Island Reversals are part of price gap structures, and form when prices are isolated by gaps on both sides of the price rally or price decline. In an extended rally, price rallies above the prior sessions close and form an upside gap. After few sessions, a downside gap is formed to close below the prior sessions close. This isolation of price-range forms an Island Reversal setup, which usually signals much larger technical declines in bullish trends, or rallies in bearish trends.

Most Island reversals are usually news driven events. Volume should be at higher levels on both sides of the gaps. It is very rare to see an Island Reversal pattern in the middle of a rally as they reverse the prior trends after the second gap.

Trade: After a reversal, enter a “short” trade (for uptrend) below the low of the second down gap. Or, enter a “long” trade (in a down trend) above the high of the second gap up.

Stop: Place a “stop” order if the market closes above the high of the “Island Reversal” pattern for shorts, or if it closes below the low of the Island Reversal pattern for longs.

Target: Island Reversals usually are very profitable as they signal a weakness in the current trend. Targets are placed near key event driven support or resistance levels.

Trading Island Reversal

Trading Island Reversal Pattern

The chart above illustrates an Island Reversal pattern from Amgen’s (AMGN) daily chart. During 2006, AMGN rallied to $76 and reversed to $56 by April of 2007. Late January 2007, AMGN showed its first upside gap and closed at $76. Within the next few sessions, AMGN closed the first gap and formed a downside gap to complete an “Island Reversal Pattern.”

  1. Enter a “short” trade one tick below the low of the second gap bar.
  2. Place a “stop” order above the high of the bar prior to the gap.
  3. Target a major “swing low” prior to the rally.

Trading Island Reversal

Trading Island Reversal

The example above illustrates an Island Reversal pattern in Broadcom (BRCM) daily chart. In March 2003, BRCM gapped down at $10 price level and traded for few bars lower. Late April 2003, BRCM reversed its downtrend and traded higher with gap closing above the previous downside gap. This scenario created an “Island Reversal” pattern and provided a “long” trade opportunity.

  1. Enter a “long” trade above the Gap bar’s high at $1 1.
  2. Place a “stop” below the low of the Gap at $9.75
  3. Place a “target” near a major “swing high prior to the downside gap.