An inverted hammer candlestick  is a type of chart pattern that often occurs at the end of a downtrend when pressure from buyers raises the price of an asset. It is named as such for its appearance resembling that of an inverted hammer in real life, with a very short lower shadow and  a long upper shadow that is more than twice the size of its real body. It signals a bullish reversal pattern where the extended upper wick indicates that the bullish traders in the market are attempting to drive the price of a security upwards. It should neither  be mistaken for the bearish shooting star pattern which occurs at the end of an uptrend nor the hanging man pattern. The inverted hammer pattern is only an indicator of a potential change in price and not a  definitive signal to invest in a particular commodity.

How do I recognize this pattern?

This type of hammer candlestick forms in response to bullish trader behaviour which causes the price of an asset to resist its downward trend and instead recover significantly over the course of a day. Downtrends occur when bearish traders dominate the market, prompting  bullish traders to attempt a recovery the following day.  In an event where bearish trader sentiments cannot rally effectively, an  Inverted hammer pattern emerges,  driving the price of an asset upwards. 

Some important indicators of this include a low that is at similar levels to the open or close, that the upper shadow is double the length of the real body with little or no lower shadow  and that there is a gap down in security price from the close of the previous day. The length of the upper shadow may be proportional to the chances of a reversal and may represent some of the risks to be considered before attempting to trade with this pattern.

 This pattern does not occur as commonly as other hammer candlesticks and care must be taken when identifying it in order to avoid confusion. Some common methods of trading in situations following the identification of an inverted hammer candlestick are through CFDs(Contracts For Difference) or spread bets. Both of these methods are derivative based and allow traders to bet on the rise and fall of security prices. 

There are certain benefits and risks involve when trading in shares after the identification of an inverted hammer pattern which are as follows :

Advantages:

  • Good Entry Points:  It is ideal to start trading on the day the inverted hammer is identified in order to reap most of the benefits of the appreciation of a security due to the bullish reversal. This is particularly true if the pattern immediately triggers a healthy upward trend in asset value.
  • Ease Of Identification: It is relatively easy to identify due to the strict criteria associated with its recognition, i.e the  proportionality between shadow and real body length as well as its location in a trend line. 

Limitations:

  • May Not Indicate Long Term Changes: While the period following the identification of an inverted hammer candlestick may lead to an upward reversal, there is no guarantee that this will last for extended periods of time. If buyers are unable to sustain their market power, the security price may head towards another downward trend.
  • Provides A Limited View Of Market Behaviour: Inverted hammer patterns are but one of a number of candlestick patterns among a wide variety of metrics used to forecast market behaviour. To simply rely on them alone without considering other indicators and prevailing conditions may lead to unfavourable outcomes.

Conclusion:

While the inverted hammer pattern may be a  good indicator of increasing buyer confidence in some cases, it is crucial to consider other technical indicators and follow certain basic principles when investing in order to avoid unfavourable outcomes. It may serve as a good entry signal in some cases. However, waiting for a confirmation signal significantly reduces the chances of maximizing returns and the conditions indicated by the pattern may or may not persist for long periods.