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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