The Hammer candlestick pattern is a powerful entry trigger. If you were to trade it, your stop loss is at least the range of the Hammer (or more). But won’t it be great if you can reduce the size of your stop loss and improve your risk to reward?

This post was originally posted here. The writer, Rayner Teo is a veteran community member and blogger on InvestingNote, with username known as Rayner and has 310 followers.

According to most textbooks:

Whenever you spot a Hammer candlestick pattern, you should go long because the market is about to reverse higher.

And that’s what you do.

But the next thing you know…

The price immediately reverses and you get stopped out for a loss.

And you wonder to yourself:

“Wait a minute, isn’t a Hammer candlestick a bullish signal?

“Why did the market reverse against me?”

“What’s going on?”

Well, let me tell you a secret…

A Hammer candlestick pattern doesn’t mean jackshit (and I’ll explain why later).

But first, let’s understand what a Hammer candlestick pattern is about…

What is a Hammer candlestick pattern?

A Hammer is a (1- candle) bullish reversal pattern that forms after a decline in price.

Here’s how to recognize it:

• Little to no upper shadow
• The price closes at the top ¼ of the range
• The lower shadow is about 2 or 3 times the length of the body

And this is what a Hammer means…

1. When the market opens, the sellers took control and pushed price lower
2. At the selling climax, huge buying pressure stepped in and pushed price higher
3. The buying pressure is so strong that it closed above the opening price

In short, a hammer is a bullish candlestick reversal candlestick pattern that shows rejection of lower prices.

Now, this is important.

Just because you see a Hammer candlestick doesn’t mean you go long immediately.

Here’s why…

The truth about Hammer candlestick (that most gurus don’t even know)

Are you ready?

Here you go…

1. A Hammer is usually a retracement against the trend
2. The Hammer doesn’t tell you the direction of the trend
3. The context of the market is more important than the Hammer

Let me explain…

1. A Hammer is usually a retracement against the trend

Recall:

I said the Hammer candlestick pattern doesn’t mean jackshit.

And here’s why…

The Hammer is usually a retracement against the trend (on the lower timeframe).

Here’s what I mean…

This means if you randomly spot a Hammer and go long, you’re likely trading against the trend.

It’s no wonder you get stopped out and lose money consistently.

 

2. The Hammer doesn’t tell you the direction of the trend

Now…

A big mistake traders make is thinking the trend will reverse when a Hammer is formed.

Wrong!

Here’s why…

A trend is made up of a series of candles (possibly 100 or more).

Now let me ask you…

What are the odds of the trend reversing because of one candlestick pattern?

Slim.

So, if you want to know the direction of the trend, ask yourself…

“Is the price moving higher or lower?”

Don’t look at an individual candlestick pattern to tell you the direction of the trend.

 

3. The context of the market is more important than the Hammer

Now you’re probably wondering:

“What is the context of the market?”

It refers to the market condition like whether the market is in an uptrend, downtrend, sideways, has strong momentum, etc.

And this matters, a lot.

For example:

If the market is in an uptrend, it’s likely the price will move higher (regardless of whether there’s a Hammer, or not).

Likewise, a Hammer can appear in a downtrend, but the price is likely to move lower since the market is in a downtrend.

Now…

You’ve learned the truth about the Hammer candlestick that most traders never find out.

And you’re probably wondering:

“So how do I trade the Hammer candlestick pattern?”

Well, that’s what you’ll discover next.

Read on…

Hammer candlestick trading strategy (My proprietary trading formula)

Here’s the deal:

You don’t want to trade any candlestick pattern in isolation.

Instead, you want to trade it within the context of the market (as mentioned earlier).

So the question is… how?

Well, here’s a simple formula that works.

I call it the T.A.E Formula.

Here’s how it works…

Trend – Trade in the direction of the trend

Area of value – Trade from an area of value

Entry trigger – Identify an entry trigger

Let me explain…

 

1. Trade in the direction of the trend

If you trade in the direction of the trend, you increase the odds of your trade working out.

You might be thinking:

“How do I define the trend?”

Well, you can use a Moving Average Indicator to help you.

Here’s how…

• If the price is above the 200MA, then have a long bias
• If the price is below the 200MA, then have a short bias

Next…

 

2. Trade from an area of value (AOV)

AOV is an area on your chart where buying/selling pressure is lurking around (E.g. Support & Resistance, Trendline, Channel, etc.).

The key thing is to enter your trades close to an AOV.

Here’s why…

• A favorable risk to reward (as your stops are tighter)
• Potential buying/selling pressure to push the price in your favor
• Stop loss harder to get triggered it’s “protected” by market structure

Next…

 

3. Identify an entry trigger

The purpose of an entry trigger is to identify a repeatable pattern that gets you into a trade.

So, once the conditions of your trading setup are met, you’ll look for an entry trigger to enter a trade.

It can be a Hammer candlestick or any other bullish reversal candlestick patterns.

Now, this is important…

You don’t want to trade entry triggers in isolation.

It’s only AFTER the conditions of your trading setup are met, then you look for an entry trigger.

Does it make sense?

Great!

Now let’s look at a few examples to see the T.A.E Formula in action…

T.A.E. winning trade on EUR/CHF:

T.A.E. winning trade on USD/ZAR:

T.A.E. losing trade on EUR/JPY:

Bonus Tip: The Break of Structure Technique

Here’s the deal:

The Hammer candlestick pattern is a powerful entry trigger.

And if you were to trade it, your stop loss is at least the range of the Hammer (or more).

But won’t it be great if you can reduce the size of your stop loss and improve your risk to reward?

This means if your original Hammer trade has a 1:2 risk reward ratio, then after applying this technique, you’ll have a 1:5 risk reward ratio (or more).

Sounds awesome?

The let me introduce to you the Break of Structure technique.

Here’s how it works…

1. Identify a trading setup using the T.A.E Formula (daily timeframe)
2. Go down to the 4-hour timeframe and look for a Bull Flag pattern
3. Buy on the break of the swing high
4. Set your stop loss 1 ATR below the swing low

Here’s what I mean…

T.A.E. Set-up on XAU/USD:

T.A.E. Set-up on HO1! (Heating Oil):

This is powerful stuff, right?

Once you’ve mastered this technique, you can consistently find insanely profitable trading opportunities (that most traders never find out).

Conclusion

So in this trading strategy guide, you’ve learned:

• A Hammer is a (1- candle) bullish reversal pattern that forms after a decline in price
• 3 things you must know about Hammer:  1) it’s usually a retracement against the trend    2) It doesn’t tell you the direction of the trend   3) The context is more important than the pattern
• How to use the T.A.E Formula to find high probability trading setups
• The Break of Structure technique that allows you to find insanely profitable trading opportunities

 

Thanks for reading.

Once again, this article is a guest post and was originally posted on Rayner‘s profile on InvestingNote. 

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