This article was written in 2007.
There are many types of price charts available today and
one of my favorite is the Japanese Candlestick chart. They are very similar to bar charts except
for the many reversal or continuation patterns which we can visually interpret
from a group of successive candles found on the chart. These patterns reflect the change in
psychology of the traders and are useful to identify turning points on the
chart.
A candlestick is made of the candle body which denotes
the opening and closing price and the shadows which denote the intra-period
high and the intra-period low where the period can be one hour, 1 day, one week
or one month. The color of the
candlestick body tells us if the bulls or the bears won the day. Whenever a candlestick has a white body, it
means that the bulls were stronger than the bears and managed to close the
price higher than the opening price. On
the other hand, a candlestick with a black body means that the bears were
stronger than the bulls and managed to close the price below the opening
price. Hence, just by looking at the
color of the candlestick body, we are able to deduce which side of the market
has won the day. As for the shadows
(intra-period high or low), they give us a measure of how much territory the
bulls and bears are willing to give to the other. In the case of long shadows, this also often
reflects that there is a sudden and abrupt change of power between the bulls
and the bears. For example, if Stock A
open at $1.00 and during the trading day it went up to $1.30. With such a surge in price, the bulls are
firmly in control as many would have expected.
However, if by the closing bell, the stock price falls from the
intra-day high of $1.30 to close at $1.00, this will leave a long upper shadow
which starts at the candle body and ends at the intra-day high (assuming we are
looking at a period of a day to draw the candlestick). For the price to fall from its intra-day high
of $1.30 to $1.00, massive selling is required.
This long upper shadow thus showed an abrupt and sudden change of powers
from the bulls to the bears. The
opposite is true for the lower shadow.
In this case, the change of power is from the bears to the bulls and we
get a long lower shadow.
A Hammer is formed if the lower shadow is longer by more
than 2 times the candle body. The upper
shadow should be very minimal (smaller or equal to candle body) or even non
existent. It has a small candle body
which is very close to the upper shadow.
Figure 1 shows an example of a Hammer pattern.
Figure 1: Example of
a Hammer.
In order to use a
Hammer pattern effectively, we have to identify the preceding trend before the
pattern is formed. This is because while
the pattern formed after a downtrend is known as a Hammer, the same pattern can
be formed after an uptrend and is known as a Hanging Man. The interpretation is different. When a Hammer pattern is formed, we observe
that the bulls are strong and managed to beat the bears by closing the price
way above the low of the day. However, when a Hanging Man is formed, we
interpret the pattern differently. We
observe the long lower shadow as evidence that the bears are flexing their
strength in the uptrend but the bulls still manage to stay in control and close
the price way above the low during that day.
When we trade a Hammer or Hanging Man, we want to see a white
confirmation candle and a black confirmation candle respectively.
Figure 2: Hammer with
white candle confirmation
As seen in Figure 2, there was a preceding downtrend
before we observed that a Hammer was formed which is then followed by a white
candle confirmation.
Figure 3: Hanging Man
with black confirmation
In Figure 3, the price was moving in an uptrend before
being interrupted by a Hanging Man pattern.
A black confirmation candle then formed and the price began to retrace.
After learning how to interpret Hammer and Hanging Man
patterns, we are going to explore another way of using this Hammer pattern to
our advantage with or without the white candle confirmation. Since Hammer and Hanging Man reflects a
strong change in power between the bulls and the bears, it will be very
effective if we can spot them near support or resistance levels. These can be determined either by trend
lines, Fibonacci, moving average and so on.
Alternatively, we can use an oscillator like RSI or Stochastic together
with the pattern too.
Figure 4: Example of
Hammer resting on support
In Figure 4, we show how to interpret a Hammer pattern
together with both the 50 day moving average and the Stochastic indicator.
Firstly, the price had been trading lower since early April'07 and a Hammer
pattern was formed (denoted by the small arrow). It was then observed that the end of the
lower shadow sits on the 50-day moving average.
As moving average can be used as support or resistance, in this case, we
say that the price is supported by 50-day moving average. Lastly, Stochastic indicated oversold level
has reached. When the stochastic is in
oversold, there is a possibility of the price moving up. Hence with the Hammer pattern indicating a
strong change in power from the bears to the bulls and with the moving average
supporting the price and Stochastic indicating oversold, the probability of the
price turning higher is very high.
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This article first appeared in Smart Investor in 2007.
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.
