Hammer And Hanging Man: Two Guys You Want On Your Side

Successful real estate investors will tell you without hesitation that "location" is the key element in real estate investment. A beautiful house with five bedrooms and five bathrooms right next to a waste dump is not my idea of a dream house. I would not invest a penny in a family restaurant located on a street infested with gangs and prostitutes.

This idea of location is also the key to the candlestick-charting technique. Many traders misinterpret the meaning of a candlestick or a candlestick formation, because they don't pay close attention to the location of the candlestick on the chart. In other words, you can ignore all candlestick patterns if they appear in meaningless areas.

What are the key locations or areas in stock trading? The answer is important because it tells you when you should be watching candlesticks carefully. Let me give you a few examples of the key areas on the chart:

• New highs or lows, such as a 20-day high, 60-day high and 52-week high

• Key moving averages, e.g., 20-, 50-, and 200-day

• Widely observed retracement levels, such as 38.2%, 50%, and 61.8%

• Long-term and short-term support and resistance levels

I'm sure you could add more, but the point is that you now know when to pay attention to candlesticks.

In this lesson, I would like to show you how effectively "Hammer" and "Hanging Man" can give us reversal signals -- especially when they appear in important price areas.

Let me start with the definition of both Hammer and Hanging Man. They look identical. They both have long lower shadows (tails) and small real bodies near the top of their trading range. The color of the real body is not important, but the lower shadow should be at least two to three times the length of the real body. Anyway, because of their unique shapes, both Hammer and Hanging Man formations are easily spotted on a chart.

Here is a daily chart of THQ (THQI | Quote | Chart | News | PowerRating). You can see a few excellent examples of a "Hammer" near the key moving averages. On March 1, for example, the stock opened near the high, then sold off and tested its 50-day moving average, but returned to its high to close. This failure of the sell off eliminated the bearish sentiment completely. The following day, THQ, immediately began to rally.

Bottom-fishing is an extremely dangerous game. I prefer to trade with the direction of the market to minimize my risk. In an uptrending market, I will be focusing on buying. Needless to say, I will be considering short-selling in a downmarket. But if you can get immediate confirmation the next trading day, a hammer is a powerful signal of bottoming-out of the market.

On March 22, Pfizer (PFE | Quote | Chart | News | PowerRating) hit a 52-week low. The issue opened near the high, then sharply sold off, but staged a strong recovery to finish near the high. The result was, as you can see, forming a perfectly shaped hammer -- a long lower shadow and a small real body near the top of its trading range. In fact, the stock followed through to the upside the very next trading day and began a rally. One more notable thing was extremely heavy volume. This was a classic case of selling climax.

I know some of you are saying, "Wait, there was another Hammer only seven trading days ago." That is why I mentioned that you must wait for a confirmation. As you can see, a hammer on March 13 also formed perfectly. The only difference was that the stock could not follow through to the upside the next day.

Now I want to talk about the exact opposite of Pfizer. This time, a hammer-like line appears near the important highs. Of course, in this case, a hammer-like line is called a "Hanging Man." As I described earlier, a Hanging Man has an identical shape to that of a hammer -- a long lower shadow with a small real body near the high of its trading range.

Let's look at a daily chart of KLA Tencor (KLAC | Quote | Chart | News | PowerRating). On May 1, KLAC hit a two-month closing high and formed a Hanging Man. Although the stock sold off, it staged a rally and closed strongly near the high. How could this be a sign of weakness?

I want you to imagine that you are in a gym. In front of you is a long rope that is hanging from the ceiling, and all you need to do is climb up. Because the ceiling is so high above, by the time you get there, you are very tired. You don't have any strength left. That is exactly what is happening with a Hanging Man. Even though KLAC closed strongly, buyers had used up all of their buying power. Also, look at volume. Advancing prices were accompanied by decreasing volume. It was a clear sign of diminishing buying pressure.

The chart below is a similar case -- a stock recording a two-month high by forming a Hanging Man. The stock could be tired especially following the May 16's wide-range bar. Transaction volume each day -- May 16 and Hanging Man day -- was unusually heavy. Buyers may need a few days of rest before resuming.

It is also profitable to pay attention to well-known retracement levels, especially when a stock bounces off the level by forming a Hammer or Hanging Man. NVIDIA (NVDA | Quote | Chart | News | PowerRating) gives us a successful example of combining a Hammer with a retracement level. Look how the stock turned away from the level. A long lower shadow was an evidence of buying pressure.

Some might argue that everything I mentioned so far does not require help from candlesticks. I agree. I don't need a Hammer to tell me I should be buying THQ -- I would be a buyer regardless. All I need to see is a successful testing of the moving average and a bounce and I would buy NVIDIA without help from candlesticks. NVIDIA was simply pulling back from its prior high. As you know, strong stocks often retreat before resuming their uptrend. A clear buy signal was given when the stock took out the high of the prior bar. Remember, candlestick charting is a trading tool -- not the tool.

Good luck and happy trading.

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