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| Inverted
Hammer Candle |
THIS CANDLE INDICATES THAT THE
SHORTS MAY BE READY TO COVER
Below you will find an illustration of the "inverted
hammer" candlestick:
If you are a regular Swing Trader
reader, then the inverted hammer should seem very familiar. However, you
may not be able to put your finger on exactly why it looks so familiar.
The reason is that the inverted hammer is identical in
appearance to the shooting star, which we discussed in our December 8th,
2003 Swing Trader issue. The difference is that the
shooting star occurs at the end of a long uptrend. The inverted hammer,
on the other hand, occurs after a significant decline has taken place.
If you examine the inverted hammer carefully, it
hardly looks like a bullish candle. Prices opened low and then rallied
strongly. By the close of trading, however, the stock has given back
almost all of the day's gains. That leaves a small real body and a very
large upper shadow. If anything, the candle looks bearish. The bulls
could not sustain a rally, so the bears took the stock back toward its
lows for the day.
So, why should this candle potentially set up an
important reversal? My theory is that the inverted hammer is a signal
that shorts are beginning to cover their positions.
Here is my reasoning. Since the inverted hammer can
only occur after a sustained downtrend, the stock is in all probability
already oversold. Therefore, the inverted hammer may signify that shorts
are beginning to cover. In addition, traders who have held long
positions in the security, most of whom are now showing large losses,
are often quick to dump their shares by selling into strength. This will
also serve to drive the stock back down.
With this candle, it is imperative to watch the next
day's trading action. If the stock opens strongly and remains strong
during the day, then a key reversal is likely in progress.
The chart of Conceptus (CPTS) below shows an example
of an inverted hammer as a symptom of short covering. The company is a
small-cap manufacturer of permanent, implanted birth-control devices. In
its current fiscal year, the firm is projected to lose $1.83 per share.
In July 2003, the stock traded at over $18. On Tuesday, February 10th it
hit bottom at $8.89 a share. That's certainly not a stellar performance
given that we've been in a roaring bull market!
CPTS reported earnings on Wednesday, February 11th and
lost 41 cents a share, a penny worse than expected. By all
rights, it seems the stock should have gotten creamed. No way! Instead,
the shares gained 99 cents on the day, or nearly +11%. Meanwhile, volume
was approximately double the daily average. The candle was the largest
white candle in months and engulfed approximately the last 15 days of
trading.
What's going on here? The shorts are almost without
doubt covering. The float of shares available for trading in CPTS is
18.7 million, and according to recent data, traders held 7.57 million
shares short, or approximately 40% of the firm's available shares!
Virtually all the shorts that took positions since mid-January are now
under water and are likely feeling pretty uncomfortable. That may drive
prices higher yet.
Technically, there are many interesting features to
this chart. Bullish divergence exists in all three indicators shown,
including MACD, RSI and stochastics. That divergence provided an early
warning signal that the stock's downward momentum was waning, increasing
the odds of a reversal. On Thursday, February 12th, CPTS also went
almost from one end of the Bollinger band to the other. If the stock can
move outside its Bollinger band, then it would give a bullish
continuation signal.
CPTS has risen above its downward 30-day moving
average and is now testing its 50-day moving average. Stochastics has
just given a buy signal and RSI has penetrated the 50-line. With 7
million shares short, it appears the stock can head higher still.
Not every inverted hammer will tune you in to this
kind of short-covering situation. However, when you do see its
appearance on a chart, then I suggest you do two things. First, check
the short interest in the stock. Second, if that short interest is
substantial, then follow the stock closely the next trading day.
Recognition of the inverted hammer may help you build market-beating
profits.
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