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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