The Complete Guide to Trading the Inverted Hammer Candlestick Pattern

The inverted hammer is one of the most popular candlestick chart patterns used in technical analysis. This powerful reversal pattern can signal a potential bottom in a downtrend, providing traders with an opportunity to go long.

In this comprehensive guide, we’ll cover everything you need to know about trading the inverted hammer pattern.

What is the Inverted Hammer Candlestick?

The inverted hammer is a single candlestick pattern that forms during a downtrend. It has a long lower wick, a small real body, and little to no upper wick. It resembles an upside-down hammer, which is how it got its name.

Specifically, an ideal inverted hammer has the following characteristics:

  • The candlestick forms during a clear downtrend.
  • It has a long lower wick that is at least 2 times the size of the real body.
  • The real body is small and at the top end of the trading range. Color is not important.
  • It has little to no upper wick.

Essentially, the inverted hammer shows that the bears were in control initially but by the close the bulls had pushed prices back near the open. This pattern indicates the potential for a bullish reversal.

How to Identify the Inverted Hammer

To spot an inverted hammer on a candlestick chart, follow these steps:

  • Confirm the asset is in a downtrend by looking at lower highs and lower lows.
  • Scan for a candlestick with a long lower wick and small real body at the top of the range.
  • The wick should be about 2 times the size of the body.
  • Make sure the candlestick has little to no upper wick.

It’s also important to check the trading volume. Higher volume on an inverted hammer day adds more validity to the pattern.

Keep in mind daily charts are the most common timeframe for trading inverted hammer candlesticks and related strategies.

Inverted Hammer Meaning for Traders

So what does an inverted hammer candlestick tell traders from an analysis perspective?

The pattern reflects a tussle between buyers and sellers during the trading period. At first, bearish sentiment prevails and prices drop significantly as indicated by the long lower wick.

However, as the period progresses the bulls regain control and push the price back up near the open by the close. This fierce battle between bulls and bears is what gives the inverted hammer its potential reversal implications.

The failure of the bears to sustain the downward momentum combined with the resurgence of buying pressure increases the odds prices may be bottoming out. As such, traders will watch for confirmation on the next candle for a potential trend change.

Using Inverted Hammer Signals

The inverted hammer itself is not enough to ensure a bullish reversal. You need to see follow through buying pressure on the next candle for confirmation.

Here are some tips for trading inverted hammer signals:

  • Wait for confirmation on the next candle before entering a long trade. Look for a candle that closes above the high of the inverted hammer.
  • The confirmation candle does not necessarily have to be a bullish candle. It could be neutral or even bearish, as long as it closes above the inverted hammer high.
  • Place a stop loss below the low of the inverted hammer. This defines your risk on the trade.
  • Take profits near resistance levels or trailing stops can be used to maximize gains as the new uptrend forms.
  • Look for increased volume on both the inverted hammer day and confirmation day for a stronger signal.
  • The larger the real body on the confirmation candle, the better. A long bullish candle adds confidence the reversal is underway.

So in summary, traders will look to buy long on a close above the inverted hammer high, with a stop below the low of the pattern.

Inverted Hammer Trading Example

Let’s review an example of how to trade an inverted hammer signal:

Step 1) Check for downtrend – In this case, XYZ stock is in a clear downtrend as defined by the series of lower highs and lower lows.

Step 2) Identify inverted hammer – On August 18th, XYZ forms an inverted hammer candlestick with a long lower wick that is over 2 times the height of the small real body at the top of the range. Volume is also above average, giving the pattern added significance.

Step 3) Wait for confirmation – On August 19th, XYZ trades higher and closes above the high of the inverted hammer, confirming the potential reversal.

Step 4) Buy and place stop – We go long XYZ stock on the close of the confirmation candle at $102. Our stop loss goes below the low of the inverted hammer at $98 to control risk.

Step 5) Book profits – Over the next few weeks, XYZ begins trending higher as the upside momentum gains traction. We sell and book profits near the resistance level around $110.

This example illustrates how traders can use the inverted hammer signal to catch reversals out of downtrends and trade in the direction of a new uptrend.

Common Questions About Inverted Hammers

There are a few common questions traders have about trading the inverted hammer pattern:

What’s the best confirmation candle?
There is no perfect confirmation candle, but a long bullish green candle with above average volume indicates strong buying pressure.

Does color of the inverted hammer matter?
No, inverted hammer color is not important. The key is the long lower wick and small real body at top of range.

Where should my stop loss go?
Always place stops below the low of the inverted hammer candlestick to define your risk on the trade.

What’s the ideal trend to trade?
Inverted hammers perform best in a clearly defined downtrend on the daily or weekly chart timeframes.

How reliable is the inverted hammer pattern?
It depends on factors like preceding trend, volume, and confirmation candle. If criteria are met, it can be quite reliable.

Final Thoughts on the Inverted Hammer

The inverted hammer is a powerful candlestick pattern that signals potential trend reversals. By mastering the tactics covered in this guide, you’ll be able to effectively trade inverted hammer signals and improve your chart reading skills.

Some key takeaways:

  • Identify inverted hammers in a downtrend with a long lower wick and small real body
  • Wait for confirmation candle to close above the pattern’s high
  • Place stops below inversion hammer low to control risk
  • Book profits at key resistance levels as new uptrend forms

Use the inverted hammer as part of your overall price action trading strategy. Combining candlestick patterns with support/resistance, volume analysis and other techniques will improve your trading edge.

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