Inverted Hammer Candlesticks Tutorial with Example: FKnol.com

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The inverted hammer candlestick pattern occurs frequently on the price charts and it resembles the inverted shape of the other closely tracked candlestick pattern called the Hammer Candlestick Pattern. Both these patterns are closely tracked by the technical analysis-following market participants for a possible price reversals from a bearish trend to a bullish one.
Like a hammer pattern, the inverted hammer is also formed on the downtrend (when the price has been moving lower and lower). Its shape represents a case of a hammer held in a way that its thick but small hitting body part is in the lower side, and the long handle is at the top side of the candlestick pattern. The small-size body of the candle (which is formed by open and close prices) constitutes the striking body, and the long-sized upper wick of the candle represents the handle - hence the name.
On the price charts, a inverted hammer appears as a single-line pattern. It is made of only one candle which may be red or green, therefore the color of the candle remains immaterial. The size of the body should be relatively small compared to the length of the whole candle. When formed on a downtrend, it indicates a possibility of price reversal - that is, the prices may increase after the inverted hammer pattern is formed.
Most of the active traders often wait for the next confirmation candle to form before taking a position on a inverted-hammer-based candlestick pattern. When formed on a downtrend, the confirmation candle should be green in color representing the price reversal to the upward direction. This article explains the details of how the inverted hammer candlestick is formed, what market conditions are indicated by its formation, how to trade the inverted hammer candlestick, and the article also covers the most recent examples of the same. To understand the working and trading of the inverted hammer candlestick, let's start by checking the factors needed for its formation.

Construction of the Inverted Hammer Candlestick Chart Pattern

Being a frequently forming single line pattern, inverted hammer may attract a lot of trade entries. However, a few more factors need to be kept in mind before getting into a trading position to ensure high chances of profitability from the inverted hammer. Its occurrence must be during the downtrend, and it must have a long upper wick (shadow) which must be at least twice the size of the body of the candle. The body is constituted by the open and close prices, while the upper wick is the portion generated by the high price. The longer the size of the upper wick, the better the signal is for price reversal to upward. Ideally, the lower wick should not exist at all, or at the most have a very negligible length.
As for the confirmation candle, the bigger its body the stronger the reversal signal. The confirmation candle should be bullish, that is - green in color indicating that the price reversal is on and prices have switched to rising side.
The inverted hammer candle can have any size and any color. The only exception is that it should not be the Four-priced Doji Candle which has the same value for all four of its prices (open, high, low and close).
Formation of a inverted hammer candle pattern indicates that the price reversal is possible, and the ongoing trend of the red-colored bearish candles is expected to end soon. Before entering a trade based on the emergence of the inverted hammer pattern, many traders may like to wait for a confirmation candle to be formed immediately after the inverted hammer candle. If a green-colored confirmation candle is formed, it further supports the probability about the price increase in near future and the end to the downward price move. Its time to go long on the stock (buy), or cut the losses if already holding a short position. This is how a typical inverted hammer candlestick appears:

Trading the Inverted Hammer Candlestick

The inverted hammer patterns form very frequently on the price charts of stocks, ETFs and market indexes - so one must be cautious before getting into a trade as not all of them will lead to profits. Many may end up as false signals, if not read properly.
The following factors need to be kept in mind to trade the inverted hammer candle.

During a downtrend, the sellers (bears) are in control of the market and have beaten the buyers (bulls). After their acts result in few red-colored candles getting formed leading to a downtrend, the inverted hammer appears with a small body formed of open and close prices, but a very long upper wick. This is the first indication that the price went to pretty high value as bumped up by the buyers who are attempting to come back to the market, but the prices again came down from the highs to near around the open price which is at the lower end of the candle. It means that the buyers (bulls) are now attempting to match the sellers. This state indicates indecision that has developed amid ongoing downtrend, and hence there is a good possibility that prices may rebound to move upwards. The confirmation candle which should be green in color - that is, a bullish candle - will further support the move. The longer this confirmation candle the higher the chance of a continued up move. It will mean that buyers are now taking charge of the market prices with high demand and are dominating over the sellers.
If either of the inverted hammer and/or the confirmation candle is accompanied by a relatively higher trading volume, then it improves up the probability of price reversal. The buyers have returned to the market in full swing with high buying demand, and hence they are getting stronger and are able to push up the prices. Therefore, its time to go long - that is, buy the security, or cut the losses if holding a short position.

The inverted hammer candle pattern gains significance when formed during the downtrend. The formation establishes the base for a potential reversal in prices. Traders enter the trade when the inverted hammer is formed at the breakout of the lower Bollinger band, or at the breakout of the trend-line (like 200-day moving average), or at the breakouts of any other suitable ranges. The larger the breakout indicated by the length of the candlestick, the stronger the reversal pattern. If the inverted hammer is formed in the middle Bollinger band or far away from the trend-line (without breaching the trend-line), then the traders may not consider it as a strong reversal signal and they avoid the trade. When formed around the middle band or away from the breakout range, the inverted hammer often leads to continuation of the existing trend instead of a reversal.

Trading Scenario for Inverted Hammer

The following are the general considerations and scenrio for trading the inverted hammer candlestick.

▶ Trade Entry: Formation of the inverted hammer candlestick pattern during a downtrend is taken as a sign of reversal, that is - the market prices are expected to go up in the near term. So traders try to take a long buy trading position at or around the low price of the inverted hammer candle. As a few traders may like to wait for the confirmation candle to form, their purchase price may be higher as the trend made the move which took the prices downwards. This will mean subsequently lower profits - but that's the tradeoff one needs to accept if waiting for a confirmation candle.

▶ Stop-loss Limit: The stop-loss varies from trader to trader based on their individual trade preferences, but usually while going long they set the stop-loss at 2-3 units below the low price of the inverted hammer baby candle. Others who enter at a higher price should adjust the stop-loss proportionatly.

▶ Profit-levels: While active trading at short intervals, traders must follow a risk-reward ratio to determine the possible profit level from their inverted hammer pattern trading. For instance, if the stop-loss limit is set at $10 for the trade (the maximum loss one is willing to take on a trade) and the risk-reward ratio one follows is 1/2, then one must take profits when it hits $20. If the risk-reward ratio being followed is 1/3, then one must aim for profits when the price hits a level that generated $3 for every $1 stop-loss set.

▶ Market Conditions: Along with the above mentioned inverted hammer formation requirement, traders should ensure that their selected price range, bands or trend-line limits are getting breached with large moves of the second bearish (and subsequent) candle. This ensures higher success rate of profitability. Although one must note that trading on technical analysis like candlestick patterns has limited success rate, so following strict stop-loss, disciplined trading and efficient capital management is advised.

Example of Inverted Hammer Candlestick

The following chart shows an instance of inverted hammer candlesticks and the uptrend that followed shortly after:

As one can observe in the above chart, the inverted hammer candle emerged with a considerably long upper wick, reversed the ongoing downtrend that preceded the first red candle, and led to an upward move indicated by the long green arrow. Additionally, there was a range breakout, though with a minimum value, which added to the possibility of the price reversal.
Traders usually set their profit targets and stop-loss levels based on the risk-reward ratio of their choice as mentioned in the previous section.

Latest Inverted Hammer Formations

Now that you've learned the basics of trading the inverted hammer candlestick patterns, its time to check for the latest formations of these candlestick patterns on the stock price charts.
FKnol.com has a dedicated section on candlesticks where the list of stocks and indices forming the inverted hammer candles is updated on a daily basis. We cover different stock markets around the globe for formation of inverted hammer candlestick chart patterns. Please select the market from the following dropdown list to see the inverted hammer candlestick chart patterns formed most recently:

The Bottom Line

Trading candlesticks like the inverted hammer needs strict discipline and emotion-free trading. Candlestick trading is a part of technical analysis and success rate may vary depending upon the type of stock selected and the overall market conditions. Use of proper stop-loss, profit level and capital management is advised.