Believe it or not, something as simple as a single candlestick can make a huge difference to your trade setups working or not.
I’m not talking about any candlestick of course… I am referring to the Inverted Hammer.
I have over a decade of experience using technical analysis in trading and have become quite proficient…
And while I have been through the ups and downs of all the many different ways to trade, in the end… I am an avid believer in technical analysis.
So much so that I base all of my trades off technicals.
You’ve got to be wondering… How can a single candle be so powerful?
Well, sit tight and I will show you…
The Inverted Hammer candlestick formation, comprised of a single candle, is commonly found at the bottom of downtrends.
It is easily identified by a small lower body and a long upper wick which is at least two times as large as the body.
The body of the candle should also be at the low end of the trading range and in contrast to the large upper wick… there should be little to no wick on the lower end of the candle.
Inverted Hammer Criteria:
- The upper wick should be at least two times the length of the body.
- The candle body is at the lower end of the trading range.
- There should be little to no lower wick.
At the end of a long downtrend, an Inverted Hammer is bullish because it is showing a hesitation in the downward pressure.
The candle is showing buyers coming in to test the selling pressure in the stock.
The long upper wick of the candlestick pattern indicates that the buyers drove prices up but the selling pressure was too much and prices back down to close near the open.
For the inverted hammer to have any significance at all… the buyers must come in the next day to take over. Otherwise it was simply a battle the bulls lost.
But keep in mind it’s simply a warning of potential trend change, not a signal to buy.
- Price gaps down on the day the inverted hammer is formed.
- Longer upper wicks.
- Look for price to gap up and trade strong the day after it forms.
Using the Inverted Hammer
At the end of last year, Facebook (FB) was in a clear downtrend….
I used the yellow oval in the chart to highlight an inverted hammer candle pattern…
Potential trend reversal?
Take a look at what happens next:
How’s that for a trend reversal?
Now that you see the significance… let’s get up close and personal with this candlestick pattern.
Below I zoomed in on the chart to get a closer look at the actual candlestick… you can see more clearly what it actually looks like…
- The upper shadow should be at least two times the length of the body – Check!
- The candle body is at the lower end of the trading range – Check! Check!
- There should be little to no lower wick – Check! Check! Check!
And there we have it… an Inverted Hammer.
So we just jump right into the stock now?
Of course not… it’s just a candlestick.
An inverted hammer is a signal of a potential trend reversal… it is in no way a buy signal on it’s own.
It’s important to trade based on your setups and any other indicators that are part of your system…
By using candlestick patterns like the inverted hammer in conjunction with your trading system, you can potentially get more confirmation and up the odds in your favor…
… it’s not a replacement or stand alone by any means…
FB is in a downtrend, it then starts making a rounded bottom pattern.
Enter the inverted hammer and now I have an extra signal that doesn’t occur in all of my trades…
You see, FB could make the rounded bottom without an inverted hammer, and still signal a trade for me…
I wouldn’t take a trade based only on the inverted hammer candle, but seeing it in conjunction with my profitable trade setups is gravy…
Next I would want to see the 8 EMA cross above the 20 SMA, which is marked by the first blue oval.
Once that occurs, I am watching for the price to stay above the 8 EMA and I marked the buy entry area in grey square on the chart…
Being in the trade one last signal to confirm the potential of a nice move up is marked by the second blue oval when the 20 SMA crosses above the 50 SMA.
In conclusion, the inverted hammer is a great tool, but it should only be used in conjunction with your trusted trade setups.
If the chart had not set up according to the pattern that I trade consistently, I would not be looking at a trade in FB there… regardless of the inverted hammer.
The inverted hammer was just an added confidence booster when my pattern did finally set up.