Inverted Hammer Candlestick Pattern (Backtest)
Last Updated on February 13, 2023
Candlesticks are a popular charting technique used in the technical analysis of financial markets. The shape of the candlestick can provide insight into market sentiment and potential future price movements. One popular candlestick pattern that is commonly seen on price charts is the Inverted Hammer. What do you know about the Inverted Hammer candlestick pattern trading strategy?
The Inverted Hammer candlestick pattern is a bullish reversal that forms in a downward price swing. As the name implies, it has the appearance of an inverted hammer — a small body at the lower end and a long upper shadow. It shows that the buyers are gaining momentum against the sellers and might soon push the price higher. The pattern is widely used by traders to identify the beginning of a potential upswing so as to enter long positions.
In this post, we take a look at the Inverted Hammer candlestick pattern trading strategy.
Understanding the Inverted Hammer candlestick pattern
The Inverted Hammer candlestick pattern is a bullish reversal pattern that forms at the bottom of a downward price swing. As the name suggests, it resembles an inverted hammer, and it is characterized by a small real body located near the lower end of the candle, a little or no lower shadow, and a long upper shadow.
In an Inverted Hammer formation, the color of the real body is not as important as its position — it must form at the lower end of a downward price swing, otherwise, it could be called a shooting star if it forms at the top of an upward swing. A green or white real body is considered more bullish, while a red or black real body is considered less bullish. However, any Inverted Hammer pattern can still indicate a potential bullish reversal even if it has a red real body.
The pattern is formed when the price opens lower, rallies during the day, but closes near its opening price. The long upper shadow indicates that the bulls tried to push the price higher, but the bears fought back and brought the price down. But despite the late fightback by the bears, the bulls are gaining confidence.
The Inverted Hammer is a significant pattern because it shows that the bears are starting to lose control, and the bulls are gaining momentum. This can indicate that a reversal to an upswing is possible. However, it is important to note that this pattern is a single-candle formation and should be confirmed by other technical analysis tools and indicators.
Traders often use the Inverted Hammer pattern in combination with other signals, such as a trendline, a support level, moving averages, and momentum oscillators, to confirm a reversal and make trading decisions.
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How to identify an Inverted Hammer pattern in trading
The Inverted Hammer candlestick pattern is a single-candle formation on the price chart that signals a potential upward reversal in a downward price swing. It is characterized by a small body located at the bottom, a little or no lower shadow, and a long upper shadow, resembling an upside-down hammer. This is how you can identify the Inverted Hammer pattern:
- Look for a downswing: The first step in identifying the Inverted Hammer pattern is to look for a downward price swing, which can be an impulse wave in a downtrend or a pullback (retracement) in an uptrend. The Inverted Hammer pattern has to form at the lower end of the downswing. If it forms at the top of an upswing, it will be called a shooting star pattern.
- Look for a single-candle pattern: The Inverted Hammer pattern is a single-candle formation, so look for a single candle in the chart that fits the pattern’s characteristics.
- Check the body: The body of the candle in the Inverted Hammer pattern is typically small and can be either bullish or bearish in color. It must be near the lower end of the pattern. So, look for a small body at the lower end, with a bearish or bullish color.
- Check the upper shadow: The most distinctive feature of the Inverted Hammer pattern is its long upper shadow, which is at least twice the length of the body. Look for a long upper shadow that is at least twice the length of the body.
- Check the lower shadow: The lower shadow of the candle is typically short or non-existent.
The meaning of an Inverted Hammer pattern
The Inverted hammer pattern suggests that buyers are starting to assert control over sellers and prices may soon rise. The pattern is formed around the lower end of a downward price swing, which can be an impulse wave in a downtrend or a pullback in an uptrend. Traders frequently use this pattern as a cue to enter into long positions, as it signals the start of a potential upward price swing, especially after a pullback in an uptrend.
One of the main features of the Inverted Hammer pattern is that it often forms around important support levels, so it can indicate a potential bullish price reversal. This can help traders make more informed trading decisions, particularly those who are looking to confirm their bullish outlook in a down market or trying to know the end of a pullback in an up-trending market.
Another interesting thing about the Inverted Hammer is that it forms when the market seems oversold, and mean-reversion traders are looking to enter long positions. So, it helps these traders confirm their bullish bias in the market. The Inverted Hammer pattern can also provide traders with insight into market sentiment and the balance of power between buyers and sellers.
However, while the Inverted Hammer pattern can be a useful tool for traders, it may be pretty useless by itself. It must form in the right context to have any significance, which is why it must be used with tools like trendlines, support levels, moving averages, and momentum oscillators.
Benefits of using an Inverted Hammer pattern in trading
The Inverted Hammer candlestick pattern is not only popular among price action traders and technical analysts, but also, occurs fairly frequently on the price chart of different assets and instruments. Using an Inverted Hammer pattern in trading can offer several benefits for traders looking to profit from potential bullish swings in the market. Some of the benefits of using this pattern include:
- It occurs very commonly on price charts: The Inverted Hammer is a very common candlestick pattern. It occurs very frequently and can be seen on any chart.
- It is easy to spot: The pattern is a simple single-candle formation that is easy for traders to spot and identify, making it accessible for both novice and experienced traders.
- It can be relatively reliable: The pattern is considered a fairly reliable bullish reversal signal, making it a useful tool for traders looking to profit from potential bullish swings.
- It can be confirmed with other trading tools and indicators: One can use technical indicators, such as trendlines and support levels, to support the bullish bias and increase the reliability of the pattern.
- It is flexible to use: The Inverted Hammer trading strategy can be used in various market conditions and timeframes. It can be combined with other technical analysis tools to create a comprehensive trading plan.
- It shows a clear stop-loss level: Traders can use stop-loss orders and other risk management techniques to limit their potential losses, making it a safer trading strategy.
How to trade using the Inverted Hammer candlestick pattern
The Inverted Hammer pattern is considered a bullish reversal pattern, especially if it forms at the bottom of a downward price swing (which can be a pullback in an uptrend or a downswing of a downtrend). So, it can be used to identify buying opportunities in the market, especially for swing trading.
But the pattern should not be used as a lone signal. You should make it a part of a robust trading strategy where the pattern can help show bearish reversal signals. For a simple price action swing strategy that uses a trendline, support levels, and the Inverted Hammer pattern, here are the steps to trade it:
- Use a trendline to delineate the direction of the trend and make sure there is an uptrend
- Mark the support levels below the price with a horizontal line
- Wait for the price to retrace to a support level or the trendline
- Look for the Inverted Hammer pattern around the support level
- After confirming the Inverted Hammer pattern around a support level, place a buy order at the opening price of the next candle
- To manage risk, set a stop loss order below the swing low where the Inverted Hammer pattern formed
- Set a profit target just below the next support level
- Monitor your trade and adjust as you deem fit
You can automate this process with trading algorithms if you know how to code, or you can hire a programmer to do it.
Key considerations for trading with the Inverted Hammer pattern
When trading the Inverted Hammer, it’s important to be mindful of several key considerations to help maximize profits and minimize risks. One of the key considerations is market context. It is essential to understand the overall market context. This includes being aware of the market trend and any major economic or political events that may be affecting the market. But more specifically, it implies studying the market structure and trend — it is better to trade the pattern in an uptrend, where it can signal the end of a pullback and the beginning of a new bullish impulse swing.
In addition, to ensure the validity of the bullish reversal signal given by the Inverted Hammer, traders should also look for confirmation from other technical indicators, such as trendlines, moving averages, momentum indicators, and volume analysis. The trading volume can provide insight into the strength of a trend and the potential for a trend reversal.
To minimize potential losses, traders should utilize stop-loss orders and implement proper risk management through position sizing and diversification. It’s important to set a stop-loss to limit potential losses and protect capital in case the price moves in the opposite direction. Additionally, spreading out risks through diversification across different markets and timeframes is also worth considering.
Profitable trading strategies using the Inverted Hammer pattern
The Inverted Hammer candlestick pattern is a bullish reversal pattern that forms in a downward price swing. It shows that the buyers are gaining momentum against the sellers and might soon push the price higher. The pattern is widely used by traders to identify the beginning of a potential upswing, especially in an established uptrend, providing opportunities to open long positions.
There are different strategies traders can use when trading the Inverted Hammer pattern. One of them is swing trading using a trend-following strategy. Since the pattern has a bullish reversal implication, price action swing traders may use it to ride impulse swings in an up-trending market. In this case, they wait for the price to retrace to a key support level and enter long positions if an Inverted Hammer pattern forms, signaling the end of the retracement and the beginning of the next impulse swing to the upside.
Another strategy that can use the Inverted Hammer pattern is mean reversion. In this strategy, the trader believes that the price would rise back to its mean after trading significantly below it. To implement this strategy, the trader may use a moving average indicator to know the mean and use the stochastic or any other momentum oscillator to identify when the market seems oversold. Other tools for the strategy are the support levels and, of course, the Inverted Hammer pattern.
If the Inverted Hammer pattern forms at a key support level when the stochastic is rising from an oversold level, a mean-reversion trader can enter a long position and ride the anticipated price upswing toward the moving average line.
Real-life examples of successful Inverted Hammer trades
The Inverted Hammer candlestick pattern is very common on price charts. Here are two example trades on the Meta Platforms, Inc. stock chart.
In the chart above, you can see the trade setups formed by the Inverted Hammer candlestick pattern when the price pulled back to the trendline or the 14-period moving average (both of which act as dynamic support levels).
Trade entry is at the open of the next candlestick. Notice where the stop loss should be — below the low of the pullback. The profit target can be at the next resistance level, or you can use a 2:1 reward/risk ratio — any of those methods can make you money.
Enhancing your trading performance with the Inverted Hammer pattern
The Inverted Hammer candlestick pattern is a powerful tool for traders seeking to increase their trading performance in the financial markets. To use this pattern to improve your trading results, you need to understand its characteristics and how to use it to identify high-probability trade setups.
Being a bullish pattern, the Inverted Hammer is best used in an up-trending market. This way, you can have two factors that support the trade: the trend and the Inverted Hammer pattern. Adding a key support level to the equation also increases the odds of success. Another confluence factor could be to use a momentum oscillator like the stochastic to confirm there is an oversold condition in the market when the pattern formed. So, your best probability trade setup is to have the following aligned:
- An up-trendline or a 200-day moving average showing an uptrend
- A pullback to support level
- The stochastic rising from an oversold level
- An Inverted Hammer pattern at the support level
In addition to getting a good entry point with the four confluence factors above, you need to have proper risk management strategies, including position sizing and the use of stop loss. Risk only 1-2% of your capital on a trade and set your stop loss below the low of the downward price swing where the Inverted Hammer formed. Set your profit target just below the next resistance level or use a 2:1 reward/risk ratio.
You can also diversify your portfolio across different markets and different timeframes to spread out your risk and enhance your trading performance. Trading different markets and timeframes manually at the same time is near impossible, so you would have to automate your strategy with the help of trading algorithms.
Common mistakes to avoid when trading with the Inverted Hammer pattern
In trading, it is important to be aware of mistakes that can affect your success and profitability. Here are some of the most common mistakes to avoid when trading with the Inverted Hammer pattern:
- Not considering the market context: Although the Inverted Hammer pattern is a bullish reversal pattern, it is ineffective when traded in the wrong market situation. It is important to consider the overall market context before making a trade to avoid unnecessary losses.
- Not seeking confirmation: The Inverted Hammer pattern is a powerful signal, but you should always seek confirmation from other technical indicators before making a trade. Moving averages, momentum indicators, and volume analysis can all provide valuable information. Without confirmation, you will get many false signals.
- Ignoring trading volume: Trading volume is an important factor to consider when trading with the Inverted Hammer pattern, as a high trading volume may support the bullishness of the pattern. Not considering the trading volume opens you to many false signals.
- Neglecting risk management: Risk management is an important aspect of any trading strategy, so you should always consider it when trading with the Inverted Hammer pattern. Neglecting that could lead to huge losses.
- Not having a defined trading strategy: You must have a comprehensive trading strategy when trading with the Inverted Hammer pattern, or else, you will make unnecessary trading errors, including emotional trading.
- Not backtesting your strategy: Backtesting helps you to know how your strategy would have performed in the past. Without this clue, you may be throwing money away with an unprofitable strategy.
- Overtrading: Overtrading is a common mistake that many traders make because the Inverted Hammer pattern occurs frequently. This can lead to many trading errors.