A hammer candlestick is a chart pattern used in technical analysis to identify a potential reversal in a security that has been in a downtrend. The hammer candlestick is generally seen as a short term technical indicator, and is most often used by active traders.
Hammer Candlestick Components
The hammer candlestick gets its name from its appearance of a hammer, with a square block on top as the head of the hammer and a long downward tail as the hammer’s handle. The block on top of the indicator represents the opening and closing price for the day right at the top of the day’s price range, while the handle represents the area where buyers and sellers fought it out until the buyers took control and brought prices up.
Generally a candlestick is only considered a hammer if the handle is at least twice as long as the head.
Trading With Hammer Candlesticks
The hammer candlestick is used as a signal that the price of a stock will likely experience a reversal. It is seen as a short term signal where a good deal of selling occurred that was overcome by buyers later in the day which would cause the long wick of the hammer.
Merely looking at the open and close price of the stock would give the impression that the price range was tight for the day, when in reality there was substantial buying pressure on the price of the stock. That buying pressure is likely to materialize in the next trading session, where sellers will likely be overrun by buyers.
The hammer candlestick is a great indicator for identifying potential reversals especially if the stock has been in a downtrend. Ideally you would want to buy on the next candle when it breaks above the highs of the hammer candle and then you can use a stop below the low to protect your position.
One key factor to keep an eye out for is volume. Ideally, you would want to see a spike in volume on the hammer candle. This will further confirm the likelihood of a reversal in price action and that it may be time to take a long position.
Hammer Candlestick: Final Thoughts
The hammer candlestick is best used as a broad signal for selecting potential trades that are then pursued further with additional research. A hammer candlestick on its own is often an inadequate signal for making a trading decision by itself, but when you combine it with other factors like volume and previous price action then it can be a reliable setup to trade.