Textbook Bullish Hammer or Bull Trap?

Today’s candle and volume demonstrate a textbook reversal day. Candlestick analysis calls today’s candle a Bullish Hammer. Modeling today’s action shows that this setup is more bearish than market lore would have you believe.

Today’s action (Bullish Hammer) is what market technicians like to call a reversal. This happens when the market drops and makes new lows but then reverses to close higher than the open. A surge in volume is almost always present. In market lore, these reversal days are seen as being bullish both in the short and intermediate terms. A reversal day is often believed to signal that a change in trend is occurring (from down to up, in this case). This is not to be confused with a key reversal day.

The chart below clearly shows the bullish hammer as well as the volume surge:

What we want to know is if this pattern is truly bullish for SPY. Let’s test it and find out.

The Rules:

Buy SPY if

1. The day’s low makes a new 100 day low
2. The day’s range ((high-low)/open) is > 2%
3. Volume is >1.75x the 50 day average volume
4. The open is lower than the close
5. ((Open – low)/open))  is > 1.5% (this is an additional variable I label the Bullish Hammer)

Sell X days later. No commissions or slippage included. All SPY history used.

The Results:

I’ve got a fair amount to cover about the results, so bear with me. Let’s start with the blue line, which shows the results of using variables 1-4 but not 5.

• There are 23 occurrences of this setup.
• Selling the close of the 3rd day after entry has the highest win rate at 55% (not great at all).
• Selling the close of the 2nd day has yielded the highest average trade at 0.99%
• After the 2nd day, the results get worse and never really improve, being bearish to neutral, at best.

Now let’s examine the red line, which shows the results of all variables 1-5. Variable 5 is what distinguishes the bullish hammer. Almost all of the setups using variables 1-5 show a fairly distinct bullish hammer. (I will include the trades below so that you can check them out).

• There are 11 occurrences of this setup.
• Selling the close of the 1st and 2nd days yields win rates of 63.94% and 70.00%, respectively.
• Selling the close of the 2nd day has also yielded the highest average trade at 2.27%
• After the 2nd day, the results turn awful to sickening to disgusting.

Bottom Line: Today’s bullish hammer candle is a bear market phenomenon. It does not typically occur during bull markets. To demonstrate this, I set the backtester to sell the trade on day 26 (note the low on day 26 the graph above). Below are the dates and results of the trades.

My opinion, which is based on these results, is that any bounce that develops over the next few days will be an excellent opportunity to open up a short position.

Those of you who have read me for some time know that I do not often advocate shorting, as the psychology is challenging and the market has a bias to the upside. However, In this case, the market does not appear to be very healthy. Indeud, SPY is trading beneath both the 50 and 200 day moving averages and a Death Cross is looming.

At the very least, position sizes should be smaller and cash should be raised. True bear markets are rare occurrences. But with economic fundamentals deteriorating quickly, the possibility of another extended bear phase should be factored into every trader’s strategy.

 

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