Three candlestick signals consist of single sessions, but unlike most candlesticks, the color of the real body does not matter. What does matter is where these indicators are found within the current trend. So the three -- the spinning top, hanging man, and hammer --- are valuable reversal flags, expansions on what day traders and swing traders like to call “narrow range days.”
The “narrow range day” (NRD) is among the favorite signals for short-term trading. The theory is that when the distance between opening and closing price is slim, it forecasts a reversal in the current trend. This has to be confirmed by what happens in the following session, but it is a powerful and important red flag telling you that the trends is coming to an end.
The spinning top is a session with a very small real body (rectangle, either white or black), with both upper and lower shadows (these represent the extent of the trading range beyond open and close). The real body should be located about halfway between in the total extension of the session and, ideally, both upper and lower shadows should be about the same length.
Spinning tops are found both at the top of uptrends and at the bottom of downtrends. It does not matter whether the real body is white or black. The significance of the spinning top is that it represents a session in which both buyers and sellers tried to move the price, but both failed.
The hanging man also has a very small real body but no upper shadow. It also has a longer than typical lower shadow. It shows up at the top of an uptrend and predicts the end of that trend to be followed by a reversal and downtrend.
Like all candlestick signals (but especially these one-session reversal indicators) the hanging man should be confirmed by what takes place on the following session. This may be a price gap, a downward trending day, or a volume spike. But the hanging man, once confirmed, is a strong and reliable sign of reversal.
The hammer looks exactly like the hanging man -- small real body, no upper shadow, and long lower shadow -- but it appears at the bottom of a downtrend. A true confirmation of the end of the downtrend happens on the following session. The most reliable confirmation is simply a session moving in an upward direction.
The hammer can fail, which is why confirmation is crucial. Every candlestick is revealing, but it can also be deceiving. These three one-session signals are strong reversal “red flags,” and the color of the real body is not significant. So you have to take the signs seriously, but always think of it as a two-part sign: discovery and then confirmation.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com.