How to Trade the Hammer Pattern

 

Hello there, this is tradingpedia.com and this video refers to a very important topic in technical analysis – Japanese candlesticks patterns, known mostly as reversal patterns, and in this video, we will cover the hammer formation.

What is a Hammer Candlestick Pattern?

This is the EURUSD daily timeframe and the hammer is a reversal pattern forming at the bottom of bearish trends. This is a single candlestick pattern, meaning that only one candlestick defines the pattern. It has a small real body (the distance between the opening price and the closing price). Whatever the market forms above the real body is called the upper shadow and below, the lower shadow.

For the hammer formation we need only one candlestick and it is characterized by a tiny real body (not a line like it is here, this is called a Doji candlestick), but something like this. To make the distinction from a Doji candlestick or another candlestick that looks like a hammer, but it is not a hammer, use the following trick – measure the length of the real body and project it minimum two times over the lower shadow’s length. If it fits, that is your hammer. If it does not fit, the pattern is not a hammer. For instance, this one here, if it would form at the bottom of a bearish trend, would not be a hammer because the real body does not fit twice into the lower shadow.

The opposite of a hammer is called a shooting star and appears at the end of bullish trends. On the hammer pattern, the market shows a battle between bulls and bears. Bears are in control, otherwise the market will not fall. But with the hammer formation, a bit of optimism appears on the market as bulls prepare to take control.

Trading the Hammer Candlestick

To trade the hammer formation, you need to mark the lows and highs of the pattern and then you use the Fibonacci retracement tool to find out the 50% and 61.8% retracement levels. This would be the entry place for a long trade. So, to trade the hammer, you should wait for the market to come to 61.8% or 50%, depending on how aggressive you want to be in a trade.

That would be the risk of a trade, and the stop loss order must be set at the lows here. Remember, the hammer formation as a reversal pattern shows a battle between bears and bulls and bears will not let it go that easy, they will try to push the market to a new low. Bulls, on the other hand, will try to position for the new bullish trend.

In order to apply a sound money management technique, one needs to use a risk-reward ratio of at least 1:2. Meaning, if this is the risk, 1% on one trade, the reward should exceed twice the risk. The higher the rr ratio, the better for the trader. In this case, then if we project the risk to the upside three times this would be the exit from the trade. So the entry is 1.0787 and exit at 1:3 risk-reward ratio.

In money management the volume traded is very important. Risking 1% of the trading account for a 3% reward is a good risk-reward ratio, better than the one offered by other classic patterns like the head and shoulders pattern for instance.

Conclusion

So this is how you trade the hammer formation. Another hammer would be this one here. If we measure the length of the real body and project it to the downside, we see the hammer. Then we measure the highs and lows, and use the 50% as an entry, this would be the risk and the reward is the risk projected to the upside three times.

Aggressive traders also trail the stop every time the market puts a new level in the risk reward ratio. For instance, if the market reaches the 1:2 rr ratio, then the trader trails the stop to the next level. Then the market goes for 1:3, the trader trails the stop again as the market is advancing. But 1:3 is enough for the account to constantly grow.

Thank you for being here and in our next video we will use the head and shoulders in contrast to how to trade the hammer. Bye bye.