What is a Hammer? Reading Hammer Candlestick Trading Charts Like a Expert on XM

What Is a Hammer?

• Considered a reversal formation and forms when price moves well below open, but then rallies to close near open if not higher. (inverted hammer is the mirror opposite)
  • Forms a candlestick with a long lower shadow (tail), and a small body with little or no wick–looks like a hammer, or mallet. (inverted hammer is the mirror opposite)
• Depending on the previous trend, a hammer may be referred to as a hanging man or shooting start, but the same concept applies. Bullish or bearish bias depends on previous price swing, or trend.
  • A hammer after an uptrend is called a hanging man.
  • An inverted hammer after an uptrend is called a shooting star.

What Does the Hammer Candlestick Look Like?

The Hammer formation is created when the open, high, and close prices are roughly the same. Also, there is a long lower shadow that’s twice the length as the real body.

When the high and the close are the same, a bullish Hammer candlestick is formed.

In contrast, when the open and high are the same, the red Hammer formation is considered less bullish, but still bullish.

Green Hammer

If the Hammer is green, it is considered a stronger formation than a red hammer because the bulls were able to reject the bears completely. Also, the bulls were able to push up the price past the opening price.

Is a Red Hammer Bullish?

A red Hammer candlestick pattern is still a bullish sign. The bulls were still able to counteract the bears, but they were just not able to bring the price back up to the opening price.

Long Lower Shadow

The long lower shadow of the Hammer implies that the market tested to find where support and demand were located. When the market found the area of support, the lows of the day, bulls began to push prices higher, near the opening price.

Thus, the bearish advance downward was rejected by the bulls.

What Does the Hammer Candlestick Mean?

Chart below of American International Group (AIG) stock illustrates a Hammer reversal pattern after a downtrend:

Chart above shows that the market began the day testing to find where demand would enter the market. AIG’s stock price eventually found support at the low of the day.

There was so much support and subsequent buying pressure, that prices were able to close the day even higher than the open, a very bullish sign.

Why are Hammers important?

• May act as a leading indicator suggesting a shift in bullish/bearish momentum
• Completed hammers may help to either confirm, or negate, a potential significant high or low has occurred. –price drives higher or lower “hammering” out a top or bottom before closing back towards open
• Significance increases with length of shadow (ideally 2-3 times the size of the body) as well as timeframe
• Hammers may also help confirm, or strengthen, other reversal indicators (i.e. may occur as part of tweezer formation, or next to doji, etc.)
• A hammer “fails” when new high is achieved immediately after completion (candle), and a hammer bottom “fails” if next candle achieves new low.
  • A hammer “fails” when new high is achieved immediately after completion (candle), and a hammer bottom “fails” if next candle achieves new low.

Example 1 - AUD/USD - 5min

AUD/USD - 5min (Same as above, but zoomed in)

AUD/USD - 5min (Same as above, but zoomed in)

Example 2 – USD/CAD – Daily

Example 2 – USD/CAD – Daily

Example
In the following 4 hour chart of USD/JPY, a hammer formed near an ascending trendline that represents a support level, suggesting of a possible continuation.

Given that the hammer did not break the trendline, we receive our confirmation to enter the trade. We buy USD/JPY at 99.60, while placing our stop-loss slightly below the ascending trendline at 99.30.

The pair rallies in line with our desired direction, advancing over 90 pips before breaking the trendline. We exit our position upon the close below ascending trendline, allowing us to attain a healthy 3:1 reward to risk ratio.