How Can You Trade with an Inverted Hammer Pattern?

In trading, patterns are powerful tools, allowing traders to anticipate changes in trend direction. One such pattern is the inverted hammer, a formation often seen as a bullish signal following a downtrend. Recognising this pattern and understanding its implications can be crucial for traders looking to spot reversal opportunities. In this article, we will explore the meaning of inverted hammer candlestick, how to identify it on a price chart, and how traders can incorporate it into their trading strategies.

What Is an Inverted Hammer?

An inverted hammer is a candlestick pattern that appears at the end of a downtrend, typically signalling a potential bullish reversal. It has a distinct shape, with a small body at the lower end of the candle and a long upper wick that is at least twice the size of the body. This structure suggests that although sellers initially dominated, buyers stepped in, pushing prices higher before closing near the opening level. While the inverted hammer alone does not confirm a reversal, its often considered a sign of a possible trend change when followed by a bullish move on subsequent candles.

The pattern can have any colour so that you can find a red inverted hammer candlestick or upside down green hammer. Although both will signal a bullish reversal, an inverted green hammer candle is believed to provide a stronger signal, reflecting the strength of bulls.

One of the unique features of this pattern is that traders can apply it to various financial instruments, such as stocks, cryptocurrencies*, ETFs, indices, and forex, across different timeframes. To test strategies with an inverted hammer formation, head over to FXOpens free TickTrader trading platform and enjoy CFD trading in over 700 markets.

Hammer vs Inverted Hammer

The hammer and inverted hammer are both single-candle patterns that appear in downtrends and signal potential bullish reversals, but they have distinct formations and implications:

Hammer: The reversal hammer candle has a small body at the top with a long lower wick, indicating that buyers pushed prices back up after a period of selling pressure. This pattern shows that sellers were initially strong, but buyers regained control, potentially signalling a reversal.
Inverted Hammer: The inverted hammer, by contrast, has a small body at the bottom with a long upper wick. This structure indicates initial buying pressure, but sellers prevented a complete takeover. This pattern suggests that buyers may soon regain strength, hinting at a possible trend reversal.

Both patterns signal possible bullish sentiment, but while the green or red hammer candlestick focuses on buyer strength after selling, the inverted hammer suggests buyer interest in an overall bearish context, needing further confirmation for a trend shift.

How Traders Identify the Inverted Hammer Candlestick in Charts

Although the inverted hammer is easy to recognise, there are some rules traders follow to increase the reliability of the reversal signal it provides.

Step 1: Identify the Pattern in a Downtrend

Traders ensure the market is in a downtrend, as the inverted hammer is only significant when it appears after a period of sustained selling pressure.
Then, they look for a candlestick with a small body at the lower end and a long upper wick thats at least twice the size of the body. This upper shadow shows initial buying pressure followed by selling, suggesting a potential reversal in sentiment.

Step 2: Choose Appropriate Timeframes

The pattern can be seen across various timeframes, but daily and hourly charts are particularly popular for identifying it due to their balance of signals and reliability.
Higher timeframes charts generally provide more reliable patterns, while shorter timeframes, like 5 or 15-minute charts, might lead to more false signals.

Step 3: Use Indicators to Strengthen Identification

Volume: A rise in bullish trading volume after the inverted hammer can indicate stronger interest from buyers, increasing the likelihood of a trend reversal.
Oscillators: Oscillators like Stochastic, Awesome Oscillator, or RSI showing an oversold reading alongside the candle can further suggest that the asset might be due for a reversal.

Step 4: Look for Confirmation Signals

Gap-Up Opening: A gap-up opening in the next trading session indicates buyers stepping in, giving further weight to the bullish reversal.
Bullish Candle: Following the inverted hammer with a strong bullish candle confirms that buying pressure has continued. This is a key signal that a trend reversal may be underway.

By following these steps and waiting for confirmation signals, traders can increase the reliability of the inverted hammers signals.

Trading the Inverted Hammer Candlestick Pattern

Trading the inverted hammer involves implementing a systematic approach to capitalise on potential bullish reversals. Here are some steps traders may consider when trading:

Identify the Inverted Hammer: Spot the setup on a price chart by following the rules discussed earlier.
Assess the Context: Analyse the broader market context and consider the pattern's location within the prevailing trend. Look for support levels, trendlines, or other significant price areas that could strengthen the reversal signal.
Set an Entry: Candlestick patterns dont provide accurate entry and exit points as chart patterns or some indicators do. However, traders can consider some general rules. Usually, traders wait for at least several candles to be formed upwards after the pattern is formed.
Set Stop Loss and Take Profit Levels: The theory states that traders use a stop-loss order to limit potential losses if the trade doesn't go as anticipated. It may be placed below the low of the candlestick or based on a risk-reward ratio. The take-profit target might be placed at the next resistance level.

Inverted Hammer Candlestick: Live Market Example

The trader looks for a bullish inverted hammer on the USDJPY chart. After a subsequent downtrend, the inverted hammer provides a buying opportunity that aligns with the support level. They enter the market at the close of the inverted hammer candle and place a stop loss below the support level. Their take-profit target is at the next resistance level. A trader could implement a more conservative approach and wait for at least a few candles to form in the uptrend direction. However, as the pattern was formed at the 5-minute chart, a trader could lose a trading opportunity or enter the market with a poor risk-reward ratio.

Advantages and Limitations of Using the Inverted Hammer

The inverted hammer has its strengths and limitations. Heres a closer look:

Advantages

Simple to Identify: The pattern is easy to recognise on charts due to its unique shape, making it accessible for traders at all experience levels.
Can Be Spot in Different Markets: The candle can be found on charts of different assets across all timeframes.
Straightforward Trading Approach: It offers a straightforward signal that can be incorporated into broader trading strategies, especially with confirmation signals.

Limitations

Reliability Depends on Confirmation: The candle alone does not guarantee a market reversal; it requires confirmation from the next candlestick or other indicators. Without this, the reversal signal may be weak.
Works Only in Strong Downtrends: The pattern might be more effective in strong downtrends; in ranging or weak trends, it generates less reliable signals.
False Signals Can Occur: False signals are possible, especially in volatile markets. Over-reliance on this pattern without additional analysis may lead to poor trade outcomes.

Final Thoughts

While the inverted hammer can provide valuable insights into potential trend reversals, it should not be the sole basis for trading decisions. It is important to supplement analysis with other technical indicators and tools to strengthen the overall trading strategy. Furthermore, effective risk management strategies are crucial while trading the setup. Setting appropriate stop-loss orders to limit potential losses and implementing proper position sizing techniques can help potentially mitigate risks and protect trading capital.

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FAQ

Is an Inverted Hammer Bullish?

Yes, it is considered a bullish reversal pattern. It indicates a potential shift from a downtrend to an uptrend in the market. While it may seem counterintuitive due to its name, the setup suggests that buying pressure has overcome selling pressure and that bulls are gaining strength.

How Do You Trade an Inverted Hammer?

To trade an inverted hammer, traders wait for confirmation in the next session, such as a gap-up or strong bullish candle. They usually enter a buy position with a stop-loss below the low of the pattern to potentially manage risk and a take-profit level at the closest resistance level.

Is the Inverted Hammer a Trend Reversal Signal?

It is generally considered a potential trend reversal signal. An inverted hammer in a downtrend suggests a shift in market sentiment from bearish to bullish. An inverted hammer in an uptrend does not signify anything.

What Happens After a Reverse Hammer Candlestick?

After a reverse (or inverted) hammer candle, there may be a potential bullish reversal if confirmed by a strong bullish candle in the next session. However, without confirmation, the pattern alone does not guarantee a trend change.

How Do You Trade an Inverted Hammer Candlestick in an Uptrend?

In an uptrend, an inverted hammer isnt generally considered significant because its primarily a reversal signal in a downtrend.

Are Inverted Hammer and Shooting Star the Same?

No, the inverted hammer and shooting star look similar but occur in opposite trends; the former appears in a downtrend as a bullish reversal signal, while the latter appears in an uptrend as a bearish reversal signal.

What Is the Difference Between a Hanging Man and an Inverted Hammer?

The hanging man and inverted hammer differ in both appearance and context. The former appears at the end of an uptrend as a bearish signal and has a small body and a long lower shadow, while the latter appears at the end of a downtrend as a bullish signal and has a small body and a long upper shadow.

What Is the Difference Between a Red and Green Inverted Hammer?

A green (bullish) inverted hammer candlestick closes higher than its opening price, indicating a stronger bullish sentiment. A red (bearish) inverted hammer candlestick closes lower than its opening, which might indicate less buying strength, but both colours can signal a reversal if followed by confirmation.

*At FXOpen UK, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules. They are not available for trading by Retail clients.

Text source: Forex Trading Blog

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