Day Trading & Forex Forum

We now look at a specific type of candle line that has a very long lower shadow called a hammer. It is so called because the market is trying to hammer out a base.

The criteria for the hammer are:

1. The real body is at the upper end of the trading range.

2. The colour of the real body can be black or white.

3. A bullish long lower shadow that is at least twice the height of the real body.

4. It should have no, or a very short, upper shadow.

The hammer reflects the market insights obtained from a candle chart—specifically the hammer's extended lower shadow shows that the market rejected lower price levels to close at, or near, the highs of the session. From my experience, most times when there is a hammer the market may not immediately move up, but may rally slightly, or trade laterally, and then, after expanding on a base, rally. If the market closes under the lows of the hammer, longs should be reconsidered.

Candle charts can be used in all time frames- from intra-day day to weekly.

In the intra-day chart, there are two back-to-back hammers (denoted by the arrow). These dual hammers took on extra significance since they confirmed a support level shown by the dashed line.

This is a classic example of the power and the ease with which one can combine the insights of candle charts (the hammers) with classic western trading signals (the support line) to increase the likelihood of a market turn. This synergy of candle charts and western technical tools should provide a powerful weapon in your trading arsenal.

An engulfing pattern is a two-candle pattern.

A bearish engulfing pattern, shown on the left-hand side of the chart, is formed when during a rally a black real body wraps around a white real body. A bullish engulfing pattern, shown on the right-hand side of the chart, is completed when during a descent a white real body envelops the prior black real body.

The engulfing pattern is illustrative of how the candles can help provide greater understanding into the behaviour of the markets. For example, a bullish engulfing pattern reflects how the bulls have wrested control of the market from the bears.  A bearish engulfing pattern shows how a superior force of supply has overwhelmed the bulls. The Japanese will say, for instance, that with a bearish engulfing pattern "the bulls are immobilized".

The chart above shows how a bullish engulfing pattern in early October called a reversal at IBM's lows. This bullish engulfing pattern was especially potent because it reinforced a support area set by a hammer.

Candles and the overall technical picture

You must remember a basic principle about the use of candles: candle charting techniques are a tool and not a system. Effective candle charting techniques requires not only an understanding of the candle patterns, but also a policy of using sound, coherent trading strategies and tactics. These include using stops, determining the risk and reward aspect of a potential trade, observing where a candle pattern is in relation to the overall trend, and monitoring the market's action after a trade is placed. By understanding and using these trading principles, you will be in a position to most fully enhance the power of the candles.

This is only a basic introduction to candle charts. There are many more patterns, concepts and trading techniques that must first be considered. But even with these basic concepts, you can see how the candles open new and unique doors of analysis.