THE HAMMER AND THE HANGING MAN
A bunch of us in the office were staring at a price chart on my monitor the other day. I mentioned that a particular technical pattern had looked promising, but in the end, it "didn't work." Somebody in the group laughed. "I love that about you technical guys," he said. "When it doesn't happen, you just say, ‘Well, it didn't work.'"
Fair enough. As long as I continue to look at price charts through the lens of technical analysis, I'll probably continue to find promising technical patterns. And I'm convinced that, on more than a few occasions, those promising technical patterns will continue to "not work" from time to time. Technicians have a habit of reminding themselves and others that technical analysis is about probabilities, about trying to always be the "smart money" by taking reasonable, controlled risks. It's a good habit to have.
But there is an odd habit among many technicians -- or at least some of those who are friendly to technical methods -- to suggest that while some technical methods are sound, other methods simply "don't work" at all. Or that some of these technical methods once worked, but are now "outdated."
The irony, of course, is that at one time or another, just about every technical method comes in for this treatment. Here's an excerpt from a recently published, widely acclaimed book on trading that, while using Japanese candlesticks to display price data in its numerous examples, observes nevertheless that:
I have really enjoyed Steve Nison's books on Japanese candlesticks and highly recommend them to anyone interested in learning more about these basic market patterns. I also think that for many years these techniques worked in the markets, but they simply do not work anymore.
This was from a chapter titled, "What Does Not Work." The author's point is that "these patterns" have become so commonplace and watched that "often the reverse of what is predicted by the particular pattern ends up happening." An extension of this argument is that there are likely hordes of contrarian candlestick chartists who look to make sure that "the reverse" is, at a minimum, at least a threat to those looking to take the signals from Japanese candlesticks completely at face value.
But I've always thought there was something flawed in this argument against candlesticks. To a degree, this argument mystifies candlesticks as something above and beyond a visual display of price data. Just what that author means by "these patterns" is hard to know. Is he referring to more complicated, multibar patterns like white soldiers or evening stars, or is he referring to single-bar patterns like hammers and hanging men?
My understanding of the fundamental value of candlesticks is articulated by trader and trading educator, Oliver Velez, who writes in his book, Tools And Tactics For The Master Day Trader:
In fact, we regard the Japanese style of charting as so superior that we would not look at a chart today if it were not in candlestick form ... Now this is not to say that candlesticks possess some magical power not shared by others, or that they contain more information than regular bar charts do, because they don't. We are immensely in love with candlesticks for only one simple reason: They make it easy to visually see which group, bulls or bears, is controlling the market. They also make it easy to see which group is about to lose or regain that control. That's it.
The last part is especially worth focusing on, because it goes to the heart of the "Do candlesticks work?" question. Through Velez, we can see that saying that candlesticks "don't work" is not too far from saying, essentially, that bar charts "don't work" or that point & figure charts "don't work." If all candlesticks are is a reflection of price data, then what's not to work?
Consider candlestick "patterns" like the hammer and the hanging man. Even though both the hammer and the hanging man are single candlesticks, I refer to them as patterns because what is important about hammers and hanging-man candlesticks is their context, not simply the shape of the candlestick.
As individual candlesticks, the hammer and the hanging man look virtually identical. The aforementioned Steve Nison describes them in his book, Beyond Candlesticks:
The hammer, with its long lower shadow and a close near or at the high, is easily understood to be a "bullish" signal.A hanging man has a very long lower shadow, a small real body (white or black) near the upper end of the trading range, and little or no upper shadow. This is the same shape as the hammer line.
Again, the difference is in the context. As Nison observes, quoting a Japanese mnemonic: "If it appears from below, buy, and if [it] appears from above, sell." In other words, if a trader or investor can remember the distinct shape of the hammer and hanging man, then all he needs to do is note when that shape occurs. If it occurs in an uptrend, it means that there is a likelihood that the uptrend is running out of steam. If it occurs in a downtrend, then it means that the downtrend may be vulnerable to a reversal.
Do these candlesticks - the hammer and the hanging man - "work"? First, let's consider what the hammer and the hanging man represent, what Velez refers to as "which group is about to lose or regain ... control." Gregory Morris, author of CandlePower, describes the "psychology" that gives rise to both the hammer and the hanging man candlesticks. He notes that before a hammer appears, the market is sliding down a slope of growing anxiety and fear. Then, on one day:
The market opens and then sells off sharply. However, the selloff is abated and the market returns to, or near, its high for the day. The failure of the market to continue the selling reduces the bearish sentiment, and most traders will be uneasy with any bearish positions they might have.
This process is what creates a hammer candlestick. Like most candlestick chartists, Morris sees such a development as an opportunity to go long in such a market, preferably if the following day "confirms" the reversal with a higher opening and a higher close.
So if a hammer "doesn't work," all it means is that the reduction of "bearish sentiment" was not as great as it may have seemed (that is, some bears remained bearish) and that their "unease" was not yet strong enough to encourage them to cover their bearish positions.
The point isn't that the hammer didn't accurately record the sentiments (as expressed by real buying and selling in the marketplace). The point is that the hammer represents a shift in probability, if not in favor of the bulls, then certainly not in favor of the bears anymore. If this occurs in a downtrend that is already mature -- a downtrend in which bearish sentiment was apparently strong enough to move the market lower -- then the reversal to which the hammer alerts traders is all the more likely to occur.
Consider the hanging man. In contrast to the hammer, the hanging man appears in an uptrend. Here's Morris's interpretation:
When the hanging man appears, the market opens at or near the high, sells off, and then rallies to close at or near the highs ... If the market opens lower the next day, those who bought at the open or the close of the hanging man day are now hanging onto a loss.
As with the hammer, candlestick traders like Morris would look for confirmation by way of an open and a close below the low of the hammer. Nison's interpretation is somewhat different, even if the same bearish conclusion is reached.
With the hanging man's long lower shadow reflecting buying interest, it may seem that the hanging man is a bullish signal. However, the hanging man's action shows that once the market has fallen, it has become very fragile. The small real body of the hanging man also shows that the prior uptrend may be in the process of changing.
Let's look at a few hammer and hanging man candlesticks in action.
In Figure 1, the chart of the Retailers Index ($MVR), note how the downswing in December culminated in a hammer by mid-month. The long lower shadow (or tail) and the small real body with a close near the high is a classic hammer shape. And coming at the end of this decline, a decline that saw $MVR drop more than 8% in two weeks, this hammer was an especially potent sign that a reversal might be just around the corner. In this case, the hammer proved quite correct, as the index rallied strongly from the December lows over the next two and a half months.
FIGURE 1: HAMMER. This hammer appeared in the retail index ($MVR) in mid-December, anticipating a significant low.
Consider the pair of hanging man candlesticks in Figure 2, the chart of the Dow Jones Transportation Average (DJTA). Here, the candlesticks were arguably less definitive, but traders waiting for confirmation in the form of prices moving below the low of the reversal candlestick would have been rewarded. Note first how the hanging man develops in early April. Prices close higher the following day, but by the second day after the hanging man, there was clear evidence that the odds were shifting toward the downside. Three days later, the transports were searching for support on their 50-day exponential moving average (EMA).
FIGURE 2: HANGING MAN. Two hanging-man patterns warned of weakness in the rally that began in late March in the transports.
Another hanging man developed on April 23 during the bounce off that same 50-day EMA. Again, the hanging man did not mark the absolute top; the following day saw an intraday high that was above the high of the hanging man day. But clearly, as prices have collapsed over the balance of April and into May, the hanging man proved a sound warning that the odds were against the bulls. And when it comes to trading and investing, that warning is often "tip" enough.
-- David Penn is Technical Writer for STOCKS & COMMODITIES.
Learn more about Japanese candlesticks!
Altucher, James [2004]. Trade Like A Hedge Fund, John Wiley
& Sons.
Bigalow, Stephen [2004]. "Market Timing With Candlesticks," Working
Money: February 25.
Form, John H. [1995]. "Candlesticks For Support And Resistance," Technical
Analysis of STOCKS & COMMODITIES: June.
Fraisse, Jean-Olivier [1991]. "Compressing Candlestick Patterns," Technical
Analysis of STOCKS & COMMODITIES: October.
Gopalakrishnan, Jayanthi [2000]. "Candlestick Charts For Daytrading,"
Technical
Analysis of STOCKS & COMMODITIES: November.
Hartle, Thom [1991]. "Steve Nison On Candlestick Charting," Technical
Analysis of STOCKS & COMMODITIES: March.
Hill, John R., George Pruitt, and Lundy Hill [2000]. The Ultimate
Trading Guide, John Wiley & Sons.
Likhovidov, Viktor [1999]. "Coding Candlesticks," Technical Analysis
of STOCKS & COMMODITIES: November.
Maiani, Giovanni [2002]. "How Reliable Are Candlesticks?" Working
Money: August 27.
Matheny, Bradley, and Gary Wagner [1993]. "Variable Cycle Lengths And
Intraday Candlestick Analysis," Technical Analysis of STOCKS &
COMMODITIES: August.
Morris, Gregory L. [1992]. CandlePower, Probus Publishing.
Nison, Steve [1994]. Beyond Candlesticks, John Wiley & Sons.
Peterson, Dennis D. [2003]. "Trading Candlestick Patterns," Working
Money: April 1.
Teseo, Rudy [1999]. "Candlestick Filtering," Technical Analysis
of STOCKS & COMMODITIES: December.
Velez, Oliver, and Greg Capra [2000]. Tools And Tactics For The
Master Day Trader, McGraw-Hill.
Yamanaka, Sharon [2002]. "When Candlesticks Cast Long Shadows," Working
Money: March 12.
Charts by Prophet Financial
Originally published in the July 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.