A hammer pattern resembles a hammer or the letter T on a candlestick chart. The bullish reversal pattern signals the security may have reached a bottom and is ready for a trend reversal. On the day of the reversal pattern, the price falls below its opening price, typically displayed with a long lower shadow, then reverses direction, ending the day near its opening price. The opening price, close, and top are generally at the same price level. Also, a long wick extends to the bottom of the pattern, which is twice as large as the short body. The reversal pattern hints that sellers are active in the market, initially pushing the price sharply lower but then are outnumbered by buyers who drive the price higher into the close.
A hammer that occurs toward the end of a downtrend may signal capitulation by the sellers. However, the days after the hammer pattern are critical to confirming the reversal. A hammer pattern does not necessarily indicate a price reversal until confirmed. An upside price reversal above the previous closing price of the hammer substantiates the bottom and confirms a rally. A hammer that develops before several declining candles tends to be more effective. A declining candle occurs when the candle for the day closes lower than the previous candle.
Opportunistic traders enter a long position or exit a short position during or soon after the confirmation candle. When establishing a long, place a stop loss below the low of the shadow of the hammer. A hammer reversal pattern should not be traded alone. Price or trend analysis, technical indicators, and other technical indications are needed to confirm the reversal pattern.
There is no guarantee the price reversal can sustain following the confirmation candle. A long-shadowed hammer accompanied by a confirmation candle within two or three days after the hammer increases the odds for a near-term rally. A hammer pattern cannot project price targets. Other technical indications are necessary to access the risk/reward profile.
On Friday, 5/20/22, the SPX action hints at the potential for a hammer candlestick reversal pattern.
A one-day hammer candlestick reversal pattern is most effective when accompanied by a confirmation candle soon after the reversal. On 5/23/22, SPX closed above the hammer’s previous closing high, solidifying the confirmation candle.
Three technical indicators, including MACD, RSI, and PPO, show short-term positive divergences as evidenced by higher-low patterns (i.e., 5/20/22 lows are higher than 5/12/22 lows). Breakouts of the technical indicators strengthen the hammer candlestick reversal pattern.
If the 5/20/22 hammer candlestick reversal pattern is confirmed, the short-term rally will likely occur within 1-3 weeks. It may even replicate the late-Jan 2022 to early-Feb 2022 oversold bounce (+367.41 points or +8.70%) or the late-Feb 2022 to late-Mar 2022 oversold rally (+522.65 points or 12.70%).
How high is the next SPX oversold rally?
A conservative projection can bring SPX to 4,091-4,158 (+7.37%-8.36%), coinciding with the 2/24 and 3/8/22 lows, 5/17/22 high, and the 38.2% retracement from 3/29-5/20/22 decline.
An optimistic projection is closer to 4,293.5-4,340 (+12.68%-13.90%), corresponding to the 50-day ma, 5/4/22 high, 61.8% retracement from 3/29-5/20/22 decline, and the Mar/Apr 2022 downtrend.
How low can SPX decline?
Below 3,810.32 or the 5/20/22 low negates the hammer reversal pattern and warns of a cyclical bear decline toward the low-to-mid 3,000s or a retest of the 50%-61.8% retracements from Mar 2020-Jan 2022 rally.