed hammer and a strong confirmation candle may push the price quite high within two periods. This may not be an ideal spot to buy as the stop loss may be a great distance away from the entry point, exposing the trader to risk which doesn't justify the potential reward.
Hammers also don't provide a price target, so figuring what the reward potential for a hammer trade is can be difficult. Exits need to be based on other types of candlesticks patterns or analysis.