KEY REVERSALS ARE OFTEN SIGNALED BY HAMMER AND HANGMAN CANDLESTICKS

In the past two installments of this "Inside the Black Box" section I have covered the various types of dojis, as well as bearish/bullish engulfing candles. The ability to recognize these candles, I've argued, is key to spotting major reversals in both the indices and individual stocks. In today's issue I'm going to focus in on another pair of key reversal candles: the hammer and hangman.

It is easily to get these two candlesticks confused since they look identical. Both the hangman and hammer have a very long shadow and a very small real body. Typically, they have no upper shadow (or at the very most, an extremely small one). To be an official hammer or hangman, the lower shadow must be at least twice the height of the real body. The larger the lower shadow, the more significant the candle becomes.

How can you tell the two candles apart? The hangman candle, so named because it looks like a person who has been executed with legs swinging beneath, always occurs after an extended uptrend. The hangman occurs because traders, seeing a sell-off in the shares, rush in to snap up the stock at bargain prices. To their dismay they subsequently find they could have bought the stock at much cheaper levels. The hangman looks like this:

On the other hand, the hammer puts in its appearance after a prolonged downtrend. On the day of the hammer candle, there is strong selling, often beginning at the opening bell. As the day goes on, however, the market recovers and closes near the unchanged mark, or in some cases even higher. In these cases, the market is potentially "hammering" out a bottom. Here is an example of a hammer candle:

As with all candles, the "rule of two" applies. That is to say, a single candle may give a strong message, but one should always wait for confirmation from another indicator before taking any trading action. It may not be necessary to wait an entire trading day for this confirmation. When it comes to the hangman, for example, confirmation may be a gap down the next day. With the hammer, a gap opening with gathering strength as the day wears on may be all that is necessary to initiate a trade from the long side.

Below you will find a historical chart of the S&P 500 dating back to August 6th. Note that the market created a strong hammer candle on Friday, October 24th. The S&P had been trending steadily lower from October 15th, and on October 24th it looked like the market would continue this pattern. In the last hour of trading, however, the S&P sharply reversed course. It closed with a small loss (hence the dark candle).

The hammer candle was formed in relation to significant moving averages. The lower shadow touched just below the 50-day moving average, a significant "line of defense." With the end-of-day rally, the real body was able to close just above the trend-following 30-day moving average.

What made the candle tricky to interpret -- at least from my viewpoint -- is that it occurred well above the bottom Bollinger band. The past three bottoms in the index had been made with a penetration outside the band.

The action of Monday, October 27th did little to clarify the situation. The candle that day was a star and showed the index's inability to sustain Friday's rally. It was not until Tuesday, when a sharp rally broke the Minor downtrend line, that the situation became technically clearer. On Tuesday, stochastics flashed a strong buy signal as well.

There is no clear example of a hangman in this chart. However, the candle I circled toward the end of September had several hangman-like qualities, including a reasonably long lower shadow and a small, negative real body. It occurred after a significant uptrend that had started many weeks earlier (on August 6th). Coming after a long white candle, it suggested the bulls were running out of force.

As the rate of change indicator shows, there was also a bearish momentum divergence at that point. That is, the index had reached a new high just under 1045, but Rate of Change had steadily deteriorated from its peak in mid-August.

The next day's candle had a large, negative real body and broke important support. Stochastics accurately flashed a sell signal on this day. The hangman-like candle warned of a sell-off that would take the index down approximately 5% in just eight trading days.

Hammer and hangman candlesticks should be an integral part of all swing traders' visual identification skills. When combined with moving averages and indicators such as Rate of Change and Stochastics, these two candles can warn of important reversals in the Minor trend.

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