How to Trade The Inverted Hammer Candlestick (The Right Way)
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How to Trade The Inverted Hammer Candlestick (The Right Way)
When it comes to candlestick patterns, there are so many different names and formations that traders get confused.
The Inverted Hammer is one such candlestick pattern that many traders get confused by.
And even worse, they trade it the wrong way.
In this post, I’m going to clear your confusion on what the Inverted Hammer is all about.
More importantly, I’ll share with you 4 ways to trade the Inverted Hammer the right way.
By the end of this post, not only will you have a good understanding of what this candlestick pattern is all about…
But you will also know the important psychology behind its formation…
And also exactly how to trade it so that you have the best chance of making your Inverted Hammer candlestick trades profitable.
Are you ready?
If so, then we need to start off by asking…
What Exactly is An Inverted Hammer?
Are you familiar with the Hammer candlestick?
It’s a bullish candlestick pattern that can be called the Bullish Pin Bar as well.
So the Inverted Hammer is simply the upside-down version of it, but it’s only called the Inverted Hammer when the market is going down.
It has a small body at the bottom and a long wick at the top.
Technicality-wise, the wick has to be two-thirds the length of the candlestick length.
But that can be very subjective because you’d have to measure it each time it appears just to confirm it’s two-thirds the length.
For our purpose, as long as the wick is longer than the body, we will consider it an Inverted Hammer.
Now, the body can either be bullish (the close is higher than the close) or bearish (the close is lower than the open).
Contrary to what it looks like, this is a bullish candlestick pattern.
That means that after this candlestick is formed, traders expect the market to go up.
Now, this candlestick pattern is an odd one.
And the reason I say that is because this candlestick pattern is like a Double Agent.
It has two identities.
If you find it at the bottom of a downtrend, it’s called an Inverted Hammer.
But if you find this bugger in an uptrend, it’s suddenly called a Shooting Star.
And it becomes a bearish candlestick pattern.
So same formation, but different names depending on where you see it.
Many times, this can also be called a Pin Bar.
So what on earth is this pattern all about?
The Odd Psychology Behind the Inverted Hammer
If you look at the Inverted Hammer just by the price action alone, it’s clearly indicating that it’s a bearish candlestick.
Let’s just analyze how this candlestick pattern is formed.
First, for it to be called an Inverted Hammer, the market has to be moving downwards.
Second, the formation of this candlestick from price action alone actually indicates that the bears are in control.
Let’s start with how the candlestick is formed from the open of the candlestick.
At the open of this candlestick, the market has to push all the way to its highs to create the long wick we see.
So for the market to push so high above its open shows that the bulls are in control at the start.
But towards the close of this candlestick, the market pushes back down and closes either slightly above the open of below the open.
This certainly indicates that the bear took back control as it pushed the bulls all the way back down to near its lows.
And just as the bears pushed the bulls back down to the lows, the candlestick closes to form the Inverted Hammer.
Therefore, at the close, the bears were clearly in control.
So if that’s the case, why then is the market expected to go higher after the Inverted Hammer is formed?
Doesn’t make much sense right?
Well, here’s my take on this weird price action phenomenon.
In my opinion, it’s because this candlestick hasn’t finished its story.
You see, candlestick patterns are defined by time.
That means if you chose a 1-hour timeframe, then the candlestick will be printed at every hour.
But that doesn’t mean the battle between the bulls and bears is over.
Let me use a Battle of Stalingrad during World War 2 to explain what I mean.
You see, in the Battle of Stalingrad, the Germans had pushed the Russians to the borders and it looked like the Germans had won.
However, what the Germans didn’t know was that this was a strategic retreat by the Russians.
The Russians had put just enough men to defend Stalingrad and let the Germans feel like they were winning.
But in reality, the Russians were secretly gathering a massive amount of troops at the flanks waiting to do a pincer attack.
So when the Germans pushed into Stalingrad, the Russians launched a pincer attack and flanked the Germans from two sides.
This divided the Germans into two groups, with one group being isolated in Stalingrad and the other group being push back to where they came from.
Then with overwhelming numbers, the Russians slowly annihilated the Germans that were isolated in Stalingrad and they eventually won the battle.
Now, imagine you were watching this battle from the start on your television.
As the Germans pushed the Russians back to the borders, you might have thought that the Germans have won and switched off the television.
At the point when you switched off the television, you printed in your mind that the Germans have won.
But in reality, the Russians were waiting to launch a surprise attack on the German troops.
And if you continued to watch the battle on your television, you would see that the Russians would eventually win.
That’s the same situation with the Inverted Hammer.
At the close of the candlestick, it shows that the bears have won.
However, it could be that the bulls are about to make a comeback but it’s being cut off because it hit the hourly mark and the chart printed that candlestick.
If you looked at a 4-hour chart, then it might show another candlestick that is really bullish like the Bullish Engulfing Candle, or maybe even a Bullish Pin Bar.
So here’s what I’m trying to get at…
Do not look at any candlestick pattern as a standalone.
Just because a candlestick pattern is bullish, doesn’t mean the market will go up.
Likewise, if the candlestick pattern is bearish, it doesn’t mean the market will go down.
We want to look at its context and then with a bigger picture we can decide the market’s sentiment.
Alright, now that we know the psychology behind the Inverted Hammer, how do you exactly trade it?
How to Trade the Inverted Hammer
There are many new traders who learn a handful of candlestick patterns, get excited and just enter into a trade when these candlestick patterns form.
So for example, whenever they see a Bullish Pin Bar, they just go Long.
They don’t care whether it’s in an uptrend, a downtrend, or whether there’s support or resistance.
They just enter into a trade solely based on the candlestick formation.
Heed my advice – Don’t do that.
You should never trade any candlestick pattern as a standalone.
And you definitely do not want to do that with the Inverted Hammer.
There must always be a context to get into a trade with and candlestick pattern.
So here are 4 ways to trade the Inverted Hammer candlestick:
1) Double Bottom
The first way is to trade it with a Double Bottom.
The Double Bottom is a classic bullish reversal pattern.
This is how technical analysts teach people to get into a trade with the Double Bottom:
They will first identify the Double Bottom, and then draw a neckline at the peak in between the two bottoms.
And when the market breaks above the neckline, they will go Long.
The Stop Loss is then placed below the second bottom.
While that is certainly one way to enter into a trade, the risk-to-reward may not be that good.
And the reason is that if the neckline is high, then the distance to the Stop Loss will be quite far from the entry point.
So in order to make just 1R, the market will have to go up the same distance.
For example, if the Stop Loss is 50 pips away from the entry point, then the market will have to go up 50 pips in order to just make 1R.
Now, what if you could get an earlier entry on the same Double Bottom pattern, but have the Stop Loss only 25 pips away from your entry?
That would mean that with the same Take Profit level, it will not just be a 1R profit but a 3R profit!
You can see that in the diagram above, on the left-hand side is the standard neckline entry.
But on the right-hand side, if you could enter in slightly earlier below the neckline, then you’d be able to get a better risk-to-reward ratio just for the same Take Profit level.
So how do you get an earlier entry?
That’s where bullish candlestick patterns like the Inverted Hammer comes into play.
So this is what you want to look out for on the charts:
Remember, we do not go Long on the formation of the Inverted Hammer candlestick…
Instead, we want to wait for a close above the high of it.
Only once it has closed above the high, then we consider it a valid signal to go Long.
Now, this is considered a rather aggressive entry compared to the neckline.
But there are times where the market can still go back down after a close above the Inverted Hammer.
Hence, I like an additional confirmation that the Double Bottom trade has a high probability of working out.
And that additional confirmation is in the form of divergence using the Stochastic Oscillator indicator.
A divergence is when the price action is moving in a different direction than the indicator.
So when the Double Bottom is formed, what I’m looking for on the Stochastic Oscillator is a higher low bottom like this:
As you can see in the diagram above, the market has formed a Double Bottom but the Stochastic Oscillator is showing a higher low.
This is a divergence and this is an indication that the market might be reversing back upwards.
So with this setup, we have a few things going for us…
First of all, we have a Double Bottom forming.
Then we have an Inverted Hammer candlestick formed at the second bottom.
Additionally, we have divergence from our Stochastic Oscillator as well.
These three signs are good indications that the market might be reversing upwards.
But we do not go Long yet.
We wait for the market to close above the high of the Inverted Hammer.
Once it closes above the Inverted Hammer, then that’s our signal to go Long.
We want as many bullish signs indicating that this Double Bottom might be going up before we enter into a trade.
This way, you will always enter into a high probability trade.
Let’s take a look at an example:
In the chart above, you can see that the market is in a downtrend with the 20 EMA below the 50 EMA.
Then as the market came down, it formed a Double Bottom.
At the second bottom of the Double Bottom, an Inverted Hammer is formed.
And at the same time, the Stochastic Oscillator is showing a higher low.
This is a divergence.
So here, we have a Double Bottom, an Inverted Hammer, and a divergence.
We have a confluence of three different signals telling us that there might be a reversal coming.
And true enough, the market went up from there.
2) V-Bottom
The second way to trade the Inverted Hammer is with a V-Bottom pattern.
V-Bottoms are reversal patterns that look like a V-shape, hence the name.
V-Bottoms can be found in uptrends, downtrends, and even in a sideways market.
This is typically how a V-Bottom looks like:
It has a sharp move down, followed by a sharp move back upwards.
This sharp movement is usually caused by a news release, but it can also be because of a breakout of some technical breakouts.
Now, we do not want to enter V-Bottoms as a standalone.
That means if you see a V-Bottom and there is also an Inverted Hammer formed with the market closing above its high, that isn’t good enough for us to go Long.
We want to see that the V-Bottom is actually formed off a support level.
In the diagram above show the criteria for our entry:
- The V-Bottom must test a prior support level.
- Look for an Inverted Hammer to be formed.
- Wait for the market to close above the high of the Inverted Hammer.
- The close must be above the support level.
When these criteria are met, then that’s a valid signal to go Long.
The Stop Loss is placed below the low of the Inverted Hammer.
Remember, the body of the Inverted Hammer need not be bullish in color.
It can also be a bearish body.
Let’s take a look at an example on the EURUSD 1-hour chart:
On the right-hand side of the chart, you can see that a V-bottom was formed and it tested a prior swing low that acted as a support level.
If you noticed, the Inverted Hammer is with a bearish body and closed right at the lows.
But in the next bar, the market shot up and formed a Bullish Engulfing Pattern.
After that, the market closed higher in the next bar, but then came back down to test the support level again.
As it tested the support level for a second time, it formed another Inverted Hammer as an Inside Bar.
From there, the market shot up.
As you can see, it’s important to trade the V-Bottom and the Inverted Hammer with a support level.
Because it acts as a “floor” for the market to bounce off of.
Hence, the trade will have a higher probability of working out.
3) Pullbacks in An Uptrend
The third way is to trade pullbacks in an uptrend.
There are many people out there teaching that Inverted Hammers are only found in a downtrend.
But that’s true.
These Inverted Hammers appear in uptrends as well.
And we can use the Inverted Hammer candlestick as a signal that there’s a possible entry on a pullback.
Here’s what you want to be looking for to go Long:
- The 20 EMA has to be above the 50 EMA.
- The market has to be making higher highs and higher lows above both EMAs.
- A pullback or retracement to either of the EMAs.
- The Inverted Hammer candlestick formed on either of the EMAs as the EMAs will act as a dynamic support.
- Once the Inverted Hammer is formed, wait for the market to close above the high of the Inverted Hammer.
- When the market closes above the Inverted Hammer, that is the signal to go Long. You can either go Long at the close of that bar or wait for the market to go down a little to get a better entry.
- Place Stop Loss below the low of the Inverted Hammer.
Let’s take a look at a chart example:
The chart above is the 1-hour EURUSD chart.
You can see that the 20 EMA is above the 50 EMA, and the market has been moving in an uptrend above both EMAs.
As you can see, there are two Inverted Hammers on the pullback in an uptrend.
In both cases, the market went up after the Inverted Hammer is formed.
And one has a bullish body, while the other has a bearish body.
So the color of the body doesn’t matter.
What’s important to see is the context of how the Inverted Hammer is formed.
And as you can see for both Inverted Hammers, they are formed when it touched the EMAs.
This shows that the EMAs are acting as dynamic support levels.
Now, most of the time you will see the Inverted Hammer as the lowest candlestick in the pullback (as shown in the chart above).
However, there are times when it isn’t the low of the pullback but can still be a valid entry.
For example, in this chart below, the Inverted Hammer shows up as an Inside Bar.
In the chart above, you can see on the left-hand side that the market has been trending upwards.
I have also plotted the 20 EMA (purple line) and 50 EMA (black line).
As the market goes below both the EMAs, it formed an Inverted Hammer as an Inside Bar.
To go Long, we wait for the market to close above the high of the Inverted Hammer.
And the Stop Loss is placed below the low of the previous candlestick.
Some traders are more aggressive and like to place their Stop Loss below the low of the Inverted Hammer.
That’s also a viable placement as it would bring a better risk-to-reward ratio.
But there’s a higher chance of getting stopped out more often.
So this is something that you want to balance.
4) Fake-outs
The last way to trade an Inverted Hammer candlestick is what I call a “Fake-out” setup.
It’s when traders see this candlestick pattern as a Shooting Star, go Short, then the market goes down a little before reversing back up.
Here’s an example of what I mean:
From the left-hand side of the chart, you can see that the market has been in a pretty strong downtrend as it has been moving below the 20 EMA.
This is a sign of strong momentum in the downtrend.
Then the market went above the 20 EMA, and the tested the 50 EMA.
As it tests the 50 EMA, it forms this Shooting Star candlestick (it’s the exact same candlestick as the Inverted Hammer, just that it’s called a Shooting Star when the market is moving up).
This Shooting Star can also be called a Bearish Pin Bar.
Now, regardless of its name, by seeing the context, you should immediately identify it as a bearish candlestick pattern.
And the reason is that it is formed when the market is still in a downtrend in the big picture, and this is considered a pullback in a downtrend.
It also reached the 50 EMA, which acts as dynamic resistance, and formed the Shooting Star.
At this point, many traders will be looking to go Short because it’s a pullback setup that many traders get into.
The next bar after that is also a Shooting Star candlestick, but it forms as an Inside Bar which shows more bearishness in the formation.
Then the bar after that breaks below the low of the Inside Bar and closed below the low of the Shooting Star.
By this point, many traders would have gone Short.
However, the market immediately reverses and starts going up from that point onwards.
This is a Fake-out because the Shooting Star has now become an Inverted Hammer.
For this setup, the Long entry will either at the break of the high of the Inverted Hammer or at a close above it.
Stop Loss will be placed just below the swing low.
While this setup may not happen very often, but when it does, it can be a very good trade.
Conclusion
The Inverted Hammer candlestick is not a candlestick that gets as many setups as the other more popular candlestick patterns like the Hammer, Bullish Piercing Pattern and Bullish Engulfing Pattern.
However, when it does appear it can provide a potentially good opportunity to go Long.
With that said, do not specifically look for an Inverted Hammer on your charts just so you can trade it.
What you should be looking out for is chart patterns like trend continuation patterns and reversal patterns.
Because if you realized, the setups that I used in this post, can easily use other candlestick patterns such as the Dragonfly Doji, Long-Legged Doji, Spinning Top, and other candlestick patterns as an entry.
So remember, we aren’t trading candlestick patterns and finding chart patterns to get an entry.
But rather, we are trading chart patterns and using candlestick patterns to get an entry.
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