by Adam Oliensis

Candlestick reversal patterns primarily apply to trending markets, though they can be meaningful near the tops and bottoms of trading ranges.  It is important to note, though, that a “reversal” in the lexicon of candlesticks does not necessitate a diametric change in direction.  A reversal here may suggest an abatement of momentum.  “Up” may turn to “flat” and doesn’t necessarily have to turn to “down.”

A reversal pattern is an indication that the market is ripe to change its behavior. It doesn’t necessitate anything.  A market may show a reversal pattern, pause, and then continue.  Or it may show the reversal pattern and subsequently confirm that reversal.  You have to keep watching and listening to a market.  You can’t take its word for what it said last week.  It may change its mind.

Hanging Man and Hammer

These two types of reversal candles look the same on the chart in isolation.  They both have small real bodies, short upper shadows (or no upper shadow), and long lower shadows at least twice as long as the real body.  Both types of candles suggest a reversal.  The difference lies in their respective contexts.  A hanging man sits on top of an uptrend while a hammer sits low in a downtrend.

The Hanging Man at Work

In the chart below, you can see three Hanging Man candles.  In each case, the Hanging Man shows the price opening above the prior day’s close, moving down intraday, and recovering to close very near the opening price.

The first hanging man has a larger real body than the latter two.  It netted some progress in the session, and indeed it was a less decisive reversal signal.  The essential ideal behind a hanging man is that after the stock has moved up in a trend the bears sell it off, the bulls fight back, but at the end of the day the bulls have not been able to make much, if any, progress.  We learn in a Hanging Man that the bulls’ strength is waning.

Hammering Out a Bottom

The next chart shows a bottom forming.  There’s a downtrend followed by THREE hammer candles, a bounce, then a retest down, and finally a HUGE reversal day.  Ultimately, Drexler went to $23.90 before this new trend exhausted itself in November 2001.

In the following chart, you can see two hammer candles in the March (grey) box.  On two consecutive days the bears pushed this stock below its 20-day moving average (20-dma) and short-term support in the $26 area, and twice the bulls rallied the stock to close virtually unchanged.

It appears that the bears capitulated at that point, as the stock rallied from there, never closing below its 20-dma again until the trend had exhausted itself the following August with the stock in the high 40’s.

There are also two Inverted Hammers in the February (grey) box on the above chart.  Inverted Hammers have implications similar to those of Hammers, and function like upside-down Hanging Man candles.  The stock opened low, the bulls pushed it up, then the bears sold it off and the stock netted virtually no change for the session.  The bulls had not yet gained the advantage, but the bears were losing theirs.

The bears may have begun thinking, “Wait a minute.  We can’t push this one down any farther.  Maybe it’s time to get out of our short positions.”  And the bulls may have begun thinking, “Hmmm.  The bears have sold it off and can’t push it lower.  Maybe I’ll go in long here and put a stop loss under the low of the Inverted Hammer just to manage risk.  That looks like a pretty good risk/reward ratio!  Look, it’s down at the lower Bollinger Band, there are two Inverted Hammers.  Maybe this one’s ripe to bounce!”  And then when the stock moved above the 20-dma more longs jumped in, and more shorts covered.  And finally, late in March, when the 20-dma survived two intraday penetrations, and the stock closed above that line both times, more shorts capitulated, and more bulls gained confidence.  That’s how the tides turn.

There are a number of objective measures for determining whether a stock is overbought or oversold, whether it’s trending or not, whether a move might be exhausted, and whether interest in the stock is drying up.  These sorts of metrics can help in determining whether a candle is a Hanging Man or a Hammer, whether you’re looking at a reversal pattern that will change the market’s direction or just some momentary indecision.  Ultimately, you’ll be able to use Japanese Candlesticks in conjunction with a number of other indicators, all of which will be “tuned” together to help you hear what the market is saying.