Using Island Reversals in Technical Analysis Charting

12/25/2015 6:00 am EST

Focus: OPTIONS

For the benefit of all technicians just starting out or in need of a refresher, James Brumley, of BigTrends.com, discusses island reversals and explains that—while true island reversals marked by gaps are rather rare—they have a relatively successful track record as a buy or sell signal.

Candlestick Chart Analysis: Island Reversals

Island reversals are a pattern on technical analysis chart that frequently—due to their abrupt and decisive nature—successfully mark a turning point for that stock or index. Generally speaking, they are marked by a small cluster of bars that are completely isolated from the bars leading up to the first bar and then the bars leading away from the second bar of the pattern. This isolation comes in the form of daily trading ranges of the bars in question that don't overlap with any of the bars leading into or away from the cluster's trading range...giving the appearance of an island, unattached to any other body.

Examples will better illustrate the predictive power of island reversals.

On the chart of PulteGroup (PHM) below, we can see a firm rally was abruptly halted and reversed, with a bigger pullback successfully marked by the third bar of the island after the subsequent bar gapped lower the next day. Though it didn't last long, the island reversal that began and ended with a bullish and bearish gap, respectively, gave fair warning of a sizable stumble.

PHM Daily Chart

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The example above required three bars to complete the island reversal. With that in mind, it's important to note there is no typical number of bars that make up an island. In fact, sometimes the spirit of a reversal effort must be interpreted rather than adhering to the hard-and-fast definition of an island reversal.

Here's another example of an island reversal, this time in a bullish direction. FirstEnergy (FE) pulled back in a major way, but once that weakness was reversed—beginning with a big jump that left a bullish gap behind—the buyers didn't look back.

FE Daily Chart

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Click to Enlarge

It's worth noting that true island reversals marked by gaps are rather rare, though have a relatively successful track record as a buy or sell signal.

By James Brumley of BigTrends.com

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