The Hammer signal is found at the bottom of a downtrend. The Japanese rice traders say, 'The bulls hammered out the bottom'.
In order for the Hammer signal to be valid, the following conditions must exist:
The stock must have been in a definite downtrend before this signal occurs. This can be visually seen on the chart.
The lower shadow must be at least twice the size of the body.
The day after the Hammer is formed, one should witness continued buying.
There should be no upper shadow or a very small upper shadow. The colour of the body does not matter, but a white body would be more positive than a black body.
The following Figure shows a classic Hammer formation. As you can see, at one point in time during the day (in reference to Daily charts), the Hammer signal was a big black candle. The bears had complete domination upto that point. However, the way the candle closed implies the bears lost control to the bulls. In order to make sure the bulls retain control of the stock, one needs to verify strength the next day. If on the next day, the stock closes down, the Hammer signal should not be relied upon as a sign of reversal at that point in the trend.
Notice the Hammer formation in the chart of ACI, Inc. This Hammer had a small upper shadow, which is ok. The Hammer was formed in oversold conditions as indicated by the Stochastics indicator. The Hammer in this case also confirmed prior support established in early March and mid February. These factors make the reversal probability very high. The Hammer was confirmed by more buying the next day indicating the bulls had not left the stock. As a candlestick trader, this would be an ideal time to go long.
Chart courtesy stockcharts.com
Notice the Hammer formation in the chart of RENUKA. With stochastics in oversold condition, the hammer was a signal not to be ignored. This, along with the fact that the hammer formed right on the support of the 50sma and 200sma, provided traders with a very high probability trade to go long. Bullish confirmation came two days later with a strong white candle.
Chart courtesy icharts.in