The Inverted Hammer signal is found at the bottom of a downtrend.
In order for the Inverted Hammer signal to be valid, the following conditions must exist:
The stock must have been in a definite downtrend before this signal occurs. This can be visually seen on the chart.
The Upper shadow must be at least twice the size of the body.
The day after the Inverted Hammer is formed, one should witness continued buying.
There should be no lower shadow or a very small lower shadow. The colour of the body does not matter, but a white body would be more positive than a black body.
The following Figure shows an Inverted Hammer formation. This is one of the reversal signals which seems contradictory to its use. The Inverted Hammer signal signifies the downtrend may be over. However, the candle itself (with its long upper shadow) seems to imply that the bears are still in control. The key is to see who controls the stock on the following day. If the stock closes with a good bullish candle, the bears will give up. Imagine from a bear's perspective. You are short the stock and everything is fine until it keeps going down. Then one day, the bulls charge and take the stock up intraday. You start to panic, but breathe a sigh of relief towards the end of the day. However, upon seeing the perseverance of the bulls on the following day, you will be prudent to cover your shorts.
Notice the Inverted Hammer in the chart of AMGN, Inc. People familiar with technical analysis will immediately see the Double Bottom formation. The Inverted Hammer in this case confirmed the Double Bottom.The stochastics were below 20 indicating oversold conditions for the stock. The day following the Inverted Hammer, the stock gapped up and formed a bullish candles. Smart short sellers will get out at this point as the bulls take over.
Chart courtesy stockcharts.com
Notice the Inverted Hammer in the chart of RELCAPITAL. Where do most investors sell? At the bottom! After a long downtrend, when the deflating price becomes unbearable, investors gapped the stock down. By the end of the day, the stock formed an Inverted Hammer formation. The following day, bulls came back in confirming the candlestick signal and providing an excellent entry for the long side.
Chart courtesy icharts.in