Learn Hammer and Hanging Man Candlestick Patterns

HAMMER AND HANGING MAN CANDLESTICK PATTERNS

THE HAMMER

The hammer and hanging man patterns are identical and have long lower shadows, short or no upper shadows, and small bodies. The pattern, shown in Figure 1.2, is called a hammer if it occurs during a downtrend and a hanging man if it occurs during an uptrend. The color of the body is not important. The lower shadow should be twice the length of the body or more. There should be no or very little upper shadow, indicating that the day’s high should be near the close for a white body and near the open for a black body.

FIGURE 1.2: BASIC HAMMER AND HANGING MAN CANDLESTICK PATTERNS

Figure 1.3 shows a candlestick chart of BBH. BBH had been in a clear downtrend during January, February, and the first part of March 2007. On 03/14/07, BBH formed a hammer pattern as marked by the up arrow. The hammer pattern marked the end of the downtrend, and BBH rose more than seven points during the next five sessions. Obviously, not every hammer pattern is a profitable trade. The important question for traders is: how often does the pattern result in profitable trades, and are there other factors that influence the results? These questions can be answered by using backtesting techniques to examine the results of thousands of trades.

FIGURE 1.3: CANDLESTICK CHART WITH HAMMER PATTERN

THE HANGING MAN

Figure 1.4 shows a candlestick chart of NEU during the first half of 2006. On 05/09/06, NEU formed a hanging man pattern as marked by the up arrow in Figure 1.4. The hanging man pattern marked the end of the uptrend in NEU and subsequently, it declined nearly 12 points during the next four trading sessions.

FIGURE 1.4: CANDLESTICK CHART WITH HANGING MAN PATTERN

When traders get together and discuss trading patterns or setups, someone usually asks why a particular pattern works. To explain trading patterns, the market is often described as a battle between the bulls trying to drive prices up, and the bears trying to drive prices down. The patterns are the result of this contest between the bulls and bears. In the case of a hammer pattern, the stock has been in a downtrend, indicating that the bears have control. When the hammer forms, the price is initially driven down further by the bears, forming the long lower tail. At some point during the day, the bulls step in and drive the price back up near the opening, forming the small body. The hammer forms at a point where bullish investors are willing to step in; therefore, the downtrend ends and the stock begins to move up.

Some traders will start using a pattern or trading system when they hear an explanation of why it works that makes sense to them. We all have a need to understand why something should work. However, for traders, it is more important to know how often a pattern works rather than an explanation of why it works. Knowing why a pattern works is interesting. Knowing how often a trading pattern works can be profitable. And, knowing in what specific market conditions a pattern works best can be very profitable. In the next chapter we will address these issues and develop a working knowledge of when to use candlestick patterns and when to use another tool from the trading toolbox.