Inverted hammer is a bullish reversal candlesticks pattern. It is the opposite of shooting star. In order to provide valid signals a downtrend must be in place before the pattern occurs. The inverted hammer can be either color, green or red. Bellow follows its graphical representation.

After a price decline and a gap down a candlestick is formed which has a long upper tail and a small body. This is the first sign that buyers are starting to react after a period of aggressive selling.

Trade set up using inverted hammer

In DHR daily chart (below) we can spot an inverse hammer in the circled area. The pattern is formed after a steep decline in a support zone that price is visiting for the first time, so the probability of a reversal is the highest possible. Preferably, in order to augment the possibility of success we want the market to be also in a midterm uptrend or forming at the same day a bullish candlesticks pattern after visiting for the first time a support level.

If we open a long position we can put the stop loss order below the low of the inverted hammer. We don’t want to put it below the support zone because in that case we risk much more money. Furthermore, if the price the next day doesn’t succeed to open and continue higher, then the signal we got from the candlesticks pattern is probably false, so we don’t want to be in this trade any more. Notice that the inverted hammer allows small stops and this is a great advantage.

In case that someone is opening a position using only the criterion of support, then he/she could place the stop under the support zone, although the non confirmation of an inverted hammer like the one above, is a sign that the support is not strong enough to provide a descent reversal. So, many times it is the entry strategy that defines where the stop should be placed.