What is the Inverted Hammer Candlestick Pattern & How To Trade With It?

In this article, we will discuss

• What is the Inverted Hammer Candlestick Pattern?
• Significance of the Inverted Hammer Candlestick Pattern
• How Does the Inverted Hammer Candlestick Pattern Differ From the Shooting Star?
• How to Trade With the Inverted Hammer Candlestick Pattern?
• Factors to Keep in Mind When Trading with the Inverted Hammer Candlestick Pattern
• Conclusion

One of the many aspects of technical analysis that traders often pay close attention to is candlestick patterns. By analysing these price chart patterns, you can gain crucial information on the current market sentiment in an asset and may even be able to decode future price movements.

Among the various candlestick formations, very few enjoy as much significance as the inverted hammer. It is a pattern that could potentially indicate shifts in the market trend. Continue reading to find out all about this particular candlestick formation, its significance and how you can trade with them.

What is the Inverted Hammer Candlestick Pattern?

The inverted hammer is a single candlestick pattern with a small body at the bottom of the candle, a very short or non-existent lower shadow and a long upper shadow. The upper shadow of the candle must be at least twice the length of the candle’s body.

The pattern gets its name due to its very close resemblance to a hammer that has been inverted. It is a bullish reversal candlestick pattern, meaning that its appearance on the price charts of an asset often leads to the market trend shifting from bearish to bullish.

Significance of the Inverted Hammer Candlestick Pattern

The inverted hammer pattern usually makes an appearance at the bottom of a long downtrend. The candle can either be coloured in green or red. If the candle’s body is green, it suggests that the asset price opened lower and closed higher. On the other hand, if the candle’s body is red, it suggests that the asset price opened higher and closed lower.

The long upper shadow of the candle indicates that buyers attempted to drive the prices upward but were unsuccessful due to the selling pressure. However, the little to no lower shadow indicates that sellers were unable to take full control and push the prices further downward.

When the inverted hammer candlestick appears during a downtrend, it signifies that the buyers are testing the strength of the sellers. Also, the unsuccessful attempt by sellers to push the price lower could be a sign of waning selling pressure. Traders usually use the appearance of the pattern as a sign of impending trend reversal from bearish to bullish and may either initiate new long positions or use the opportunity to square off their existing short positions.

With the pattern, the colour of the body is not a major factor. But a green candle is generally considered to be a stronger sign of an impending bullish reversal than a red candle. This is primarily due to the fact that the buyers were able to drive the prices upward despite the prevailing bearish trend. Such a move indicates that the sellers are losing steam and buyers are gaining traction. However, it is important to remember that even with a red body, the reversal candlestick pattern could still lead to a reversal in the trend.

How Does the Inverted Hammer Candlestick Pattern Differ From the Shooting Star?

The inverted hammer pattern is a bullish reversal candlestick that appears during a downtrend. When the pattern, with the same visual characteristics, appears at the top of an uptrend, it is known as the shooting star.

Both of these patterns look visually the same, with red or green candles and a long upper shadow that is twice as long as the body. The only differences between these two candlesticks are the timing of their appearance and what they indicate. The shooting star is a bearish reversal candlestick that suggests an impending trend reversal from bullish to bearish.

How to Trade With the Inverted Hammer Candlestick Pattern?

As a trader, you must know how to structure a trade once you spot the reversal candlestick pattern. Here is a quick guide explaining the ideal entry, stop-loss and profit target points that you can consider when trading with the pattern.

• Entry Point

If you are a risk-aggressive trader, you could consider entering into a long position as soon as you spot the inverted hammer candlestick pattern. This will allow you to maximise the profit potential of your trade. However, such an approach comes with high risks. The market may not follow through with the reversal and could continue with the downtrend. If that happens, you could potentially suffer heavy losses.

The more advisable course of action would be to wait until the reversal is confirmed before entering a long position. The confirmation of the bullish reversal could come in the way of a green candle immediately succeeding the inverted hammer.

The ideal point of entry for the trade would be slightly above the candlestick pattern’s high point. Having this as your entry point gives you confirmation that buyers are gaining control and pushing prices higher, supporting the bullish bias.

• Stop-Loss Point

Setting a stop-loss for your trades is one of the best ways to manage risk and protect your trading capital from unexpected market movements. There are two different ways to determine the ideal stop-loss point when trading with the inverted hammer. Here’s a quick overview of each of the methods.

• Key Support Level

The stop-loss point for your trade must be just below the nearest key support level for the asset. Placing your stop-loss slightly below these levels gives you room for minor price fluctuations and ensures that they do not prematurely trigger the order.

• Low Point of the Pattern

Alternatively, you could also set the stop-loss order just below the low point of the pattern. Doing so lets you account for the possibility of a false signal or a failed bullish reversal. This approach is more conservative since the stop-loss level is much tighter. However, it carries the risk of the stop-loss getting triggered prematurely due to minor price fluctuations.

• Profit Target Point

Identifying the right profit target point is important for maximizing the effectiveness of your trades. The ideal profit target point for your trade could be the nearest key resistance level or the most recent swing high. Selling pressure usually tends to be high near these points and may potentially limit upward price movements. Therefore, it is advisable to set the profit target slightly below these points to lock in the gains and mitigate the risk of a sudden reversal.

Factors to Keep in Mind When Trading with the Inverted Hammer Candlestick Pattern

To maximise the effectiveness of your trades, you must consider a couple of key factors when trading with the pattern. 

• Trading Volume

Analysing the trading volume of the asset could give you crucial insights into the strength of the bullish reversal. If there is a major spike in the volume after the appearance of the candlestick pattern on the price chart, it usually indicates a strong reversal. Low volumes, on the other hand, may suggest a weak reversal or maybe even a false signal.

• Other Technical Indicators

Combining the inverted hammer candlestick with other technical indicators that are designed to indicate trend reversals is a good way to increase the effectiveness of the pattern. Once you spot the pattern, look for confirmation from other trend reversal indicators to strengthen the validity of the trading signal. This way, you can ensure that you enter a long position based on false signals.

Conclusion

With this, you must have now understood how to interpret and trade with the inverted hammer candlestick pattern effectively. The formation, with its distinctive visual appearance, is a good indicator of bullish reversals in market trends.

That being said, the appearance of the pattern on the price chart is not a guarantee of trend reversals. The market may still choose to continue in the direction of its prevailing trend. Therefore, you must exercise caution when trading with the reversal candlestick pattern and use strict risk management practices to protect your position from unexpected market movements. Also, it is advisable to wait for the confirmation of the bullish trend reversal before initiating a long position. This way, you can not only mitigate risk but also increase the chances of profitability.

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