There has been much written about the origin of candlestick charting and its uses so I won’t bore you with the standard story. However, I will say that for those not yet familiar with candlesticks they are certainly worth learning more about.
The Hammer is one of the most popular candlestick patterns. Hammers are formed when a market drops significantly after it opens, only to recover and close back near where it began. The three main types of Hammer patterns are shown below – a close above the open, a close equal to the open, and a close slightly less than the open. As the name suggests, all three resemble something you would find in a carpenter’s toolkit.
Hammers on a daily chart show a market has recovered after an intra-day decline - which indicates strength. When this happens often times new short positions have been suckered in only see the market reverse hard against them. Down the track those shorts can add fuel to the uptrend when they are forced to buy in order to close their positions – know as a “short squeeze”. Most strong uptrends start with a short squeeze, so this is exactly what any would be bull wants to see on their chart. For that reason, many significant lows will form as a hammer.
Knowing this, the hammer can be used for a variety of trading set-ups and/or confirmations. One example is a recent Wave 4 Buy trade on BioMarin Pharmaceutical Inc (BMRN). Seeing a hammer candle in this situation gives added support to the case for a bullish move.
Chart 1 - Wave Hammer
click to enlarge
Often the best way to confirm a pattern like this is to wait until the next day. If the market can break the high of the hammer candle, often this is enough to confirm a low has been found. As we take a closer look at BMRN we see that the candle after the hammer did trade higher and also closed above the blue EBOT (Elliott Break-Out Trigger) line.
Chart 2 – Entry Signal
click to enlarge
Winding the clock forward a few weeks we can see the rally that followed. No doubt any short stock, long put or short call positions were hurting as the move unfolded.
While this discussion has focused on Wave 4 buy trades, hammers can be used in the same manner on Wave 5 buys. For Wave 4 and 5 sells the inverse of a hammer – called a shooting star - helps highlight strong bearish trades.
The constant challenge for a reversal or retracement trader, is confirming that the trend – major or minor -is in fact over. Looking for hammer patterns is a simple method of ensuring that the chances of success are improved.