Knowing how to spot potential reversals in the market may help traders achieve better results.

In this article, we will dive into a bullish reversal candlestick pattern: the inverted hammer.

What is an inverted hammer?

An inverted hammer is a single candle that generally forms during a downtrend and signals a potential bullish reversal.

The candlestick pattern has a small body, a long upper shadow, and little or no lower shadow. The upper shadow is typically more than twice the length of the body.

As the name suggests, the inverted hammer looks like a hammer turned upside down.

How does an inverted hammer occur?

An inverted hammer might appear at the bottom of a downtrend when selling pressure subsides with buyers stepping in.

The long upper shadow of the candlestick pattern shows buyers tried to push the price much higher but the price retraced.

Fortunately, the buyers still managed to close the session near the opening price, creating a small body on the candle. The pattern indicates the sell-off initiated by the bears may draw to an end.

In the next trading session, if the price closes above the hammer’s body with an increase in trading volume, the bullish signal might be confirmed, indicating a potential reversal of the prior downward move.

How to identify an inverted hammer?

An inverted hammer has several features that make it easier to identify.

● Downtrend

An inverted hammer is a single candle that typically forms after a downtrend. A downtrend means that the price makes lower lows.

● Long upper shadow

The candle’s upper shadow should be long, indicating that buyers tried to push the price much higher but it still pulled back. In general, the upper shadow should be more than twice the length of the body, while there is little or no lower shadow on the candle.  

● Small body

A small body means the closing price is close to the opening price. The color of the candle does not matter. In other words, it can either be a bullish or bearish candle.

● Confirmation

A bullish signal is likely to be confirmed in the next trading session if the price closes above the hammer’s body. However, once the price breaks below the hammer’s bottom, the pattern fails.

Case study

The chart below shows an inverted hammer candlestick pattern of Meta Platforms (NASDAQ: META) formed in late 2018.

The stock was in a prominent downtrend starting in late July 2018.

On the day the inverted hammer was formed, the stock opened lower at US$123.10. The selling pressure might be a continuation of the prior day’s selloff.

Then the bulls stepped in, pushing the price to an intraday high of US$129.74.

However, the price retraced much of the gain and closed slightly above the open, forming a long upper shadow and a small body.

On the following day, the price made a sharp jump and closed well above the hammer’s body, triggering a bullish trading bias.

Summary

The inverted hammer could be considered a bullish reversal candlestick pattern which generally forms during a downtrend.

The pattern might help traders to determine a potential entry point for a long trade. However, it may not work all the time.

Like other technical tools, investment decisions should not be solely based on a single indicator. The inverted hammer should be used in concert with other methods.