What is a hammer candlestick pattern and how to trade it?

What is a hammer candle? 

A hammer is a candlestick pattern that typically forms during a downtrend and signals a bullish reversal. Its structure resembles a hammer—a small body located in the upper range of the candlestick, a long lower shadow (at least twice the size of the candlestick body), and little to no upper shadow. The hammer is one of the most recognisable candlestick patterns used by traders due to its simplicity and reliability. 

Bullish vs. bearish hammer 

The hanging man is the bearish version of the hammer candlestick. While they look the same, their meaning changes based on where they appear. A hammer forms during a downtrend, suggesting a possible bullish reversal. It usually has a green body. The hanging man, on the other hand, shows up in an uptrend, signalling a potential bearish reversal and typically has a red body.  

Why are hammer candlesticks useful? 

Hammer candlesticks are useful as they indicate a potential trend reversal while providing valuable information into price action and market sentiment. 

The long lower wick shows that bears initially pushed the price lower but failed to sustain the decline. Ideally, the long lower shadow should be twice or more the size of the candlestick body. The rebound from the low indicates renewed buying pressure, suggesting bullish momentum. 

The hammer has more significance when it is located near a major support level, as buyers are more likely to step in.  

How to identify hammer candlesticks 

Since a hammer candlestick is a bullish reversal pattern, it should appear during a downtrend.  

The hammer itself is easily identifiable by its shape and unique characteristics: 

• The body of the hammer is relatively small and positioned at the top of the candlestick. 
• The long lower wick is at least twice the size of the body, indicating a failed attempt to push prices lower. 
• Ideally, there should be either no upper shadow or a minimal amount. 
• The hammer can be green or red, but (since we are looking for a bullish reversal), a green hammer is preferred as it reinforces bullish sentiment.

Hammers can appear across all timeframes and in various markets, including forex, stocks, commodities, and cryptocurrencies.

How to trade hammer candlesticks 

To trade the hammer candlestick, traders should first identify an instrument that is in an existing downtrend.  

Once a hammer candlestick is spotted, it is ideal to confirm whether it has formed near a significant support level. While this is not necessary for the hammer candlestick to be valid, it does improve the odds of a successful trend reversal. 

After the hammer has formed, traders anticipate the next candle to confirm the signal. Ideally, the next candle should close above the peak of the hammer candle; the higher the candle, the better. 

Once the hammer is confirmed (by the next candle closing above the hammer), traders can now enter a long position, placing a stop loss just below the low of the hammer candlestick. This is crucial, as false signals can occur with every candlestick or chart pattern. 

Where do traders place their take-profit orders?  

Since the hammer candlestick does not give us an idea of where to place the take-profit order, traders use other tools for guidance, for example, the next significant resistance level. However, it is crucial to consider the risk-reward ratio, which dictates that the distance from the entry level to the take-profit level should ideally surpass or at least equal the distance from the entry level to the stop-loss level. 

Hammer candlesticks can easily be combined with technical indicators and other chart patterns, which can improve the quality of the trade signals. A hammer forming near a key support level has better chances of being a valid signal, as it will attract more buyers. 

Furthermore, traders can make use of technical indicators to improve their odds. One example is the RSI indicator—bullish RSI divergence appearing during the formation of the hammer candlestick would be a good sign, as would be the instrument being in oversold territory. 

Traders can use the same tools to determine when to exit a trade. For example, if a hammer candlestick signals a valid reversal and the price begins to rally, traders should watch for key resistance levels. If the price reaches a significant resistance level and the RSI indicates overbought conditions, this may be the right time to exit the trade. 

How can we avoid a fake signal? 

Fake signals are inevitable, but traders can reduce risk by following these guidelines: 

• Wait for confirmation: Do not enter a trade based on the hammer alone. Ensure the next candlestick closes above the hammer. 
• Trade near key support levels: Hammers are more reliable when they appear near strong support zones. 
• Ensure an existing downtrend: A hammer is a reversal pattern, so it must appear after a decline. 
• Combine with technical indicators: Use RSI, moving averages, or volume analysis to confirm signals. 

Examples of hammer candlestick patterns 

Hammer = bullish

Hanging man = bearish

Hammer vs. Doji 

Both the hammer and doji can signal a potential reversal, but their structure is different. 

While a hammer signals a bullish reversal, the doji can indicate indecision, i.e., a battle between bulls and bears without a clear winner. 

The doji has a very small or no body at all, and the shadows at both ends can be long. This candlestick can appear in both uptrends and downtrends and show that no party is in control.

Pros and cons of hammer candles 

Pros 

1. Easy to spot due to its distinct shape. 
2. Widely recognised by traders, increasing its reliability. 
3. Works across all timeframes, from intraday to long-term charts. 
4. Applicable across markets from stocks to forex and commodities. 
5. Can be combined with other technical indicators for better accuracy. 
6. Provides a clear sign of a bullish reversal with a clear entry point. 

Cons 

1. Appears frequently, which can lead to false signals. 
2. Requires confirmation in the form of a bullish candle that forms after the hammer. 
3. Only valid in downtrends. 
4. Lacks a clear take-profit level, requiring additional indicators for exit planning. 

Conclusion 

The hammer candlestick is a powerful bullish reversal pattern that appears in downtrends and signals a potential price rebound. It is easily identifiable due to its small body, long lower shadow, and minimal upper wick. 

Since hammers frequently appear, traders should always wait for confirmation before entering a trade. Combining it with support levels, volume analysis, and technical indicators enhances its reliability.

Ready to trade your edge?

Join thousands of traders and trade CFDs on forex, shares, indices, commodities, and cryptocurrencies!

This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation and needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability with regard to the accuracy and completeness of the content in this publication. Readers should seek their own advice.