Hammer is the most recognized candlestick pattern due to its uniqueness in shape, the small body, and a long tail. It is a candlestick pattern which signals the onset of a bullish reversal.
Identifying a hammer candlestick
To begin with, there has to be a downtrend in the market that has prevailed for some time. This is because a hammer will always form at the end of a downtrend or if you like at the onset of a bullish trend. Therefore, you will have to first identify a downtrend before looking for a hammer candlestick.
A hammer has a short body and a long tail. The tail is on one side and not on both sides of the body. If the tail appears long on both sides then it will be termed as a doji but not a hammer candlestick.
The tail has to be longer than the body. They should not be of the same length. Again, you can confirm by looking at the candlestick that forms after the formation of the hammer candlestick. The candlestick that forms after the hammer should be bullish.
Psycology behind the hammer
A hammer candlestick always signals the onset of a bullish reversal after a downtrend. It gives a clear indication of a reversal and at times a support level too.
When a hammer forms, it is a clear indication that the buying pressure is outweighing the selling pressure. The tail is formed after prices move down as per the downward trend but at some point before the specific candlestick closes the prices are pushed up by the prevailing buying pressure.
The longer the tail in relation to the body, the more the probability of a long term bullish trend.
What is an inverted hammer?
An inverted hammer is formed when the long tail of the hammer is on the upper side instead of being on the lower side.
In spite of being inverted, the inverted hammer is still a bullish reversal pattern and forms at the end of a downtrend.
The inverted hammer is formed after there is enough buying pressure to drive the prices upwards after the opening price which is followed by selling pressure that pushes the prices back down considerably although not past the opening price. In this case, the buying pressure is still higher than the selling pressure and the market trend has therefore changed from bearish to bullish.
Therefore, the inverted hammer works the same as the normal hammer candlestick.
Placing an order after identifying a hammer
Any time a hammer is formed, it is an indication that the market trend has changed from a downtrend to a bullish trend. The only problem is knowing whether to place a long term buy or a short term buy.
You will have to approximate how long the bullish trend will continue so as to determine whether to place a long term or a short term buy trade.
To determine if the reversal will take a long or a short time, you should wait for a while to note the kind of candlesticks that form afterwards. Never be in a hurry to place an order, you should probably place your buy order after the second or third candlestick.
The timeframe will also determine the kind of bullish trend to expect. If it forms on a daily, weekly or monthly timeframe, then you can expect it to indicate the onset of a long-term bullish trend which would take a minimum of probably a day. On the other hand, if the hammer candlestick forms on a tight timeframe like 1minute to 5 minutes, then you should anticipate the bullish trend to be short lived.
So, as a trader, you should place your buy order accordingly depending on how long you anticipate it to run in the market. Depending on the type of trade (whether long term or short term) you should adjust your stop losses (take profit and stop loss) accordingly.