Hammer Time For The Hourly S&P 500

07/03/07 03:47:16 PM

by David Penn

Hammer candlesticks help traders trade trend reversals and corrections alike.

Security: $SPX
Position: N/A

One of the best quotes I ever heard about swing trading came from Oliver Velez Jr., the author of the books Strategies For Profiting In Every Trade and, my favorite, Tools And Tactics Of The Master Day Trader. He was talking to a group of traders during a seminar when he remarked that "your job as a trader" when confronted with an uptrend was to "buy every dip.

"Not some of the dips. Not most of the dips. All of the dips. The only question is when."

There are a variety of answers to that, some of which involve basic trading patterns (such as Velez's 3-5 bar drop), while others involve technical tools like retracements to support, or even technical indicators like Bollinger Bands or stochastics. But looking at the question more closely, we can see that all the information we need to answer the question of "when" is available in the price action itself.

The "when" is that moment in an uptrend when we see evidence that those betting on higher prices have regained control of the market from those betting on lower prices. Actually, it could be argued that it is a two-step process. Ideally, we would like to see first evidence that the bears have become weaker than they were. Then, the second evidence would be that the bulls have become stronger than they were. In the context of an uptrend, these two pieces of evidence are more than sufficient for a trader: the clear signal and the confirming close.

Looking at the chart of the hourly Standard & Poor's 500 (Figure 1), we can see how this two-step process of the signal and confirming close helped traders get long for the end of June bounce. The larger context was a consolidation, with the S&P 500 finding itself at the lower, support boundary of the consolidation. The market had been trending lower since the middle of the month and, as it neared the lower support boundary, a hammer candlestick line developed in the hourly chart.

The hammer candlestick line is among the most important of the Japanese candlestick patterns. It features a very small real body, indicating little distance between the open and close of the session. The hammer also features a very long lower shadow. In the context on an uptrend, this long lower shadow reflects weakness on the part of the bears, who were able to push the market down (as would be expected in a downtrend), but not able to keep it there.

So the appearance of the hammer gives us the signal. What is necessary now is a confirming close.

FIGURE 1: STANDARD & POOR'S 500, HOURLY. Hammer candlestick lines provide signals that downtrends were ending. The first instance shows a hammer line anticipating the end of a significant downtrend. The confirming close comes three sessions later. The second instance shows a hammer line anticipating the end of a pullback in a developing advance. The confirming close arrives less than two sessions later.

Graphic provided by: eSignal.

Why a confirming close? While it is possible to take intraday signals, waiting for the confirming close eliminates much of the risk of getting whipped into potentially weak positions. As Velez often puts it, as a trader, you want to be on the side of the team that is winning the battle. How can you know who is winning the battle unless you wait for the close? For me, taking a position based on an intraday signal is like leaving a baseball game in the seventh inning just because the home team is ahead by a few runs.

Sure, this means that sometimes a trader will not make as much money as he or she might have if an earlier signal were taken. Sure, this means that sometimes a trader will sometimes have to let trades go by untaken. But the advantage the retail trader has over all other traders is the option not to trade at all. Unlike long-term trend traders, the shorter-term momentum trader knows another opportunity is right around the corner.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Hammer Time For The Hourly S&P 500

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