Chart patterns are very popular among retail investors and professional traders alike. They offer the possibility to detect abnormal price behavior that tends to produce certain results with some probability above 50%. Among popular chart patterns is an inverted hammer formation, which enables traders to detect reversals early and capitalize on market movements. In this guide, we will briefly explain what this pattern is and why you should add it to your trading tools arsenal.
Inverted hammer formation
The inverted hammer pattern is a single-candle reversal pattern that typically signals the end of a bearish trend. Its main structure consists of:
- Small real body at the lower price range
- Long upper shadow typically 2x and more of the body length
- Minimal or no lower shadow at all
The main idea behind this formation is that buyers attempted to dominate but failed as they faced strong resistance, closing near the open. The psychology behind this behavior is that bears are exhausted due to prolonged selling pressure, which depletes downward momentum. Buyers test resistance levels but lack the power to fully overtake sellers. Despite this failed attempt, this candle indicates that a potential reversal might be closer as bears were almost overwhelmed by buyers. An inverted hammer generally forms at the bottom of a bearish trend, but using only this pattern for trading decisions will lead to losses, as you need to combine it with other indicators or fundamental bias.
Bullish engulfing pattern
This is a two-candle reversal pattern. A bearish candle is followed by a larger bullish candle that fully engulfs the prior candle’s body ([open – close]). Generally forms at downtrend bottoms. The market psychology is that bears dominated initially, but aggressive buying pressure reverses the momentum, closing above the previous open. This does not include wicks beyond the body. The pattern is stronger when the volume is high. Traders should use confirmations and not use this formation as a standalone indicator for trading decisions.
Hanging man pattern
Another popular candlestick pattern is the hanging man. This is the mirror image of a hammer but after an uptrend. It also features a small body, long lower shadow, and minimal upper shadow. Hanging man signals a bearish reversal and is used to confirm the peak of a bullish trend. Key criteria include a long shadow, which is at least twice the length of the body, and confirmation is when the next candle closes below the hanging man’s body.
Confirmation and techniques
As we have already discussed, it is a very bad idea to use any pattern as a standalone indicator for trading decisions. Using other confirmation techniques is important. One such technique is a bullish or bearish candle close. The next candle that must close above or below the pattern’s high or low is considered a relatively more powerful long signal. If the pattern is confirmed with a volume spike, it is also effective. Many traders also use oscillators, and when the oscillator aligns with the pattern, they take it as a strong trading signal.
Advanced filtering methods
Here are some advanced methods for experienced traders:
- Support Confluence – When the patterns form within 1.5% of Fibonacci retracements(61.8%/78.6%) or volume-weighted VWAP.
- Multi-timeframe analysis – When the pattern is painted on several charts, such as 4-hour and daily. It was on a daily chart, and now it is painted on a 4-hour chart; there might be a potential bullish reversal soon.
- Sentiment integration – When the pattern coincides with COT or Commitments of Traders data or put/call ratio extremes (equities), then the pattern is also more reliable.
Pitfalls to avoid
Trends sometimes tend to continue no matter the patterns. If there is a bearish supercycle or a market crash, then the pattern can not be taken as a trading signal, as trends tend to continue even though there might be several bullish patterns. Generally, supercycles defy all technical and fundamental analysis. Context filters are crucial, therefore, and if you know there is a strong bearish trend due to major economic forces, it is a bad idea to trade against the market and risk money. Together with the market context, traders should also employ several indicator methods. For example, when the price closes above the inverted hammer’s high, indicators turn bullish, and volume rises; it is when traders should look closely for high-probability setups.
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