Most Forex traders know about hammer candlesticks. They are also known as pin bars. They are generally believed to signify that a price reversal has just begun to take place, which obviously is very interesting as it would give traders the chance to enter a low risk, high reward probability trade and make some profit. Unfortunately although a lot of traders focus on finding these hammer candlesticks and trading them, they still find it difficult to achieve sufficient profitability using this method. In this article I will examine why this happens, and suggest methods that traders can use to only pick the best-quality hammer candlesticks to trade.
No Edge in a Single Candlestick
Our starting point should be in acknowledging a brutal truth: candlesticks taken on their own have no predictive power regarding what they price is going to do next, with the exception of very long time frames. For example, if the price is higher than it was a few months ago, the price now is more likely to go up than down. In any case, when we are looking at more typical time frames such as 5 minutes, 1 hour or 1 day, studies of individual candlesticks (such as hammers) on these time frames show they have no statistically valid predictive power.
This means that we have to add some filters, and examine whether certain conditions are present when a hammer candlestick appears, in order to decide whether they are worth trading or not. There are several filters that can be applied that have been proven to signify when a positive edge is likely to be present. I will run through them in order of their effectiveness.
Trade in the Direction of the Trend
It is tempting to trade hammer candlesticks as they form whether they are pointing up or down. While some of the counter-trend trades will work, you will get better results overall if you focus on the hammers that form that point in the direction of the trend over many weeks / several months. Trading in the direction of the long-term trend is usually the best favor most traders can do for themselves!
Lowest / Highest Wick of Last Several Candles
If the hammer candlestick is bullish, for example, it helps if it has the lowest candle wick of the past 5 or so candles. Similarly, if the hammer candle is a Flying Buddha candlestick, that is also a positive sign.
Bigger than Last Several Candles
If the total range from the high to low of the hammer candlestick is greater than the range of any of the previous 5 or so candlesticks, then this also increases the quality of the candle, provided the range is not freakishly huge. Of course, time of day can be a factor here, if you are looking at the shorter time frames. There are times of the day where volatility tends to increase quite a lot, so a comparatively large candle right after a major session open like London or New York open might not be a very reliable indicator.
Confluence with Support or Resistance / Round Number / Key MA / Trend Line
It the wick of the hammer candlestick is poking through an area which is suspected to be support or resistance, this makes it a stronger signal. Round numbers, previous daily highs or lows, or key moving averages can all strengthen a hammer candlestick as indicating a price reversal. This is known as “confluence”. A good example of confluence is shown below in a recent hourly chart of the AUD / USD currency pair:
Note the hammer candlestick market by the downwards arrow. There were a few reasons to notice this candlestick as it formed as indicating a higher probability that the price would reverse. Firstly, you can see that the price of about 0.6957 has triggered a fall in price twice, the last two times the price has been up there. The bearish hammer touched this level and the price fell quite quickly. Secondly, a semi-round number – actually a “half number” – of 0.6950 was involved in this rejection. Where .00, .50, or even .75 or .25 are involved, pay attention, as these round, half and quarter numbers tend to carry greater weight as support or resistance. Thirdly, the hammer candlestick is also a bearish Flying Buddha: it does not touch either the 5 EMA or 10 SMA, and the 5 EMA is above the 10 SMA so the moving averages are in the correct order to produce a bearish Flying Buddha. Finally, the candlestick’s low was broken on the very next candlestick, which suggests some bearish momentum is present.
Previous Candlestick Closes Nearby
If there is no obvious confluence at the area of price that is being rejected by a hammer candlestick, look to see whether there were a few closes of previous candlesticks at nearby prices. If there were, the hammer is likely to have more weight, unless it is a Flying Buddha.
An example is shown in the chart below. Note how the previous candle’s close was not near to any other recent closes. However the final candle on the right is forming and looks as if its close is going to be near the previous candle’s close. This second hammer candlestick looks like it is going to be more reliable than the first candlestick. It has also formed a double bottom at the low of the previous candlestick, and is rejecting a key level of potential support marked by the blue line.
Candlestick Open and Close both Near Top or Bottom of Range
Hammer candlesticks are usually defined as meaningfully long candlesticks with the open and close both in either the top or bottom quarter of the candlestick’s range. If both the open and close are even higher or lower, say in the top or bottom 10% of the range, it is even better.
Price Breaks Out on Next Candle
Hammer candlesticks that produce important reversals usually push the price up in the intended direction very quickly. For this reason, it is quite common to trade them by putting a trade entry stop order just above the high of a bullish hammer, for example, and cancelling the trade if the price is not reached by the very next candle. This can help in filtering out a few trade entries of inferior quality.
Conclusion
Trading hammer candlesticks can be a great way to start Forex trading in a profitable fashion. However do not take every hammer candlestick or you won’t be profitable. Pick the candles that meet at least some of the criteria listed here, especially those in line with strong trends. If you also let your winning trades run, you are highly likely to find yourself ahead and making money after a while.
