Inverted Hammer Pattern - Meaning, Types, Strategy

Candlestick patterns are one of the oldest and most classic tools that traders use to understand the price action in the security. Among the various candlestick patterns, the inverted hammer pattern is one of the simplest patterns used among traders. In this article, we will understand the meaning of the Inverted Hammer Candlestick Pattern, its types, Interpretation, trading strategy, and more. So let’s get started!

What is Inverted Hammer Pattern?

An Inverted hammer candle is a bullish candle that comprises a small body, with little to no lower wick, and a large upper wick which is at least twice as large as the body of the pattern. As marked in the below image as well. This is a reversal pattern that is preferred to appear after a downtrend.

Types of Inverted Hammer Patterns

Based on the color of the Inverted Hammer Candlestick, it can be broadly classified into the following:

Red Inverted Hammer Candlestick

In a red inverted hammer candlestick, the body of the pattern is red because the closing price is lower than the opening price during the session. This version of the inverted hammer pattern suggests that sellers are losing momentum allowing the buyers to gain control.

Green Inverted Hammer Candlestick

In a green inverted hammer candlestick, the body of the pattern is green because the closing price is higher than the opening price during the session. This version of the inverted hammer shows a stronger bullish sentiment as it indicates that the buyers have gained control over the sellers during the session.

Although the color of the pattern is not very relevant while trading using this pattern, it is important to note that the green inverted Hammer candlestick indicates a more potent bullish reversal than the red inverted hammer candlestick due to its price closing higher than the opening price during the session.

Formation and Interpretation of Inverted Hammer Pattern

As an Inverted Hammer Candlestick pattern is considered a bullish reversal pattern, it should be noted that before the formation of the pattern, a few red candles should be formed in the security that is pushing the price lower. 

As the uptrend progresses, there will be one candle that moves largely against the prior downtrend. However, by the end of the session, the price ends up closing near the opening price of the session. This suggests that the sellers may have lost control of the downtrend and a reversal may occur.

The formation of the next candle after the Inverted hammer pattern confirms the reversal in the security. That is, the next candle should preferably close above the high of the inverted hammer pattern. For reference check out the image below.

How to Identify an Inverted Hammer Pattern?

The following are the key points to remember to identify the Inverted Hammer Pattern:

• Location: For a candlestick pattern to be called an inverted hammer pattern, it should only appear after a downtrend. If a similar candlestick pattern appears after an uptrend, then that pattern is considered to be a shooting star pattern.

• Shape: The pattern should have a small body, an upper twice as large as its body, and little to no lower wick

• Color: The body of the inverted hammer pattern can be red or green in color. However, a green-bodied inverted hammer pattern indicates greater conviction for reversal as it indicates the price closing higher than the opening price during the session

Inverted Hammer Pattern Strategy

As mentioned earlier, one should only trade using an inverted hammer pattern if the prior trend before the pattern formation is a downtrend. Once this basic criterion is met, one can look to enter a long position in the stocks which is explained using a live example below

Inverted Hammer Pattern Example

• Entry: There are two ways to trade using this pattern. The first approach is you wait for the next candle after the inverted hammer candlestick to close above it. Following this, one can enter a long position in security.

  The second approach is an aggressive approach where you enter a long position as soon as the next candle starts trading above the inverted.

• Stop Loss:  If the security starts moving above the low of the inverted hammer, one can consider closing the long position in the trade.

  But, if the size of the body of the inverted hammer is very short, one can set a stop-loss using the risk-to-reward ratio or the prior support level (whichever comes first).

• Profit Target: Because the inverted hammer is a single candlestick pattern, there is no standard way to calculate the profit target. Here, one can book profits using the risk-reward ratio, the immediate level, or even the trailing stop-loss strategy.

The best scenario for an Inverted Hammer Pattern

As the inverted hammer pattern indicates a bullish reversal, its probability of success is likely to increase as it appears near a well-established level of support. 

Support zones are levels where significant price action has occurred in the past, making them strong demand zones where the security may reverse in an upward direction.

Thus, the formation of the inverted hammer pattern near a well-established support level creates confidence among the traders that the sellers are losing momentum and the price will likely reverse upwards.

Limitations of Inverted Hammer Patterns

While the Inverted hammer candlestick pattern is a well-recognized candlestick used by traders, it does come with the following limitations:

• Requires additional confirmation: As the Inverted Hammer pattern is a single candlestick pattern, validation from the next candle is required for any trading potential signals.

• No Profit Targets: As the Inverted Hammer Candlestick is a single candlestick pattern, it does not provide levels where traders would need to book profits in a trade. 

• Strength of the candle: The strength of the inverted hammer pattern is relatively lesser when compared to the hammer pattern.

Inverted Hammer and Shooting Star Pattern - Key Differences

Both the Inverted Hammer and Shooting Star Pattern have a similar appearance. However, they have the following distinguishing features:

Conclusion

We have reached the end of the article on Inverted Hammer Pattern. Before we wind up, it is important to note that the Inverted Hammer is comparatively weak compared to the hammer pattern. It is important to use this pattern and other technical tools and indicators and place proper risk management strategies to mitigate huge losses.

Ready to take your trading to the next level? Open the Demat account with Rupeezy today and enjoy margin trading for delivery and F&O positions. Plus, earn a 20% commission on every trade by referring friends and family!