What it is and how investors use it

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 rises within the period to close near the 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 opening and closing prices, while the shadow shows the high and low prices for the period.

Understanding Hammer Candlesticks

A hammer occurs after the price of a security has fallen, indicating that the market is trying to determine a bottom.

Hammers indicate a potential capitulation by sellers to form a bottom, accompanied by a rise in price to indicate a potential reversal in price direction. This all happens during a single period, where the price drops after the opening, but regroups to close near the opening price.

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 when 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 entering new long positions, a stop loss can be placed below the low of the hammer’s shadow.

Hammers are usually not used in isolation, even with confirmation. Traders typically use price or trend analysis, or technical indicators to further confirm candlestick patterns.

Hammers appear 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 drop followed by a hammer pattern. This pattern had a long lower shadow, several times longer than the real body. The hammer indicated a possible price reversal to the upside.

Confirmation came on the next candle, which yawned higher and then saw the price bid up to a close well above the closing price of the hammer.

Traders usually step in to buy during the confirmation candle. A stop loss is placed below the low of the hammer, or even possibly just below the hammer’s real body if the price moves 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 indicates indecision because it has both an upper and a lower shadow. Dojis can indicate a price reversal or a trend continuation depending on the confirmation that follows. It differs from the hammer, which occurs after a price decline, indicates a potential upside reversal (if followed by confirmation), and has only a long lower shadow.

Limitations of using hammer candlesticks

There is no assurance that the price will continue to move to the upside after the confirmation candle. A long shadow hammer and a strong confirmation candle can push the price quite high within two periods. This may not be an ideal place to buy, as the stop loss may be a large distance from the entry point, exposing the trader to risk that does not justify the potential reward.

Hammers also don’t offer a price target, so it can be difficult to figure out the reward potential for a hammer trade. Exits should be based on other types of candlestick patterns or analysis.

Psychology of the Hammer

As we have seen, a useful hammer pattern generally emerges in the context of a downtrend, or when the chart shows a series of lower highs and lower lows. The appearance of the hammer indicates that more bullish investors are taking positions in the stock and that a reversal in the downward price movement may be imminent.

The long lower shadow on the hammer candlestick indicates an attempt to continue the price’s downward trajectory, but the higher close represented by the right body indicates that the sellers were ultimately unsuccessful in taking the price to its intraday low keep. The price’s rally from its session low to a higher close suggests that a more bullish outlook has won the day, paving the way for a possible reversal to the upside.

Practical application

If you have seen a hammer candlestick on a price chart, you may be eager to make a trade and profit from the possible upcoming price movement. Before you place your order, let’s look at some practical considerations that can help you make the most of a trade based on the hammer pattern.

The hammer signal

The first step is to ensure that what you see on the candlestick chart actually corresponds to a hammer pattern. If you’re looking for a hammer signal that implies a potential upside reversal, it should occur in the context of a downtrend, or bearish price action characterized by a series of lower highs and lower lows.

Under these conditions, the signal you are looking for is a hammer-shaped candlestick with a lower shadow at least twice the size of the real body. The closing price may be slightly above or below the opening price, although the close should be close to the open, which means that the real body of the candlestick remains small.

Looking for confirmation

Confirmation of a hammer signal occurs when subsequent price action confirms the expectation of a trend reversal. In other words, the candlestick following the hammer signal should confirm the upward price movement. Traders hoping to profit from a hammer signal often buy during the formation of this bullish confirmation candle.

To place stop and take profit

As with any trade, it is advisable to use stops to protect your position in case the hammer signal does not play out the way you expect. The level at which you set your stop will depend on your confidence in the trade and your risk tolerance. However, it can be useful to set a stop loss below the low of the hammer pattern, which provides protection in case the downward pressure resurfaces and the upward move you expected never materializes.

On the other hand, if the price does start to rise, rewarding your recognition of the hammer signal, you will have to decide on an optimal level to exit the trade and take your profit. On its own, the hammer signal provides little guidance on where to place your profitable order. As you strategize on a potential exit point, you may want to look for other resistance levels such as nearby swing lows.

The Bottom Line

A hammer candlestick pattern occurs when a security trades significantly lower than its opening, but then rallies to close near its opening price. The hammer candlestick shown on the chart has a lower shadow that is at least twice the size of the real body. The pattern suggests that sellers tried to push the price lower, but buyers eventually regained control and returned the price near its opening level. The pattern indicates a potential price reversal to the upside.