Forex Strategies that Work – Using Hammer, the Strong Reversal Pattern

There are a lot of forex strategies that work; in this article, we’ll talk about one of the easiest strategies to follow: price action. Price action does an excellent job of showing you what is happening in the markets. It is your job as a trader to see the things the way they are. Price action is not a complex phenomenon as it may sound. It is nothing but a depiction of how the price is behaving on the charts.

Price at any point of time is a reaction of a fight between the bulls and bears. Price goes with the one who wins.  In simple words, if there are enough buyers in the market, the price is likely to go up. Opposite happens when the sellers are in majority. Price action gives you a glimpse of the outcome of the battle.

There are many patterns of price action which are helpful to determine the future course of price with reasonable probability.  Some of the famous patterns are called hammer, shooting star, inverted hammer, hanging man to name a few. The most basic pattern is called hammer. It is also called pin bar aka Pinocchio bar. This pattern is a sign of a reversal.

The Hammer Pattern

You must have often heard that trend is your friend and a trader should always trade with the trend. But once in a trend, price has to reverse somewhere.  It is unrealistic to expect the price to continue in one direction. You will often see the hammer at the end of a trend signalling the reversal of a trend. Hammer in a downtrend indicates a possible reversal of the downtrend and a start of an uptrend or a consolidation.

Here are the few characteristics of a hammer. On the candlestick charts, it shows a small body compared to the complete range of a candlestick. Ideally the body should be a third of the range of the candlestick. The body sits near the one end of a candlestick. For bullish reversal, it will be towards the upper end. For bearish reversal, the body will be towards the lower end. There is a small or no upper shadow of the candlestick. For bearish reversal, there will be small or no lower shadow. The colour of the candlestick is of little importance. The reason for its significance will be explained later in the article.

Now let’s look at the logic behind the hammer. Look at the figure 1. The cable is experience a short term uptrend. The hammer formed on the 21st December 2011, indicates a possible reversal of this short term trend. Now let’s look at the hourly chart of the hammer in question as marked in blue in figure 2.  The day starts with a consolidation as neither of bulls or bears have an edge. But few hours into the day, bulls start to take the control. Price reaches the peak and it seems that the price will go up and up. But alas! Bears come back into the game and bring the price back to where it started the day. The logical conclusion is that the bears have taken the control. It doesn’t matter if the candle closes in green or red as long as it closes as per the hammer description.

Figure 1 (click for actual size)

Figure 2 (click for actual size)

The word of caution is that you should not trade any of the price action patterns in isolation. You should complement the price action with additional information such as indicators, divergence etc. Price action can be played with lot of success if you use it with support and resistance. First plot the support and resistance on your graph and wait for the price to reach there. If the price prints any of these patterns at these levels, you can go into the trade with more confidence and an edge.

Avoiding Fake Hammer

There are many instances when you will encounter a fake hammer. You can avoid many of the fake hammers if you stick to some rules. The foremost rule is that you look for a confirmation of a price action with any of the tools mentioned in the above paragraph. You enter into a trade only on the break of high or the low of the hammer. In case of bullish hammer, you will enter long on the break of the high of the hammer. For bearish hammer, you will go short on the break of the low of the hammer. This way you enter only when the hammer is validated and confirmed. You should enter on the next bar and wait for one timeframe to trigger the order. For example, if you spot a hammer on daily timeframe, you enter only on next day and wait for one day to trigger the order. The stop loss should be set on the other hand of the candle.

Summary

Hammers are one of the strongest reversal patterns known and by utilizing it properly, you already master one of forex strategies that work. The hammers don’t materialize every day. But they appear once in a while. AND the probability of working the trade as per your expectation is very high. Go back in history of your chart and look for the hammers. Price has a tendency to repeat these patterns. Wait for them to unfold and play when they appear. This is what is called trading like a sniper.

For more strategies involving reversal patterns, I suggest you check out HIGH PROBABILITY REVERSAL PATTERNS by Chris Lori, CTA.