Island reversal pattern: gaps, confirmation and failures

What is the island reversal pattern?

An island reversal is a chart pattern in which one or more sessions are separated from the trading before them by a gap in one direction and from the trading after them by a gap in the other direction. On a chart the isolated sessions look like an island. An island top forms after an advance, with a gap up into the island and a gap down out of it; an island bottom forms after a decline, with a gap down in and a gap up out.

The island can be a single session or several weeks of trading. Classical chart analysis reads it as an exhaustion gap in the old direction answered by a breakaway gap in the new one: traders who bought the gap up into an island top, or sold the gap down into an island bottom, are left holding positions at prices the stock has since abandoned.

How to identify an island reversal

An island needs true gaps, which are defined by whole price ranges rather than by the open. A gap up means a session's low is above the previous session's high; a gap down means a session's high is below the previous session's low. A stock that opens higher and then trades back into the previous range has an opening gap, not a true gap.

1. A trend comes first: an advance for an island top, a decline for an island bottom.
2. A true gap opens the island.
3. The island sessions trade entirely beyond that gap, for one session or many.
4. A true gap in the opposite direction closes the island, in roughly the same price area as the first gap.
5. No session on either side overlaps the island's range.

Trend context: an island versus an ordinary gap

Gaps are common, and most of them are not islands. An ordinary gap moves price in one direction and is either filled or left behind as the trend continues; an island needs a second gap that reverses the first at about the same price. In the figure, the island top follows a ten-session advance of 14.5%, the kind of extended move after which an exhaustion gap is most plausible.

Location helps separate islands from noise. An island top that forms just above a prior high, or an island bottom just below a prior low, records a breakout or breakdown that failed within days. Small islands in quiet sideways trading usually say much less. See stock price gaps for the types of gaps and how they are filled.

Confirmation: the second gap must hold

The second gap completes the island, but it does not confirm it by itself. Confirmation comes from the sessions after it: for an island top, closes that stay below the island's low and leave the gap down unfilled; for an island bottom, closes that stay above the island's high. Some chartists wait several sessions before treating the reversal as established.

• In the figure, no session after the gap down trades back up to the island low of $49.10; the highest later high is $48.55.
• A session that trades into the gap without closing inside the island tests the reversal without breaking it.
• A close back inside the island's range fills the gap and invalidates the reversal.

Volume analysis for an island reversal

Volume often rises at both gaps. Heavy trading on the first gap shows the late surge that exhausted the old trend, and heavy trading on the second gap shows many participants accepting the new direction. A second gap on ordinary volume is easier to fill.

• In the figure, the first island session trades 1.6 times the average volume of the previous ten sessions and the gap-down session 1.8 times.
• CleverScan's volumeRatio field compares a session's volume with its 20-session average, which includes the current session; a value above 1 means heavier than usual.
• Inside an island that lasts several weeks, volume often fades as the move stalls before the second gap.

Failure examples: when the gap fills

An island reversal fails when price returns into the island and closes there, filling the second gap. In the hypothetical failure below, a two-session island top forms after an advance and the gap down comes on ordinary volume. Two sessions later price trades back above the island low and closes inside the island, and the next session closes above the island high as the advance resumes.

Failures like this one are why the second gap is watched rather than assumed. A breakaway gap that fills within days was not a breakaway gap after all, and the island turns out to have been a pause within the old trend.

Look-alikes: exhaustion gaps, abandoned babies and gap fills

Several gap patterns resemble an island, and the difference is usually the second gap. Ask of each one whether price left an area behind on both sides or only on one.

• Exhaustion gap alone: a late gap in an old trend without a matching gap back. It can mark the end of a move, but without the second gap there is no island.
• Gap and fill: a gap followed by trading back through it in the following sessions, with no gap on the other side. Price returned rather than leaving the area behind.
• Abandoned baby: the candlestick version of a one-session island, in which a doji star gaps clear of the candles on both sides; see the morning star guide.
• Opening gap only: a session that opens beyond the previous close but trades back into the previous range. It leaves no true gap, so it cannot isolate an island.

Research checklist and gaps to inspect

TradeClever does not detect island reversals, but CleverScan can list recent gaps worth inspecting on a chart. The rule below keeps stocks whose latest session opened at least 3% below the previous close and never traded back up to it during the session.

securityType = "Stock" and gapPct <= -3 and high < previousClose

1. Open the stock in Stock Charts with a 3M range.
2. Find the gap that started the island and confirm that both gaps are true gaps between session ranges.
3. Mark the island's low and high.
4. Compare volume on both gaps with the recent average.
5. Track whether the second gap stays unfilled over the following sessions.