Capturing market reversals by trading an Inverted Hammer Candlestick is one of the top skills you need to develop as a Forex trader. This pattern is very attractive since it offers a chance to enter a trade at the beginning of a new trend, increasing the chances of getting profits.
The Inverted Hammer Candlestick is a price formation that consists of a single candle with a long wick on its top; this pattern usually takes shape at the bottom of the downtrend, signaling a potential upside reversal in the price.
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Characteristics of an Inverted Hammer Candlestick
The characteristics of this pattern are that the open (O), close (C), and low (L) prices are all at the roughly same level. As you can see in the picture below, the most critical element of this formation is a long upward wick, which conveys an important message to traders, which we will discuss at a later stage.
Both pictures above are valid examples of the inverted hammer. The figure on the left, which occurs when the close price (C) is higher than the open price (O), offers arguably a stronger scenario.
As mentioned before, the inverted hammer candle is a reversal pattern. In other words, it usually takes place at the bottom of the downtrend that has been driving the price action lower. Therefore it is not rare to see a chain of red candles before an inverted hammer appears.
Please note that this formation doesn’t offer a trading signal; instead, it represents a warning or a message that a bearish run is in the getting weak and a reversal may occur soon.
The long wick that extends to the upside illustrates the signs of bulls’ strength as the price briefly printed higher levels, although the bears still managed to force a lower close.
We may still see a new low as the closing price should be very close to the candle’s lowest price. Still, the price action conveys a signal now, the bears have no full control anymore and there might be light at the end of the tunnel for the bulls.
Even though the inverted hammer consists of a single candle, the next candle is the one that brings legitimacy to the pattern. In other words, it gives traders an idea as to whether or not the prices will go higher or lower.
Advantages and Disadvantages
The main strength of this pattern is that it sends us a market reversal signal that can help us improve our trading strategy and pave the way to a profitable trade.
On the other hand, its apparent weakness is that it provides only a warning that requires further confirmation.
Therefore, it is essential to consider that we are trading in a downtrend and the bears may still take the price action further lower.
In the next section, we will take a closer look at an example of how to trade this pattern and we will share some valuable tips that will help you avoid traps and earn money by trading the inverted hammer candlestick.
How to Spot an Inverted Hammer Candlestick
To trade this formation, you must first spot it and be aware of not mixing it with other similar patterns:
The Inverted Hammer versus the Hammer Candlestick:
The inverted hammer should not be confused with a hammer candle that is also a bullish reversal pattern. The latter has a long wick that extends to the downside. Also, the open, close, and high price levels are in the upper part of the candle.
The Inverted Hammer versus the Shooting Star:
Moreover, the inverted hammer should not be mixed with a shooting star, which unlike both hammer and inverted hammer, occurs at the of the uptrend, and it signals a bearish reversal.
As you can see below, they both have the same form – the open and close are at the bottom of the candle – but signals that they send are different.
The next step when spotting an inverted hammer is to check whether the price action is in a clear downtrend or not. For this, you need to see if a series of lower highs and lower lows is present, which has driven the pair’s price lower.
Secondly, you should check if the key elements of the candlestick are present. The easiest way to do this is to look for a long wick upwards. This shouldn’t be difficult as in the downtrend you may not have a lot of long wicks that extend higher.
Let’s assume you have now finally spotted the inverted hammer candlestick and you are ready to make some profit by following our tips.
How to trade an Inverted Hammer Candlestick
As mentioned earlier, to validate the pattern, you need to identify a bullish reversal confirmation. We get this in the context of the next candle. If the next candle is long and bullish, it means that the trend has reversed and the price is aiming for higher levels.
This is the exact case in the example below. The GBP/USD was trading lower and we see a clear downtrend that pushed the price around 400 pips lower. After a long red candle, we get the first sign that the bears are running out of steam.
During the daily trading session when this candle is formed, the bulls managed to push the price higher, almost to a level where the previous day’s fall had started. However, the bulls were not able to sustain the momentum, and the price goes lower and closes at the bottom of the daily range.
Then, we get a large bull candle next to the inverted hammer candlestick that confirms the bull message that we received the day before – the reversal is taking place.
You can either risk more and open the trade as soon as the inverted hammer is created, or wait for the bullish confirmation. The next candle, in this example, is both positive and negative for us.
Positive, since it confirms the reversal. On the other hand, the fact that the price trades more than 200 pips higher is negative, as we may already be late as the most significant portion of the reversal potential might have been completed.
In case you don’t want to wait for the bullish confirmation and you are confident that the reversal is about to take place, you may want to open the trade as soon as the inverted hammer is completed.
Identifying TakeProfit and StopLoss levels
As always, placing a trade can be challenging and you should never open trades without consulting other indicators and elements of the technical analysis process. Here, we have drawn two trend lines that connect important data points to help us identify levels that may be relevant for us.
The red trend line connects lower lows and a potential penetration of this zone would invalidate our trading formation. Any move below the trend line support opens the road to lower levels, which are only going to hurt our position.
On the other hand, the upper (blue) trend line connects previous swing highs. In this case, we use it as a profit-taking level. A move to this level means that the reversal has fulfilled its early potential as the price action now trends towards the same zone where the previous high is located.
For informational purposes, there are nearly 400 pips between the entry and our profit levels.
The inverted hammer candlestick pattern is a reversal pattern that indicates that the bulls are testing the power of the bears. It is not a direct trading signal, but rather a warning that the current bearish trend may come to an end.
The next candle (after the inverted hammer) will give us a confirmation, indicating if the price is likely to go higher or lower from there. As always, we should always use other technical indicators to define stop-loss and profit-taking levels to help us better protect our capital.