In this discussion we are examing the widely-used Japanese candlestick reversal formations of the "Hanging Man" and the "Hammer'.
The hangman and the hammer are visually similar as they both have small bodies, long lower shadows and no upper shadow (or very small upper shadows). Both are also considered reversal patterns:
- the hangman candlestick pattern forms at the end of an uptrend, whilst
- the hammer forms at the end of a downtrend.
That is, when the hangman appears in an uptrend, it could signal the beginning of a downtrend. It follows that the appearance of hammer in a downtrend suggests a potential change in direction upwards.
The trading theory behind the hangman in an uptrend argues that there has been considerable bearish pressure near the market open, but then the bulls are able to push the price back near the opening price by the days end.
When a hammer appears during a downtrend, the hammer candle theory contends that after the market opens there is strong selling pressure, but by the days end the price recovers at, just below, or above the open.
Please note that the hangman or hammer can be white or black. As always, it is strongly recommended that with either candle, the short-term trader should wait for the next day for a
confirmation candlestick that the share price is reversing direction, as in the practical example below..
Practical Example The chart below is of Nufarm Limited (NUF) from August of this 2006. This chart shows how to use the hangman candlestick in analysis.
As you can see in the above chart, NUF was in an uptrend from the beginning of August.
- The hangman appeared on the 1/9/06 (yellow circle).
- Notice the following two days, the candlesticks were both hangman type formations.
- Either one of these would have confirmed the possible reversal.
- The RSI indicator moved from an 'overbought' position (green rectangle).
- The MACD crossover occurred several days later, and even if you entered on this signal, you would have made a profit from shorting NUF.
As you can see it's always prudent to use than more than one indicator before entering a trade.