Many textbooks state that the Hammer candlestick pattern is a signal that the market is about to reverse higher.
So, anytime you spot it in your chart, you go long.
However, the price reverses immediately and you get stopped out, making a loss.
You are left with questions like…
“Is the Hammer candlestick a bullish signal?”
“How comes the market reversed against me?”
In this article, I will help you know how to trade this chart formation profitably!
What is a Hammer Candlestick Pattern?
The Hammer candlestick is a 1-candle bullish reversal candlestick that forms at the bottom of downtrends.
The Hammer candlestick is characterized by the following…
- Little or no upper shadow.
- Price closes at the top ¼ of the range
- Long lower shadow, about 2 or 3 times the length of the body.
Consider the following graphic…
The above graphic shows how a Hammer candlestick looks like.
From the graphic, the upper shadow is very small. Some Hammer candlesticks don’t have the upper shadow.
This is in contrast with the lower shadow, which is 2 or 3 times the size of the body.
So, what does it mean?
It means the following…
That after the market opened, the sellers took control of the market, pushing the price lower.
When they reached the selling climax, a huge buying pressure came in, pushing the price higher.
The buying pressure was so strong such that it closed above the opening price.
So, the Hammer candlestick is a reversal candlestick pattern that shows a rejection of lower prices.
Consider the following chart…
The above chart shows the formation of the Hammer candlestick pattern.
Before the formation of the Hammer candlestick, the price action went through a downtrend.
This has been shown using the red arrow.
At this stage, the sellers are pushing the price lower, and the market is looking for where buying pressure can come in.
The formation of the Hammer candlestick as shown on the chart signals the entry of buyers into the market.
The upper shadow of the Hammer is small compared to the lower shadow.
The lower shadow of the Hammer candlestick is also about 2 times the size of the body.
After the formation of the Hammer candlestick, a bullish trend begun.
The price finally managed to close higher than the open.
Note that just that you’ve spotted the Hammer candlestick on your chart doesn’t mean that you go long immediately.
Let me give you the reasons…
Facts about the Hammer Candlestick Pattern
So, let me give you some of the facts about this chart formation that even most trading gurus don’t know…
#1: The Hammer is a Retracement against the Trend
Always see the Hammer as a retracement against the trend on the lower timeframe.
This is in contrast to what most traders think, that it marks the beginning of an uptrend.
Consider the following chart…
From the above chart, it’s very clear that no major bullish move followed the formation of the Hammer candlestick.
The Hammer candlestick is only trying to retrace the trend on the lower timeframe.
So, you don’t have to go long immediately you identify the Hammer candlestick on your chart.
Doing so means that you will be trading against the trend.
That’s why most traders get stopped and lose their money!
#2: The Hammer Candlestick Doesn’t Tell You the Trend Direction
This is the biggest mistake made by most Forex traders!
Yes, the Hammer Candlestick forms after a bearish move.
When most traders see the Hammer candlestick, they think that it marks the end of the bearish move and the beginning of a bullish move.
This is wrong!
Let me give you the reason…
A trend is composed of a series of 100 or even more candles.
So, ask yourself this question…
What are the chances that the trend will reverse because of 1 candle?
The chances are very minimal!
To know the direction that a trend will take after the Hammer candlestick, ask yourself…
“Is the price going lower or higher?”
NEVER make a conclusion regarding the direction of the trend based on an individual candlestick!
Instead, consider many candles on your chart.
#3: The Market Context is more important than the Hammer
The market context is simply the condition of the market.
The market can be in a sideways movement, uptrend, downtrend, in a strong momentum etc.
This matters a lot than the Hammer candlestick!
So, give the market context the first priority when determining the direction that the market is most likely to take.
For example, if the market is in a downtrend and a Hammer candlestick is formed, the market is most likely to maintain its downtrend.
Also, the Hammer candlestick can be formed in an uptrend, and the market is most likely to move higher since the market is in an uptrend!
With the above 3 points, you know so much that most traders don’t know.
So, how should you trade the Hammer candlestick pattern?
That’s what I will be showing you next…
How to Trade the Hammer Candlestick Pattern
The deal is…
Don’t trade an isolated candlestick pattern.
So, how should you trade the Hammer candlestick?
Let me give you three tips that will help you trade this chart formation profitably…
#1: Trade in the Direction of the Trend
Remember what I stated above…
That the Hammer candlestick doesn’t signal the possibility of a trend reversal.
But there are high chances of the current trend maintaining its direction after the formation of the Hammer candlestick.
So, to stay safe, trade in the same direction as the trend!
This way, you will increase chances of your trade working out.
But, how can you define a trend?
Well, you can use the Moving Average indicator.
The 200 day moving average indicator is the best.
After inserting it on your chart, you will know the position of the market in relation to the 200MA at any particular point in time.
If the price is trading above the 200MA, it’s time to go long!
And if the price is trading below the 200MA, it’s time to go short!
If you don’t follow this, wait for a loss!
Here is the second tip…
#2: Trade from an Area of Value (AOV)
Each chart has areas where buying/selling pressure lurks around.
Such areas are known as areas of value (AOV).
So, your goal should be to enter trades close to an AOV.
There are a couple of reasons as to why you should do this.
First, your stop loss orders will be placed tight to each other.
This means that you will get a favorable risk/reward ratio.
This way, you will get optimal returns for each dollar that you risk in your trade.
Again, in case the trade fails to move in your favor, you will only incur a minimal amount of loss.
Secondly, there will be an adequate buying/selling pressure to push the price in your favor.
Thirdly, your stop loss order will be protected by the market structure and it will be hard for it to be triggered.
This can help you stay in a trade for long, and make an extra profit.
#3: Look for an Entry Trigger
What pattern repeats itself and makes you enter a trade?
That’s how you can identify an entry trigger.
Once all the conditions for your trading setup have been met, you can look for an entry trigger.
This is what you can use to enter the trade.
It can be the Hammer candlestick or any other bullish reversal candlestick pattern.
Here is something important for you to note….
Don’t trade entry triggers in isolation!
So, first ensure that all the conditions for your trading setup have been met.
It’s after this that you can look for an entry trigger to enter a trade.
Now, let’s put the above 3 points into action…
Consider the chart given below…
The above chart shows how to trade the Hammer candlestick pattern.
The black line running horizontally is the Support level for the chart.
Our first goal is to trade in the direction of the trend.
That’s why we added the 200 day moving average to the chart.
This is the continuous line marked 200 MA on the chart.
When you consider the position of the price action in relation to the 200 MA, the price action is trading above the 200 MA.
That’s why we had to go long.
If the price action was trading below the 200 MA, we would have gone short.
The second goal is to trade close to an area of value.
In the above chart, I have traded close to the Support level.
This means that I have used the Support level as an area of value.
Due to this, the stop loss order has been protected by the market structure.
It is hard to trigger the stop loss, hence, the trader will stay in the trade for long.
This will give the trader a chance to earn an extra profit.
The last goal was to identify an entry trigger.
In this case, we are using the Hammer candlestick pattern as the entry trigger.
That’s why the point of entry is just at the top of the Hammer candlestick.
The position at which you can take your profit has also been shown.
Note that we have not traded the Hammer candlestick in isolation.
Other factors such as the position of the trend in relation to the 200MA have been considered.
It is after all the trading conditions were met that we identified an entry point.
With such an approach, there are high chances of trading correctly.
The Break of Structure Technique
As you’ve seen, the Hammer candlestick acts as a great entry trigger.
When trading the Hammer candlestick, your stop loss should be at least the Range of the Hammer.
Of course, you can use more.
However, it will be good for you to reduce the size of your stop loss.
The major benefit of doing this is that you will improve your risk/reward ratio.
So, if your original Hammer trade had a risk/reward ratio of 1:2, you will get a risk/reward ratio of 1:5 after applying this technique.
So, you were initially risking $1 to make $2, but you’re now risking $1 to make $5, or even more.
This sounds awesome!
You can achieve this using The Break of Structure Technique.
It works as follows…
- Use the above approach (the 3 tips) to identify a trading setup on a daily timeframe.
- Go down to a 4-hour timeframe. Find a Bull flag pattern.
- Buy on the break of the swing high.
- Place your stop loss order 1 ATR below the swing high.
Consider the following chart…
In the above chart, we have managed to identify a trading setup successfully.
This is the area enclosed within a red rectangle in the chart.
I have used the 3 tips discussed earlier to identify the setup.
A Hammer candlestick has been formed in this area.
The price is trading above the 200MA, hence, we will go long.
Now, let’s look for a bull flag within a 4-hour time frame on the same chart.
The following chart shows this…
We have identified a bull flag on the chart.
This has been marked using two black lines running parallel to each other and marked as Bull Flag.
The entry point, which is the position at which the trader should buy the currency pair has been shown.
This is the point on the chart where there is a break of the swing high.
The stop loss order should be placed 1 ATR below the swing low.
The position of the stop loss order has been shown using a red horizontal line marked as Stop Loss.
This is what you’ve learned…
- The Hammer candlestick is a 1-candle pattern formed after a decline in price.
- The Hammer candlestick can have a small upper shadow or no upper shadow at all.
- The lower shadow of the Hammer candlestick is 2 or 3 times the size of its body.
- Most traders think that the Hammer candlestick signals the end of a particular trend. This is false.
- The Hammer candlestick is simply a retracement against the trend.
- It does not tell traders about the direction of the trend.
- If the market was in an uptrend, it is most likely to continue in an uptrend after the Hammer candlestick.
- If the market was in a downtrend, it is most likely to continue in a downtrend after the Hammer candlestick.
- When trading the Hammer candlestick, the context of the market must be considered.
- The context here is the direction of the price action. You can determine this using the 200 day moving average.
- Don’t use the Hammer candlestick alone to make trade decisions. Combine it with other factors within your trade setup.
- You can use the Break of Structure technique to identify more profitable opportunities.