Bullish Japanese Candlestick Pattern: Hammer

The hammer candlestick pattern for trading is a single candlestick pattern. It involves a small real upper body and a longer lower shadow. In order for this pattern to be called a hammer it must occur in a downtrend. If this pattern occurs in an uptrend it is not a hammer. If it occurs in a sideways pattern on the stock chart then this pattern should be ignored. It is called a hammer pattern because it is said that the market (or individual stock) is “hammering” out a base. The hammer is considered bullish pattern.

The small real body can either be white or black (or in my case red or green since they are my preferred colors). However, there are some particular things about the candlestick that must be true. Let's touch on a few of those.

There are three characteristics that must be true of the candlestick pattern itself. The first is that there must either be no upper shadow at all or the upper shadow must be very small. It is ideal the the top be shaven. This would mean that either the open or the close was also the high of the day.

The second characteristic is that the small real body needs to be at the upper end of the candle. The fact that is has a small real body means that the stock open and closed within a tight range. As mentioned above the real body can be white or black but the pattern is considered to be stronger is the real body is white.

The third characteristic of the hammer bullish pattern is the the longer lower shadow must be at least twice as long as the small real body. It the shadow is not twice as long then you do not have a hammer on your hands. The longer that this lower shadow is the stronger this pattern will be. What it means is that the stock continued the selling pattern during the day but at some point it rallied back to close near the point that it opened.

Also, remember as I mentioned above that this candlestick needs to occur in a downtrend.

Below you will see an example of a hammer pattern in WFC.  This occurred in August of 2010.  The hammer is circled in white.  You will notice that it is found at the bottom of a downtrend.  The stock did not take off immediately; it took a  couple of days before starting more than a 10% move. 

The next example is FITB (Fifth Third Bank).  You will see that once again the hammer pattern occurred during a downtrend and short thereafter an uptrend began.  In this instance the hammer actually has a small upper shadow.  This is OK as long as the upper shadow is not too long.  This stock also rallied for more than a 10% gain. 

You will probably get a number of different opinions on how to do this.  Personally, I merely look for the stock to trade above the small real body of the hammer pattern on the following trading day.  It doesn't have to close above it for me to enter a position.  Normally, I would set an exit that would cut any losses that I have at a certain point below the low of the hammer pattern.  I am not worried about the stock trading below the hammer but I would normally only give it a range of about 3% - 5%.  The stock would have to close below this level for me to exit the trade at a loss.  You can see that FITB traded below the low of the hammer but never actually closed below that level. 

Others would be more strict in their stop loss and would exit the trade if the stock ever closed below the low of the hammer.  You will need to determine what your risk tolerance is and how much you are will to risk. 

Once the stock starts to move in the direction that you had hoped you will need to determine at what point you will take profits.