How to Trade with Inverted Hammer Candlestick Pattern
How to Trade with Inverted Hammer Candlestick Pattern
16 October 2022
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Why Use the Inverted Hammer Candlestick Pattern, and How It Will Boost Your Trading Career?
In the modern financial market, most traders use various tools to boost their investment strategy and spot potential profitable trends. Moreover, an essential factor in a successful investment plan is the ability to foresee the upcoming bullish or bearish signals. The inverted candlestick pattern is widely used among traders in the forex market since it provides a more transparent view of the market’s momentum.
In this article, we will explore the definition of the inverted hammer candlestick pattern, how a trader can form it, and how to implement it correctly in any trading strategy. Moreover, we will provide an informative guide on how to spot and interpret it accurately so it will help investors discover their trading opportunities.
What is the Inverted Hammer Candlestick?
Most traders try to abstract information regarding the performance of the market by analyzing candlestick charts. When traders choose to utilize the inverted hammer candlestick pattern, they need first to know its meaning and the way it works.
The inverted hammer candlestick is a reversal pattern that works as a sign of a possible upcoming uptrend after a strong downtrend. Thus, this type of pattern is commonly known in the trading world as a “bullish reversal” candlestick pattern. Moreover, it depicts a strong momentum reversal, that appears from the constant pressure of the buyers to raise the asset’s price to higher levels.
The inverted hammer candlestick describes the state of the market which indicates that the price has reached the lowest point and in a short time is expected to reverse and start rising again. The shape of the pattern is an upside-down version of the hammer candlestick pattern with long upper and short lower wicks, that are attached to a small body.
Moreover, when traders spot an inverted hammer candle they should be aware not to mix it with the “shooting star” phenomenon. Both technical indicators may be similar in their shapes but they define different situations. A shooting star is met on the top of an uptrend and it is a bearish sign, and the inverted hammer is located at the bottom of the downtrend and is considered a bullish sign.
Formation of the Inverted Hammer
When traders choose to use the benefits of this pattern, they need to be able to recognize what an inverted hammer candle looks like. This pattern is located at the bottom of a downtrend when the price opens at a low level and then is boosted to a higher point. The candle has a long shadow at the top of its real body which is rather small with the shape of a rectangle and also has a short wick attached at the bottom of it. Moreover, the size of the upper wick should be at least twice the size of the candle’s real body. When it comes to the down wick it may be very small or not appear at all.
Depending on where the closing price level is located compared with the opening price the candle’s color can be red or green. If the closing price is lower than the opening the candle will be red. Conversely, if the opening price is lower than the closing the color will be green. Both occasions are situated at the bottom of the downtrend indicating a potential bullish reversal.
As we have already mentioned, the inverted hammer candlestick pattern is formed in a downtrend of the market when bullish traders start to gain momentum against bearish ones. The long upper wick is structured when the traders try to press the price to go higher, and the small down wick is formed by the constant efforts of bearish traders to resist the boost of the price and push it to lower values. Nevertheless, the bullish trend prevails the bearish, thus, the shape of a reversed hammer is formed.
What Does Inverted Hammer Tell Traders?
The inverted hammer candlestick pattern is a technical indicator that helps traders to understand an upcoming possible trend reversal in the asset’s price. Since this reversal pattern is formed at the bottom of a downtrend it signifies the reversal to the uptrend and shows the strong rejection of the traders for the price to go lower.
However, as with all trading tools, analyzing the inverted hammer pattern alone is not a safe strategy since various other factors can influence the performance of the market. Components such as the price action as well as the location of the inverted hammer candles play a significant role in forming a robust trading strategy.
Once traders have spotted and understood the form and location of the inverted hammer candle they need to wait for the next candle to be formed. If the latter has a price lower than the inverted hammer and its color is red, this is a signal that the pattern has failed (Picture 1). Conversely, if the candle that follows the inverted hammer has a growing price and its color is green then traders need to be patient and monitor this reaction until the price goes higher than the inverted hammer (Picture 2). This indicates that the pattern is successful and the bullish traders take control of the market, pushing the price to higher levels.
When traders utilize the inverted hammer pattern usually specify a stop-loss level at the bottom of the candle. Thus, if the price falls under this point the pattern is incorrect, and the reason the trader choose this pattern failed. Moreover, it is strongly advised for any trader to be patient when a strong downtrend appears and wait until the market stabilizes.
How to Use the Inverted Hammer Candlestick Pattern in Trading
Traders who implement the inverted hammer candlestick need to keep in mind that in isolation this pattern can not give accurate information about the market’s performance. As mentioned before, it is very important to locate the position of the candle and what comes after it. Moreover, to achieve a higher level of accuracy, traders can combine the inverted hammer candlestick with some classic technical analysis patterns such as double bottom and v-bottom.
The double bottom pattern also known as the W trading pattern is another powerful reversal pattern that is commonly used among investors. The reason that is called the W pattern is because of its shape that forms the letter “W”. This reversal pattern is formed by repeated trend reversals. It consists of two bottom points that are approximately at the same level. The W pattern is formed by a peak that intervenes between those two lows.
Traders can spot and correctly analyze the double bottom pattern and after that take its second low as the inverted hammer candle. The latter confirms the upcoming trend that is prominence by the double bottom and the combination signals that a potential uptrend is about to happen. Thus, traders wait until the market stabilizes and closes at a higher level than the inverted hammer’s high, and then they open a long position.
Another widely used trading mechanism in the financial market is the V-Bottom pattern. This technical analysis tool is very popular among investors since it indicates a rough momentum change. Its name comes from the shape of the letter V that the pattern forms as a result of a rough reversal from a strong selling to a strong buying condition.
This type of pattern is used most frequently before a trader enters the market. When combining the V-bottom with the inverted hammer candlestick, traders need to keep in mind that it is very important to monitor and spot the time that the market closes above the high of the inverted hammer. This indicates that it is time for the traders to enter a long position. Moreover, investors should always keep in mind that this combination of patterns usually bounces off the trends. Thus, it is necessary to implement a support level and secure any trading activity.
Inverted Hammer Trading Rules
For those who follow a day trading strategy, there are some specific rules that should be taken into account before entering the market.
One of the most important factors is to spot the time when to enter a trade. The safest choice is to open the position after the candlestick pattern is formed. Thus, this has fewer risks for the traders but since they enter the trade later the price will be higher and their profits lower.
Another important factor for safer trading is to spot the reversal points. Support and resistance levels and rising trendlines are just some of the potential price reversal points that can be spotted on a chart.
Traders always appoint their stop-loss level before any of their investment decisions. This level is usually 2-3 units lower than the lowest price of the inverted hammer candle.
Essentially, before using the inverted hammer pattern it is reasonable to analyze the form of the candle. If the upper wick is very long and the body of the inverted hammer candle is big then it is more likely for the reversal to occur. Always keep in mind that the color of the candle doesn’t have a significant meaning, although the green candle is thought to be a more bullish sign than the red one.
The Pros and Cons of an Inverted Hammer Candlestick Pattern
Since there are no ideal candlestick patterns that can work successfully with no deviations, the inverted hammer candlestick also has its benefits and drawbacks that users need to analyze before applying it to their investment portfolio.
One of the most important benefits of the inverted hammer pattern is that it provides traders with an opportunity to enter the market when a strong uptrend starts. This way they can benefit from the beginning of the full upward trend of the market and capitalize on it from the first moment.
It is one of the easiest patterns to be spotted since it has the distinct shape of the inverted hammer and is met after a downtrend and before a potential uptrend. Thus, it is very difficult to be confused with other patterns.
Considering those benefits, any trader can understand that the possibility of a reward is relatively high. However, they need to analyze the pattern as a total and not as a single technical tool. Moreover, there are some significant pitfalls that traders need to keep in mind.
This type of chart pattern is solely counted on a single candle. This represents the price action and the potential upcoming momentum reversal. If traders don’t take into consideration additional indicators and oscillators may be misled which can result in the wrong outcomes for their strategy.
Even if traders analyze correctly the inverted hammer candle, this pattern may fail for no obvious reasons. Moreover, like all the candlestick patterns it may indicate a short-term trading opportunity and not a longer-term one, and if this is interpreted wrong it may lead to a remarkable loss of profits. This can happen in a momentary bullish reversal when buyers were not able to sustain the buying pressure and it turns into a downward trend.
Inverted Hammer vs Shooting Star
There are times when traders can confuse the inverted hammer with the shooting star and consider that they have relative meaning. Their shape may be identical, with a small body, a long upper wick, and a short lower wick, but the trend reversals that indicate those two patterns give a completely different signal. The shooting star is a phenomenon that is met after an uptrend whereas the inverted hammer candlestick pattern occurs after a downtrend.
Moreover, the inverted hammer is an indicator that is only met as the bottom candle of a downtrend before the trend reversal to an uptrend takes place. Conversely, the shooting star is the top element of the uptrend and signals a potential momentum reversal and an upcoming downtrend. Thus, those two indicators may have similar shapes but they indicate different trends.
The Bottom Line
An inverted hammer is one of the widely used technical chart patterns. It has a small body with long upper and short or no lower wicks. This pattern usually occurs after a significant asset price decline and often indicates a potential bullish reversal. However, it’s crucial to remember that its signals require confirmation with other patterns or technical tools, such as the double bottom, v-bottom, and others. Moreover, an inverted hammer shouldn’t be confused with a shooting star. Although these chart patterns look exactly the same, they appear in different market conditions. While the former occurs at the bottom of the downtrend, the latter can be spotted on the top of an uptrend.
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