With so much exciting (and tradeable) price action happening across different markets and currency pairs, we’re now seeing an influx of valid, strong technical signals, some of which haven’t been around for a little while. Perhaps that’s why Lazy Traders currently have six (6) open positions, the most I can recall having at any one time in recent years!
In fact, it dawned on me while presenting last week’s Market Insider Webinar (login required) that I maybe hadn’t called out hammer or smash bar patterns all that much lately, but I did on that day. So, with those patterns now in play, please read on to learn more about the hammer and smash bar formations, what each means to traders, and how to react whenever one of these strong technical signals flashes on your screen.
A hammer is a single-bar chart pattern that occurs only in down markets and signals a potential buying opportunity in advance of a reversal to the upside. This signal is not to be confused with a hanging man, which is important to note considering the two are identical in their construction. The only difference being that a hammer is seen at the end of a downtrend, while a hanging man occurs in upward-trending markets and suggests weakening momentum.
Hammer bars get their name from their construction, which involves the candle’s body being set at the very top of the tail, or “handle.” To qualify as a hammer, the general rule is that the tail must be at least twice as long as the candle’s body. (See diagram at right.)
Traditional hammer bars can be either bullish or bearish and would still be considered strong technical signals, although the bullish kind are considered even more favourable. So, too, is any hammer bar that prints on higher time frames like the daily, and especially the weekly and monthly charts.
Now take a good look at the hammer’s construction for a moment. Can you see that if only the tail had a “shadow,” or extended a bit above the bar, the hammer would likely be classified as a pin bar reversal instead?
What Does It Tell about Price Action?
Much like a pin bar reversal does, a hammer on a chart of any time frame signals renewed buying coming in amidst a loss of selling momentum. This makes for a higher likelihood of a reversal to the upside at that point, particularly when the hammer occurs at a key technical juncture on the chart. This may include established support from a trend line, moving average, pivot, Fibonacci retracement, or a period-based low, for example.
An “ideal” hammer formation would have the tail penetrate (or at least test) the key support level in question, with price then rallying and closing either at the high (bullish hammer) or just below it (bearish hammer), either of which would signal buyers coming back in and defending the key support level. Certain technical indicators like the Relative Strength Index (RSI) and others may be used to help validate this change in momentum back in favour of the buyers.
How to Use a Hammer as a Trade Signal
You can probably recognise by now that a hammer is rather similar to a pin bar reversal in terms of both construction and application in the market. And because of that, we trade qualifying hammer patterns using a strategy that’s very similar to our pin bar reversal trading strategy:
In the event that the trade is triggered and begins moving in your favour, risk-conscious traders may then opt to move the stop up to breakeven to protect against downside risk and preserve early profits.
NEXT: Read Part 2 of this article, discussing smash bar patterns and how to use them in your trading.
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