Hammer Candlestick: 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 rallies 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 been declining, suggesting that the market is attempting to determine a bottom.

Hammers signal a potential capitulation by sellers to form a bottom, accompanied by a price rise to indicate a potential reversal in price direction. This happens all during a single period, where the price falls 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 if 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 taking new long positions, a stop loss can be placed below the low of the hammer’s shadow.

Hammers aren’t usually used in isolation, even with confirmation. Traders typically utilize price or trend analysis, or technical indicators to further confirm candlestick patterns.

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

Confirmation came on the next candle, which gapped higher and then saw the price get 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 potentially just below the hammer’s real body if the price is moving 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 signifies indecision because it is has both an upper and a lower shadow. Dojis may signal a price reversal or a trend continuation, depending on the confirmation that follows. This differs from the hammer, which occurs after a price decline, signals a potential upside reversal (if followed by confirmation), and only has a long lower shadow.

Limitations of Using Hammer Candlesticks

There is no assurance that the price will continue to move to the upside following the confirmation candle. A long-shadowed hammer and a strong confirmation candle may push the price quite high within two periods. This may not be an ideal spot to buy, as the stop loss may be a great distance away from the entry point, exposing the trader to risk that doesn’t justify the potential reward.

Hammers also don’t provide a price target, so figuring what the reward potential for a hammer trade is can be difficult. Exits need to be based on other types of candlestick patterns or analysis.

Psychology of the Hammer

As we have seen, an actionable hammer pattern generally emerges in the context of a downtrend, or when the chart is showing a sequence of lower highs and lower lows. The appearance of the hammer suggests 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 effort to continue the price’s downward trajectory, but the higher close represented by the real body indicates that the sellers were ultimately unsuccessful in holding the price at its intraday low. The price’s ascent from its session low to a higher close suggests that a more bullish outlook won the day, setting the stage for a potential reversal to the upside.

Practical Application

If you’ve spotted a hammer candlestick on a price chart, you may be eager to make a trade and profit from the potential upcoming price movement. Before you place your order, let’s take a look at a few 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’re seeing on the candlestick chart does in fact correspond with a hammer pattern. If you’re looking for hammer signal that implies a potential upside reversal, it should occur in the context of a downtrend, or declining price action marked by a series of lower highs and lower lows.

Under these circumstances, the signal you’re keeping an eye out for is a hammer-shaped candlestick with a lower shadow that is 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 near the open, meaning that the candlestick’s real body remains small.

Looking for Confirmation

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

Placing Stops and Taking Profits

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

On the other hand, if the price does begin 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 profits. On its own, the hammer signal provides little guidance as to where you should set your take-profit 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-shaped candlestick that appears on the chart has a lower shadow at least twice the size of the real body. The pattern suggests that sellers have attempted to push the price lower, but buyers have eventually regained control and returned the price near its opening level. The pattern indicates a potential price reversal to the upside.