The paper umbrella is a single candlestick pattern that provides traders with an opportunity to set up directional trades. Its interpretation shifts depending on where it appears on a chart.
A paper umbrella is made up of two candlestick patterns, the hanging man and the hammer. The hanging man indicates a bearish reversal, whereas the hammer reveals a relatively more bullish trend change. Typically, paper umbrellas consist of an extended lower shadow and a moderate-sized body at the top.
When the base of a downward trend is reached, it is called a ‘Hammer’.
When a paper umbrella appears at the peak of an uptrend, it is referred to as ‘Hanging Man’.
In order for a candle to be considered a paper umbrella, its lower shadow must exceed the length of the real body by at least double. This is referred to as the ‘shadow to real body ratio’.
Let us analyse this example: Open = 100, High = 103, Low = 94, Close = 102 (bullish candle).
Now, the real body’s length is Close – Open, i.e. 102-100 = 2 and the length of the lower shadow is Open – Low, i.e. 100 – 94 = 6. Lower Shadow is more than double the size of Real Body, indicating that a paper umbrella has formed.
The Hammer formation
The bullish hammer is a significant candlestick pattern, recognizable at the bottom of the trend. It has a small real body at the upper end of the trading range and a notably long lower shadow. The longer, the lower shadow, the greater its level of bullishness is.
Be mindful of the thin upper shadow on the blue hammer—it is within normal parameters as per the rule, “Be flexible – quantify and verify”.
A hammer can come in any shade, and the ‘shadow to real body’ ratio must still be met regardless of colour. However, a blue-hued one might give more comfort.
The downward movement of the hammer should have been a downtrend; the curved line indicates this. The logic behind the hammer formation is as follows:
These are the criteria that must be met in order to initiate a hammer trade:
The following arrangements should be made: This trade system will be organised as follows:
A risk-taker will purchase the trade at Rs.444/- when the Hammer candle appears.
He buys for the risk-averse at Rs. 445.4/- once he has determined that the candle is blue.
The stoploss for traders has been set at Rs.441.5/-, the low of the hammer formation.
Take note of the evolution of trading, with a desirable intraday return.
This graph illustrates how a risk-averse investor would have prospered under the ‘Buy strength and Sell weakness’ approach.
Check out this intriguing chart that has two hammer formations.
Both hammers met the necessary criteria for a hammer as follows:
The risk-averse trader avoided a loss-making trade due to Rule 1 of candlesticks. But, the second hammer could have tempted both cautious and bold traders to enter a trade. Unfortunately, though, the stock did not move up; in fact, it almost stayed stagnant before eventually dipping further.
Once you have initiated a trade, try to leave it until either the stop loss or target is hit. Avoid making changes until this happens. The first hammer represents a calculated risk that must be taken, however, the potential losses are inevitable.