Put This Hammer In Your Trading Toolbox!

| January 7, 2010 | 0 Comments

Growing up on a ranch gave me a lot of great experiences.  Most of these experiences involved hard work and early mornings.

“Get out of bed, we’re going fencing!” Dad said, interrupting my last minute of early morning sleep.  Dragging myself out of bed and grabbing a bite to eat, I headed out into the open range.

Most of my early summers as a teenager revolved around swinging a hammer.  I walked miles of seemingly never ending fence, fixing breaks in the barb wire and pounding nails.  Yes, the basic tool used for centuries, the hammer, was my summer companion.

The hammer, strange as it may sound, is a useful trading tool as well.

Hammers are a type of candlestick bar that can give you a low risk setup…

Transocean (RIG) shows a great example of how to use a hammer.  RIG is a leader in the offshore drilling industry with a market cap of over $29 billion.

Take a look at the bar marked “Hammer”.  A hammer is formed when the price goes to a new low on the day.  During the same trading day, the price will reverse upwards and close above the open of the day.  Looking at the chart, you can see this is exactly what happened in RIG.

Now here’s the key to using hammers effectively…

Hammers are only useful when they happen after a short term downtrend.  They must also coincide with a technical support level. Also, seeing big volume on the same day as the hammer is a great confirmation.  The high volume means lots of shares are trading hands around that price.

Now, if you look through as many charts as I do, you’ll notice hammers occur quite often.  Most of the time, hammers are not an entry signal.  If they occur when a stock is trading sideways, or they don’t occur at a support level, they mean nothing.  It’s just “noise”, don’t use it as an entry signal.

I’ve also found that hammers are most effective in highly liquid, higher priced stocks.  In my opinion, you should stay away from using hammers in penny stocks.

But in the case of RIG, we had the necessary criteria for a trade…

The hammer formed after a downtrend.  It was also at a support level (in this case a test of the 200-day moving average).  We got a nice high volume day on the same day as the hammer.

You would enter this trade when RIG traded above the hammer on the following day.  In other words… for RIG, your entry would have been just above $68.  You would set a stop loss below the hammer at around $64.90.  Remember, you always control your downside risk.

As you can see, RIG screamed to over $82.  That’s a sweet 20% return on your investment in 18 days.

As you may know, I like to put results into terms of reward to risk.  For this trade, your risk was $3.10 ($68-$64.90=$3.10) and your reward was around $14 ($82-$68=$14).  This gave you a reward to risk ratio of around 4.5 to 1.  That’s what I call a great trade…

So as you go through your charts every day, be on the lookout for these trading opportunities.  Just remember, you need the right kind of setup.  The hammer must coincide with… a support level, high volume on the day, and following a short-term downtrend.

Hammers can be a great low risk way to add profits to your portfolio!

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Category: Technical Analysis

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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