Definition - After a black body, an Inverted Hammer will show that boasts a small body and a long upper shadow. Although it has similarities to the Bearish Shooting Star, the Bullish Inverted Hammer signals a bullish reversal during a downtrend.
- During a prevailing downtrend in the market, a black candlestick will form on the first day.
- At the lower end of the trading range, a small body will start to form on the second day; the colour isn't seen as important.
- Normally, the upper shadow will be double the size of the body whilst there is very little lower shadow.
Patterns and Flexibility
Whilst the body of the Inverted Hammer is small, the upper shadow is twice as long but never shorter than the average length of a candlestick. In a perfect scenario, there will little to no lower shadow. Also, the preceding candlestick’s body should be higher than the bottom of the inverted hammer.
Behaviour of Trader
Whilst already in a bearish market, the initial black candlestick suggests that the trend will continue. After opening on the second day at the low, a rally will soon occur which changes the direction of the price. However, the bulls do not succeed and the price finally closes back to the low of the day. Ultimately, the next day will very much decide what happens next and there are no clear signs as to why this price action is seen as a potential reversal signal.
For those who shorted at the open or close of the Inverted Hammer day, they will lose money if the next day opens higher than the Inverted Hammer itself. If the market stays in this position for some time, these traders will look to cover their position. As a result, a small rally might be seen which, in turn, could see the bottom pickers look towards longer positions.
Buy/Stop Loss Levels
For there to be confirmation, the prices should cross above the confirmation level which, in this scenario, is the midpoint of the Inverted Hammer’s upper shadow. For the two lows, the lower of the two will be used for the stop loss. If prices fall and two consecutive days are seen where the lows fall below the stop loss level after the buy, the stop loss will be triggered assuming that there is no bearish pattern.