The inverted hammer described as a single candlestick form but to use it, you have to use it like a morning star, which is an upward reversal figure composed of three candlesticks.
The 2nd candlestick, the star itself is here an inverted hammer. This upward reversal figure is less powerful than a morning star.
The elements that characterize it are:
- The inverted hammer should appear after a downtrend.
- The 1st candlestick must have a red body.
- The 2nd candlestick should form an inverted hammer, preferably draw a bearish gap and ideally have a green body.
- The 3rd candlestick should, ideally, trace a bullish gap and has a large green body.
Such a pattern appears after a downtrend, the day after losses happened, when prices open gap down, then rise and fall again before finally closing at almost the same level as they opened. The day after, prices open gap up and rise to win back most of what was lost in the 1st gap. This confirms the pattern and the major force is now bullish.
Note that the inverted hammer is a figure less powerful than the morning star because the 2nd candlestick, the inverted hammer, prices open at their lows in the 2nd candlestick which is the Inverted Hammer, they then rise and fall again which shows that the bulls are not strong enough yet. The body of the Hammer should preferably be green as this shows that the bears have not been able to make prices go down to their lows. A red body is still acceptable though.
The bigger the 2nd gap, the more significant the figure. Large volumes on the 3rd candlestick will also come in confirmation of the figure.
The inverted hammer is a less powerful figure than the morning star, but it is worth paying particular attention to the validation of the figure if it does occur, or if other technical bullish signal strengthen it, it could lead to purchases at J+2 (J being the day of an inverted hammer and J+1 that of the light green one). The threshold for invalidation may be placed either below the lowest structure formed or under the second gap formed.
On the other hand it is interesting to combine the observation of reversal figures with the lines of support and resistance. An inverted hammer can sometimes form at the level of support and even momentarily cross it without invalidating it (as is the case in the example with 4500 pts) and then give rise to an upward reversal.