How to Use the Inverted Hammer Pattern
The inverted hammer candlestick pattern is a one-candlestick formation that can signal a potential reversal from a downtrend to an uptrend in the market. Traders and technical analysts often look for this pattern to identify potential buying opportunities in financial markets. In this article, delve into the meaning of inverted hammer candlestick and explore various examples of the formation on a price chart.
What Is an Inverted Hammer?
The inverted hammer candlestick pattern appears on a chart when buyers exert pressure to drive up an asset's price, typically at the bottom of a downtrend, indicating a potential bullish reversal. It is characterised by a shape resembling an upside-down hammer, with a long upper wick, a short lower wick, and a small body. The pattern is formed as bullish traders gain confidence, pushing the price up while bears attempt to resist the higher price.
Traders can apply the setup on various financial instruments, such as stocks, cryptocurrencies*, ETFs, indices, and forex, across different timeframes. CFD trading at FXOpen can allow you to utilise margin and the most negligible slippage while trading with an inverted hammer.
Hammer vs Inverted Hammer
The hammer and inverted hammer are both candlestick patterns that are used to identify potential trend reversals in technical analysis. The hammer occurs during a downtrend and has a small body at the upper end of the trading range with a long lower shadow. It suggests a potential shift in market sentiment from sellers to buyers.
The upside down green hammer or the red inverted hammer candlestick also occurs during a downtrend and consists of a single bar with a small body at the bottom and a long upper shadow. It states that buyers are taking control.
Both patterns indicate bullish reversals but have slight differences in their candlestick formations. Traders typically seek confirmation before considering long positions based on these patterns. You can analyse both formations for free at the FXOpen TickTrader platform to find the differences.
Identifying an Inverted Hammer on Trading Charts
To identify the setup on trading charts, you need to:
- Set a timeframe: Determine the timeframe you want to analyse, whether it's intraday, daily, weekly, or any other interval. The inverted hammer can be found on any of them.
- Look for a downtrend: Identify a prevailing downtrend on the chart. This will be characterised by a series of lower highs and lower lows.
- Identify a bullish/bearish candlestick: Look for a small-body candlestick with a long upper shadow and a small or nonexistent lower shadow after a bearish candlestick. The colour of the candle doesn’t matter, but if it’s green, the signal is supposed to be stronger.
- Context: Assess the overall market context and other technical indicators to support the potential reversal signalled by the inverted hammer.
Trading the Inverted Hammer Candlestick Pattern
Trading the formation involves implementing a systematic approach to capitalise on potential bullish reversals. Here are some steps traders may consider when trading this pattern:
- Identify the Inverted Hammer: Locate 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: Choose to enter a long position at the close or above the high of the reversal hammer candle or wait for at least several candles to be formed upwards.
- 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 setup candlestick or based on a risk-management strategy. The take profit can be the next resistance level.
- Manage Risk and Reward: Calculate your risk-reward ratio and ensure it aligns with their trading plan.
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 at the support zone or below the bar. Their take-profit target is at the next resistance level.
Final Thoughts
While the inverted hammer chart pattern 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 mitigate risks and protect trading capital.
Once traders have developed a solid trading approach that incorporates the formation and other technical indicators, they may open an FXOpen account to execute their trading strategies in live market conditions.
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?
After identifying the formation, wait for confirmation signals, such as a higher closing price in the next candlestick, to validate the potential bullish reversal. Once confirmed, you may enter a long position above the high of the bar while placing a stop loss below the low of the candlestick to manage risk. Traders may set a target price or use trailing stops to secure profits as the market moves favourably.
Is the inverted hammer a trend reversal?
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.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
Read more: https://fxopen.com/blog/en/how-to-use-the-inverted-hammer-pattern/
Text source: Forex Trading Blog
