HAMMER PATTERNS

The hammer pattern may mark a reversal of a stock’s downtrend. Hammers have long lower shadows or tails, short or no upper shadows, and small bodies. They actually look like a hammer, with the long tail being the handle and the small body being the head of the hammer. The color of the body is not considered important; it can be either a white or black body, implying the hammer can occur on either an up or down day.

The most common definition requires the lower shadow to be twice the length of the body, or more. The common definitions indicate there should be no or very little upper shadow showing and the day’s high should be near the close for a white body and near the open for a black body. One of the advantages of backtesting a potential trading pattern is that we can investigate this definition and determine things like whether the color of the body matters, whether different lengths of the lower shadow affect results, and just how small the upper shadow has to be.

Figure 4.1 shows a hammer pattern in EXBD that occurred on 07/14/06 and is marked by the down arrow on the chart. EXBD had been in a clear downtrend, as marked by a series of lower highs and lower lows, for 10 weeks. On 07/14/06, the stock moved down after the open, which is the bottom of the body on a white candlestick, and then retraced the move to close up for the day. This trading action left a long lower shadow, which is more than twice the length of the body, and a small upper shadow that completed the definition of a hammer pattern. After forming the hammer pattern, EXBD moved up more than $3 in the next few trading sessions.

FIGURE 4.1: HAMMER PATTERN IN EXBD ON 7/14/06

Hammers can also have a black body, indicating they closed down for the day. The only requirements are a small upper shadow and a lower shadow that is more than twice the length of the body. Figure 4.2 shows a black-bodied hammer that occurred in PHI on 06/28/06 and is marked by the up arrow on the chart.

FIGURE 4.2: HAMMER PATTERN IN PHI ON 6/28/06 Courtesy of AIQ

PHI had been in a downtrend for two months when, on 06/28/ 06, it opened down and continued moving down. Later in the day, it rallied and closed near the highs of the day, forming a long lower shadow and a black body. During the next four trading sessions, PHI ran up over 13%.

DETERMINING THE OPTIMAL PATTERN DEFINITION-SHADOWS

The requirement in the hammer definition that the pattern have a small or no upper shadow is not well defined. In order to backtest the pattern, we need a specific definition. I chose to start with the requirement that the upper shadow be less than 15% of the day’s trading range. The good thing about backtesting is that we can easily test a range of lengths for the upper shadow to determine if it makes a significant difference, and if it does, we can then determine which is the best one to use.

INITIAL TEST PERIOD: 1/3/06 to 5/1/07

Figure 4.3 shows a hammer with a large upper shadow (marked by the down arrow) that occurred in ZF on 04/18/05. In order to determine if larger upper shadows affect the trading results of the hammer pattern, we can use backtesting techniques.

FIGURE 4.3: HAMMER WITH LARGE UPPER SHADOW IN ZF ON 4/18/05

The backtest results of Figure 4.4 were obtained by looking at all the hammers that occurred in downtrending stocks during the period of 01/03/06 to 05/01/07. When a hammer pattern formed, a trade was entered the next day at the opening price, held for five days, and sold. The tests were run on a database of about 2,200 stocks that comprise trading candidates that have an average daily volume greater than 200,000 shares plus most of the sector ETFs. This is the database from which I trade. A stock with lower average daily volumes may have wide bid/ask spreads and can be hard to enter and exit quickly.

FIGURE 4.4: INITIAL BACKTEST OF HAMMER PATTERN

Figure 4.4 indicates that hammer patterns occur quite frequently since the backtest took more than 3,800 positions during the 1/2-year test period. The basic pattern shows an annualized ROI of slightly over 10%. This sounds interesting until you notice that the annualized ROI for trading the SPX during the same period was slightly over 14%. Our first pass indicated that during this test period the hammer pattern, as defined, is not something I would trade. However, backtesting techniques allow us to explore how this pattern works in different market conditions and also if changes in the basic definition would improve results.

The hammer definition does not clearly define what “little or no” upper shadow means, so that is a reasonable place to begin our investigation of the pattern. The test results of Figure 4.4 used a requirement that the upper shadow be less than 15% of the day’s trading range. Examining the results of testing different upper shadow length requirements will help us understand what works best.

One of the important aspects of trading patterns is to make sure they are clearly defined. When a pattern definition contains adjectives such as big or small, it leaves room for interpretation in the definition. When there is room for interpretation, traders using the same pattern may see different results due to the interpretation issues.

DIFFERENT UPPER SHADOW LENGTHS

Table 4.1 shows the effect of different upper shadow lengths on the test results of the hammer pattern during the 01/03/06 to 05/01/07 testing period. For this particular test period, it appears that reducing the upper shadow length reduces annualized ROI. Rather than requiring the hammer pattern to have little or no upper shadow, the results of Table 4.1 indicate we should consider hammers whose upper shadow length is 20% or less of the day’s trading range.

TABLE 4.1 EFFECT OF UPPER SHADOW LENGTH ON HAMMER RESULTS DURING 1/03/06 TO 5/01/07

Since the initial results indicate that shorter upper shadows actually reduce returns of the hammer pattern and since this result was unexpected, I decided to run the tests in a different time period. I also ran a test that was twice as long. If results are similar in different time periods, they are more likely to be correct.

Table 4.2 shows the results of testing the hammer pattern during the three-year period of 01/01/04 to 12/29/06. This data leads to several interesting conclusions. First, since the number of trades increased in rough proportion to the increase in the testing time frame, it would appear that hammer patterns are a regular occurrence through different time frames and market conditions. This is a positive result, since patterns that occur infrequently or are found only in one time frame may be event-driven rather than a natural part of market activity.

TABLE 4.2 EFFECT OF UPPER SHADOW LENGTH ON HAMMER RESULTS DURING 1/01/04 TO 12/29/06

The second interesting result of comparing the data in Table 4.1 and 4.2 is that the annualized ROIs were similar. This indicates that in different time periods and market conditions, the pattern performs about the same. This gives confidence that the returns are not driven by specific things that just occurred in one time frame and hence may not repeat in the future.

The third interesting result of comparing the data in Table 4.1 and 4.2 is that in both test periods the annualized ROI decreased consistently as the upper shadow length was decreased. This lends credibility to the thought that when using hammer patterns, we should allow upper shadow lengths of up to 20% of the day’s trading range.

Since the data in Tables 4.1 and 4.2 indicate that the annualized ROI decreases as the upper shadow length requirement decreases, it raises an interesting question. What happens if we require hammer patterns to have an upper shadow length of at least 5% of the day’s range, and less than 20% of the day’s range? This test result is shown in Figure 4.5.

FIGURE 4.5: HAMMER BACKTEST WITH UPPER SHADOW >5% AND <20% OF DAY’S RANGE

UPPER SHADOWS BETWEEN 4 AND 20%

Figure 4.5 indicates that testing the hammer during the three-year period of 2004, 2005, and 2006 shows improved results by adding a requirement that the upper shadow in the pattern be between 4% and 20% of the day’s trading range. This new requirement filters out hammer patterns with small upper shadows between 0 and 4% of the day’s trading range. It improves the annualized ROI as compared to just a requirement that the upper shadow be less than 20% of the day’s trading range. It appears that the hammer pattern works best with at least a small upper shadow.