Island Reversal - Gap Trading

Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. This sudden move by a stock, the sudden change in demand, is often the beginning of a major move.

Today we are going to highlight a rare Gap situation, the 'Island Reversal'. This formation consists of;

• An exhaustion gap in the direction of the share price move.
• A tight trading range. This could be one or more candles.
  
• A breakaway gap in the reverse direction of the earlier prevailing trend.
  
• The result is a candle or candles that are left as an island
  

As the name implies, an "exhaustion" gap occurs at the end of a move. It is often referred to as the last fevered push of the bulls. Moreover, "Exhaustion gaps" are typically closed in one trading week or less. Technical analysts suggest that once the "exhaustion" gap has been closed, the short to medium-term trend has peaked.

Within an Island Reversal Formation, the more candles 'in the island', the stronger the reversal signal. This pattern is rare because the market is reversing its view on the stock.

While the Island Reversal sounds like a very important event, pragmatically, the second gap usually just produces a reversal of the previous movement. In other words, the stock, if it is a "bearish island reversal," is likely to retrace to approximately where it was when the upturn started. Note the chart below.

The Daily Chart from BHP Billiton Limited (BHP) shows all the technical criteria for a bearish Island Reversal formation. The share price has retraced back to the current medium-term uptrend. To go long from where the last candle is, the short-term trader would need to see bounce off the current uptrend accompanied by indicators, such as heavy volume, stochastic crossover, and MACD turning up. If shorting, the stock would need to break the uptrend, however as it is medium-term bullish on the chart, controlled stop losses need to be in place as going against the trend can be fraught with issues.