We are coming back to the Japanese candlestick techniques and this time we are looking at one of the most important reversal patterns and this is called hammer.
It is a bullish pattern so naturally a BUY CFDs or CALL options will be the instruments of choice to trade it. A hammer, like mentioned above, is a bullish pattern and this means it comes after a previous bearish trend. The second thing to look for is the fact that such a pattern it is almost always being followed by bears trying to take the lows of the hammer and this is providing us the entry price for placing the trade.
Identifying a Hammer
The hammer is one candle and the most important thing to consider is the fact that in order for a candle to be considered a hammer we should look for two times the real body to be minimum to be fit in the shadow of the candle. In plain English, look at the candle, measure the length of the body (regardless if it is red or green, it really doesn’t matter) and project the outcome on the shadow of the candle (or the tail as it is also called).
The tail should be minimum two times longer than the actual real body and this is the decisive factor most of the traders are failing to actually recognized. Is the hammer a powerful reversal pattern if it is formed only out of one single candle? Oh yes, it is. Or, put it in a different way, exactly because it is a single candle, we should look for it to be a strong reversal pattern.
Hammer as a Simple Bullish Pattern
Look at other reversal patterns we’ve covered in the Forex Academy and you’ll see that most of them imply a lot of waves and/or candles. Not this one. The hammer, being a bullish pattern, represents a battle between bulls and bears, as bears are trying to dominate and bulls are only starting to show their horns. This means that after the hammer is formed, we should not see a quick jump in prices as bears are not going to give up that easy on their bearish trend and they are looking to push prices below the low established in the hammer candle.
Squaring of a Short Position
One more thing it is worth mentioning here: trading in general and trading currency markets in particular is dominated by traders being forced to take some specific actions, in the sense that on a Friday, for example, if a trader is short all week, it is forced to close the short by the end of the week. In order to close a short position, one must buy, so a squaring of a short position would be seen in the market as a strong bullish candle that might look like a reversal one, a hammer.
In other words, try to avoid trading hammers that appear/are formed on Friday in the same day, but wait for the next Monday to open before taking the actual trade. If you feel that those current prices are really perfect for a striking price in a call option, then prepare to ride out the trade for a bit longer, or in case of binary options, choose an expiration date that should be big enough to spare you the trouble of the hammer being a fake candle on a Friday trading day. The usual caveat applies here as well, in the sense that the bigger the time frame the pattern appears, the stronger the implications and the reversal signal.
Bulls vs Bears – Waiting for a Retracement
Being a battle between bulls and bears and the latter ones dominating, after the candle is formed it is advisable to wait for a retracement before buying call options as that retracement should come in the very short term after the hammer is completed.
If the hammer is forming on the daily chart, then the retracement that should offer the perfect striking price should come in the early hours of the next day.
When trading a call options and price is going and break the lows established by the hammer, then the way to go is to reverse the trade and trade more heavily a put option or more, as the reversal pattern just got invalidated and the reasons why one went on and traded a call option are no longer valid. In doing that, I would split both the investment and the expiration date as market is clearly still dominated by bulls and short term expiration date should be more attractive than long ones. Then, depending on the outcome of the short term expiration date put options, one may insist on bigger ones as well until the investment with trading the call option is recovered.
Find out more details regarding this pattern by watching the two video analysis we added to the article.