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.